Excesses in this area, especially related to home mortgages, have been blamed for market collapses in 2008 and have tied the word "derisive" to derivatives in many minds. But most traders cannot hold barrels of oil or bushels of soybeans or bars of bullion. They do not want to be merchants but are only interested in speculating on changes in price in these markets.
Buyers of individual stocks actually own a piece of a company, or they can buy bonds to loan money to a company. Those interested in stocks can also trade sectors or baskets of stocks in derivative instruments such as mutual funds, which gained prominence in the 1960s and 1970s; index funds, introduced in the early 1970s, or exchange-traded funds (ETFs), launched in 1993.
For those interested in a little more action, other derivatives such as futures or options offer more potential profit - and more risk, as well. They won't fit everyone but offer an attractive alternative for anyone who wants to be an active trader.
Whatever the instrument, it is advisable to look for contracts that (1) are traded on a centralized exchange governed by exchange and government regulations, (2) have close ties to its underlying "cash" or "real" market, (3) are sized appropriately for the size of your account, (4) have a history of sufficient price movement to create profits, (5) have adequate volume to provide smooth in-out liquidity and (6) trade in a transparent setting with price quotes and information available to all parties.
Key features of futures
Although sometimes associated with "gambling" or "gunslinging", futures serve a real economic purpose. They are a means of price discovery as traders worldwide establish a value for a market with a bid/ask process, and they can be used to transfer risk from someone who has it to someone who is willing to assume it.
In markets, risk exists; futures traders are only speculating that prices will move in their favor. In gambling, risk does not exist but is created by the turn of a card or roulette wheel.
Everything is standardized in a futures contract - the amount of the underlying market involved, the expiration date in a given month, the exact grade or quality of the underlying market, the precise means for settling a contract, etc. A futures trade is a temporary replacement for a future transaction in the underlying market unless the contract is offset prior to expiration. Therefore, time is a key consideration in futures - that is, if you expect a price movement to occur, it must happen before the contract expires.
The major benefit of futures is leverage. To trade a futures contract, you must post a minimum "performance bond" or "good-faith deposit" - the futures industry term for what is called "margin" in stocks. This amount may be as low as 3%-5% of the value of the futures contract, depending on the market and trading conditions. The purpose of this bond is to assure that the terms of the contract will be fulfilled to protect the integrity of the market.
Here is what leverage can do:
o Futures contract valued at $100,000, buy at 100, deposit of $5,000 (5% of value)
o Market rises 10% to 110, gain of $10,000
o Return of 200% on initial deposit
But keep a couple of things in mind: The amount of a deposit may preclude a trader from participating in a market, depending on the size of the account, and - MOST IMPORTANT - the market could also go down, wiping out your account. Leverage is a two-edged sword in futures.
Futures do offer several other benefits:
o You can go short as easily as you can go long, anticipating a price decline. Yes, you can sell something you do not own, using the same deposit requirements.
o Futures transactions are a fast, efficient way to get in or out of a market.
o Futures can provide insurance, actually decreasing speculation by protecting against adverse moves in a stock portfolio, for example.
o The cost of a futures transaction is very low for sizable positions.
Key features of options
Options have become a popular trading vehicle since being introduced on individual stocks in 1973 and on futures in 1982. Like futures, they are a standardized contract, a temporary replacement for a future transaction, time is critical and exchanges regulate performance. But there are distinct differences between option buying and selling, and you can't talk about options without knowing terms like volatility, calls, puts, premiums, strike prices, etc.
For option buyers, the key benefits are leverage - even greater than in futures, in some cases - and limited risk with unlimited profit potential. The downside is that options are a wasting asset and lose value due to time decay, increasingly so as expiration nears.
Few financial instruments offer as much flexibility as options, which can be tailored with stocks or futures to views from very bullish to neutral to very bearish. They can provide protection for an investment portfolio, add incremental income on underlying market positions, allow positioning at better prices and can be incorporated into many different strategies.
Options do add another layer of analysis to a market, and prices may be subject to sharp changes in volatility.