The Basics on Getting Started

WHAT ARE FUTURES AND OPTIONS? WHY DO THEY EXIST? AND JUST WHO TRADES THEM, ANYWAY?

A futures contract is just what it's called - a contract. It is not equity in a stock or commodity. It is a contract - a contract to make or take delivery of a product in the future, at a price set in the present. If you agree in April with your Aunt Sue that you will buy two pounds of tomatoes from her garden for $5, to be delivered to you when they're ripe in July, you and Sue just entered into a futures contract.

In formalized trading of futures contracts on exchanges, standardized agreements specify price, quantity and the month of delivery. Futures markets have their roots in agriculture, but today futures and options on futures are traded on a wide range of products from wheat to natural gas to stock indexes, precious metals and currencies.

Options on futures can be thought of like insurance. An option buyer (the insured) pays a premium to an option seller (the insurance company) for the right to buy or sell a futures contract at a specific price. However, just like with insurance, the option buyer may or may not exercise his right (use his insurance).

Why do futures and options markets exist? Two reasons: risk transfer and price discovery.

Professionals such as grain merchants, energy firms and portfolio managers use futures and options to reduce the risk to their business associated with volatile prices. For example, a flour miller might use a futures contract to set a price now for wheat that he knows he will need to purchase in the future, rather than face the chance that prices could be even higher when he buys the wheat. Similarly, a natural gas producer might use a futures contract to set a price now for gas he will sell in the future, locking in a profit rather than being exposed to the possibility of lower prices. These types of futures and options users are known as hedgers, and are in the market specifically to reduce risk

People who assume risk take it on in exchange for the opportunity for profit. Thus the futures and options markets serve the important function of risk transfer.

Futures and options markets also provide the economy with price discovery. Futures prices are determined by supply and demand. An exchange itself does not set prices; it simply provides a place where buyers and sellers can negotiate. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. The prices discovered through futures markets offer valuable economic information about supply and demand in a competitive business environment.

An added economic benefit of using futures and options markets for many investors is lowered transaction costs. For example, someone interested in investing in Internet stocks can in one transaction purchase a Kansas City Board of Trade ISDEX" Internet stock index futures contract representing 50 stocks, rather than buying and paying a commission on each stock separately in 50 different transactions.

HOW DOES TRADING FUTURES WORK?

Similar to stocks, gains and losses in futures trading are the result of price changes. If you have sold a futures contract, your trade will show a profit if prices fall. If you have bought, higher prices will produce a profit. To make a profit on a futures trade you can first buy low and then sell high, or reverse the order and sell high, then buy low.

It is important to understand losses may be highly leveraged. This means that if the price moves in the direction you anticipated you could realize large profits in relation to your initial investment. Conversely, if prices move in the opposite direction of what you anticipated, you could realize large losses in relation to your initial investment.

Options on futures are different from futures themselves in that the most a buyer can lose is the cost of purchasing the option, known as the premium, along with transaction costs. An option seller, however, has unlimited risk. Think of the insurance example we used earlier. The option buyer is like the insured and is paying only the insurance premium for his protection. The option seller is like the insurance company and is taking on unlimited risk in hopes that he can collect the premium and the insurance will not be used.

Should an investor decide to participate in futures or options trading, just as with stocks, there are a number of factors to consider. Similar to trading stocks, in futures you can trade your own account - with or without the recommendations of a brokerage firm. Another alternative is an account that is still your individual account, but you give someone else written power of attorney to make and execute trading decisions on your behalf. You can also choose to use an individual or firm that for a fee provides advice on commodity trading. Yet another choice is to participate in a commodity pool, similar in concept to a stock mutual fund. Your money is combined with other participants and traded as a single account, and you share in profits or losses in the pool.

Just as with trading stocks, before you can start trading futures you'll need a registered broker. This may or may not be a person who also trades stocks, but it must be a person who is licensed to trade futures. Just as with any other financial endeavor, we urge you to feel comfortable with all aspects of your relationship with a potential broker before entering into a business arrangement.

Again, as with trading stocks, when you apply with a broker to open an account, you can expect to be asked to provide information on topics such as your income, net worth and investment experience. At a minimum, the person or firm that handles your account is required to provide you with risk disclosure documents or statements specified by the Commodity Futures Trading Commission and obtain written acknowledgement that you have received and understood them.

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Marin Financial, The risk of trading futures and option can be substantial. Past performance is not necessarily indicative of future results. Each investor must consider whether this is a suitable investment. Current known news may already be factored into the market. By accessing this information you are acknowledging your understanding and consent to the foregoing. Please read the Privacy Policy and Disclosure