This is the long “awaited” last part of my five part series on Investing Basics. I last covered Mutual Funds I would not even categorize options or futures as basic. I personally do not invest directly in futures (at least not in my home portfolio). I dabble with options. Most people, I would think, can skip these and other derivative investments and be more than OK.

Both options and futures are considered derivatives. Warren Buffet has called derivivatives financial weapons of mass destruction. Of course, these are weapons that Mr. Buffet enjoys stockpiling. While it may seem on the surface inconsistent that Warren would slam derivatives one day, and praise their use the next, Berkshire Hathaway use of derivatives is completely consistent with it’s role as one of the largest insurers and re-insurers in the world. Selling insurance is not too different from selling options.

So what are derivatives? Derivatives encompass wide variety of financial products. Options, futures (forwards) and swaps constitute the vast majority of derivatives. Derivatives all have one thing in common. They are nothing in themselves. The value of any derivative contract is tied to the value of a real underlying product. In the case of stock options, the value of the option is directly tied to what a particular stock trades at. In this regard derivatives are the most akin to gambling. When you make a bet, the bet itself doesn’t have any intrinsic value. Rather the value is in the cards that are played, or who wins the basketball game. The bet is secondary to the actual event.

Options
So what is an option? An option is exactly what the name implies, it gives the owner of option the opportunity to buy or sell at a given price. A call option grants the right to buy, and a put option grants the right to sell. While a share of stock only really has one attribute – price, an call option on particular stock has number of attributes.

  • Price
  • Strike Price: The price at which you have the right to buy the shares – can be below or above the current stock price
  • Expiration Date: The date on which option become invalid.

    • There are two types of option expiration conventions, European and American. American options can be exercised on any date before the expiration date, and European options only on the expiration date. In practice, there is nary a difference as there’s almost no reason to ever exercise an option before expiration. By excercising an option, you’ve basically given up the value of the “option” to exercise.

    Below is chart of example value of call option with a strike price of 20 given the trading value of the underlying stock.


    An option will never be worth less than 0, and at all points should have some value reflecting the option premium, and the intrinsic value. For example if the stock is trading at 20 and the strike price is 20, the option premium might be $2. $2 reflect the value of having the right to buy the stock for $20. The intrinsic value at that time is 0 because there’s no value in exercising the option to buy at $20 when the stock can actually be had for $20. However if the stock were to move to $30, then the intrinsic value would be $10. I could use my option buy the stock for $20, and turnaround and sell it for $30 – instant $10 profit.

    Futures
    Futures are standardized forward contracts. Forward contracts have two of the same components as an option. 1) Price 2) Date. Unlike an option a forward contract is an obligation to transact at a certain price. In many regards an option is modified forward contract. A future is a forward contract in standard form and can be traded on an exchange. For example oil futures that are traded on the New York Mercantile Exchange have given specifications for method of delivery, quantity, and the type of product.

    So a if I were to buy an oil future for $200 a barrel with a delivery date of June 2009, in June 2009 I would be obligated to pay $200 a barrel even if oil prices at the time were $50. Forward and future contracts developed originally in the agricultural world to allow producers and users to get price certainty for goods that would be delivered later. Many companies such as Airlines still use futures to hedge future uncertainty, but there are just as many investors who buy and sell futures purely for financial reasons.