How to Invest in Futures & Options

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Research Your Investments Carefully
Research Your Investments Carefully (Image: http://www.sxc.com/gunnar3000)

Investing in futures and options is really a series of consecutive trading positions. This is because futures and options have regular expiration dates that cause the trader to close existing positions at expiration and open new positions at longer expiration dates. Traders must always be aware that they are trading a leveraged proxy for a more valuable underlying security such as oil, gold, stocks, bonds, or agricultural products.

Understand that options and futures both represent underlying stocks, commodities, or indexes. Options and futures have expiration dates and trade at a premium to the value of the underlying assets. That is because instead of putting up cash for the underlying asset the investor only puts up a good faith deposit and is liable for the balance. Premium declines in value over time so that at the time of expiration the security trades near the underlying security value.

Because futures and options are leveraged investments there is risk separate from the underlying asset. This is called volatility. Volatility represents the daily difference between the high and low price of the stock. Volatility disguises the underlying direction of the stock. Volatility raises premium levels necessary to realize the increased risk of the future or option.

Trade successfully by having a money management and trading strategy to minimize risk. Money management requires that risk is systematic and kept to a small loss per trade, often less than than 2% of the total portfolio size . Professional traders manage risk by trading stocks and commodities together in order to add diversification. Money management is the single most important skill a trader must have. No trading strategy can work without sound money management to control diversification and volatility and to build confidence in one's plan.

Trading strategies involve one of three general themes. Trend following is an intermediate strategy of following the general trend, both up and down. Hedged trading involves the purchase of a security and the sale of a call or option in order to collect the time value of the premium. Pattern recognition requires familiarity with technical analysis and the statistical probability that certain chart patterns will result in bull or bear moves.

Futures and options are difficult to trade since they are always trading with respect to their premium and the price of the underlying security. Because of the large amount of leverage, traders should not really consider trading anything but the smaller contracts called "mini-contracts." Minimum capital should be $25,000 but more is recommended. Experience in trading stocks and bonds is strongly recommended as is a written complete trading plan that the trader will employ.

Tips & Warnings

  • Consider simple trading strategies such as covered calls to become familiar with options. Covered calls provide for the investor to buy a stock and sell a future or option on the stock in order to collect the time premium. It is a considered a low-risk hedged position.
  • Paper trade or practice trading your investment strategy over different time frames and during both bullish and bearish markets.

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