Buying Stocks 101

Lately, there has been much in the press about futures markets - mainly negative press relating to oil markets. While, the futures markets have to shoulder some blame for the steep escalation of gas prices in 2008, that serves to underscore just how important they are to our capitalistic economy. Futures markets provide the foundation for wholesale prices, and ultimately retail, of just about every commodity regularly sold around the globe. And futures aren’t just about commodities; they involve stocks, bonds, and other mainstream investment vehicles as well.

So what are futures?

Simply, a future is a contract, referred to as a futures contract, and is held similar to a stock or a bond. But where a stock and bond represent equity and debt respectively, a futures contract sets the terms or conditions for delivery of financial instruments or commodities at a specified time in the future.

What is the difference between Options and Futures?

It is easy to confuse futures with options. Both are contracts, and both reference a specific asset being traded. But where a futures contract gives the buyer the obligation to purchase a specific asset, an options contract gives the buyer the option or the right to purchase that asset. Similarly, a futures contract obligates the seller to sell an asset at a specified future date, unless the position has been closed prior to the date of expiration. Another difference between futures and options is the cost of entry. An investor can enter into a futures contract with no cost upfront aside for brokerage commission, whereas an options position requires the payment of a premium. Think of it like this: no cost upfront for futures but you are obligated to buy or sell; a premium payed upfront for options but you have the option to buy or sell. The premium gets you out of the obligation. One other point is that futures are generally sold in larger positions than options.

What are some details about Futures?

Before trading futures, you need to understand some of the fundamentals. Futures contracts expire, meaning they cease to exist unlike buying stocks or bonds, so you are forced to make a decision: sell the contract to someone else and take your profit or loss or take delivery of the product represented by the contract. Also, futures contracts have daily price limits, meaning that they can only go so high or so low in a given day, due to the natural volatility of this type of security. Lastly, most brokers require that any investor trading in futures have a certain amount of money in their brokerage account, usually around $5,000. Again, this is due to the risk of trading futures contracts.

Are there any terms I need to know?

The futures market has it’s own language. Going Long means you believe the price of the underlying asset is going to rise, and therefore are investing in futures contracts on that asset. Being short means you believe that the price of the underlying asset it going to go down, and so you shorting futures contracts on the asset. Speculators are traders who are trying to make money due to the fluctuation of prices, but never intend to take delivery of the asset itself. Hedging is a technique used to manage risk, where you set up a trade that protects you if the market goes either way. Most of these topics require a post all to them selves so it would benefit you to do some additional research before tackling the futures market. Buying stocks and bonds is one thing; buying or selling futures and options is a whole other dimension of investing.

For the novice investor, stock options tend to garner one of two emotions: lust or fear.  On one side, you have those who have been warned to never trade options because they are perceived to be too risky and difficult to master.  One the other side, there are those who view them with awe and burn to understand them, fueled heavily by traveling stock gurus on the seminar circuit.  But Options are just another tool in your investment arsenal, and every serious investor should educate themselves on how and when to use them.  To that end, I will unpack the basics of stock options and hopefully provide a launching pad for further exploration or experimentation.

What is an Option?

At its core, a stock option is a contract between a buyer and a seller which gives the buyer the right to buy (call) or sell (put) an asset (usually a stock) on a set date in the future at an agreed price.  An option buyer has the RIGHT to buy, but not the obligation.  An option seller has the OBLIGATION to sell.  So what does the seller get?  In return for granting the option, the seller collects a payment (called a premium) from the buyer.

Types of Options

There are two types of options: calls and puts.  A call option gives the buyer the right to buy the asset under the terms of the contract.  If the call is excercised, the seller MUST sell to the buyer at the agreed upon price.  A put option gives the buyer the right to sell the asset under the contract terms.  If the put is excercised, the seller of the contract MUST buy the asset from the buyer at the agreed upon price.  But either way, the buyer has the choice of whether to excercise the option to buy or sell, or simply let the option expire.

Basic Stock Option Trades

In American-Style stock options, there are four basic trades which form the bulk of option transactions.  In the U.S., one option contract usually represent 100 shares of the underlying security.

Long Call

When an investor buys a call option on a stock expecting that the stocks price will INCREASE, this is known as a long call.  If the stock price upon the date of expiration of the option contract is above the strike price by more than the premium paid for the contract, then the investor will make a profit.  If the price doesn’t go up that much, he would just let the option expire and only be out the money he paid for the contract.  An investor may buy an option for the security instead of the security itself because he could buy more options than shares, and thus have a higher potential gain.

Long Put

An investor who believes a stock will DECREASE, might buy the right to sell the stock at a fixed price.  If the price at expiration is below the strike price by more than the premium paid for the contract, then the trader will profit.  If not, he only loses the premium.

Short Call

If an investor believes a stock will DECREASE, he might choose to sell (or write) a call.  If the stock price decreases, the investor will profit by the amount of the premium paid by the investor who bought the call.  If it increases over the strike price, he will be obligated to sell to the call buyer if the buyer exercises their right to call.

Short Put

On the other hand, if the investor believes the stock price might INCREASE, he might sell a put.  This means that if a stock goes down below the strike price, he would be obligated to buy the stock from the put buyer if he exercises his option.  But if the stock price is above the strike price when the contract expires, the investor will make a profit in the amount of the premium.

Summary

Understanding stock options isn’t a subject that can be fully covered in a short post like this one.  But, like buying stocks, once you grasp the basics mentioned here, you will have enough knowledge to start to investigate some of the option strategies which make the risk and reward much more interesting.