One of the terms you may have caught on various financial forums or magazines is the use of the term “option futures.” This is an investment vehicle that the experienced investor can use to keep their portfolio valuable even in a fluctuating market. To understand what they are though, you need to know some underlying concepts.
Most people have a portfolio with a mixture of stocks and bonds in it. In a few cases, the investors may have thought about adding options to their portfolio. An option is a financial instrument that allows the investor to sell a security at a specified price by a certain date.
For example, you can buy an option to sell 100 shares of XYZ Co at $100 per share by March 31. If you see the price of XYZ Co stock down to $90, you can choose to exercise the option and sell those 100 shares at $100 apiece. You pocket the $10 profit on each of those shares. However, if you do not exercise the option before March 31, you do not gain anything from the transaction. This is an instrument often used to hedge the bets against a volatile market.
What are futures? Futures are contracts where one party agrees to buy an asset from another party in the future at a specified price. The investor is hoping that the value of the asset will be higher in the future than the specified price of the future. Examples make this concept a bit easier.
Let’s say that today you get a futures contract on gold at $1500 per ounce for 100 ounces. The future will come due on December 31. You know the price of gold if fluctuating all over the place. When you buy that future, you are betting that the price of gold will be higher than $1500 on December 31. When December 31 arrives, you buy the gold for $1500 per ounces for 100 ounces. If the price is $1600 per ounce on December 31st, you are automatically $100 richer per ounce. If the price is $1400 per ounce on that day, you are down $100 per ounce.
Now bring those two concepts together for option futures. When you buy an option on futures, you purchase the right to sell futures at a given price by a certain date. So, if you own an option on those 100 ounces at $1500, you can exercise it on or before the December 31st date, depending on the value of the gold.