Futures Offer a Fast and Liquid Market

Options on futures. In some ways, they just about replicate the "Regular
Stock Option Experience" but there are some really profitable ways to use
futures if you know what to look for. All options give you the right, but not
the obligation, to buy (if calls) or sell (if puts) a specified quantity of some
underlying instrument. An option on a stock or exchange-traded fund is quite
simple in this regard. Say in mid-July you owned 1 August 135 call in SPY the
SPDR S&P 500 ETF (NYSE: SPY ) that tracks the S&P 500 Index. The SPY was
one-tenth the value of the S&P 500, so it would be trading around $135 if the
index was near 1,350. As a call option owner, you had the right (but not the
obligation) to buy 100 shares of SPY at $135 sometime between mid-July and
August expiration, which occurs at the close of the third Friday of August (Aug.
19 this year). Obviously if SPY closed above $135 on expiration, you would have
exercised your right to buy SPY at $135, or you might sell your call. Given the
market's turmoil, however, you would have let your call expire without acting
on it eating your fee, but not wiping out your portfolio as the SPY crashed as
low as $112 in August 2011. A SPY call, or a call on anything for that matter,
has a nice risk/reward backdrop. Your gains are theoretically boundless, whereas
your losses are limited to the amount you paid for the call. This gets into two
important distinctions of being long an option and being long the stock or ETF.
First, options are cheaper than the underlying, giving the holder greater
leverage. Second, the careful holder can get in and out of his position without
taking ownership of the underlying security. There are a number of trading
vehicles linked to the S&P 500 Index because of its influence and popularity.
One of the most active is CBOE S&P 500 Index Options (CBOE: SPX ). The SPX is 10
times the price of the SPY. In many ways, SPY tracks SPX, and the two pretty
much move exactly in line. If SPX moves up 10 points, SPY moves up one, and if
SPX drops 10, SPY drops 1. The F utures Advantage But the options on SPX are
very different from the options on SPY. They are futures options, and here's
the advantage of this product over standard options: Instead of getting delivery
of a stock (or basket of stocks in this case) you theoretically get delivery of
the corresponding SPX future. Except the future itself simply cash settles. So
if you had owned 1 SPX August 1350 Call, and SPX closed above $1,350 say $1,355
you would have collected the $5 cash difference. You need no extra money to
settle the SPX call and you have no residual position once SPX expires. In
contrast, if you had exercised that SPY August 135 Call and taken delivery of
SPY, you would have needed to put up the bucks to own the basket of stocks in
the index, or more precisely, the percentage of stock that each makes up of the
S&P 500 Index. That might be a choice for an institutional investor, but few of
the rest of us are interested in that. (Just to be clear, few SPY options
traders decide to take delivery but instead sell their profitable long position
and pocket the profits.) One solid resource for futures products is the CME
Group , the exchange that lists many of the most liquid futures products. It
products include futures on metals , a slew of energy and oil products , foreign
currencies and interest rates . The Futures Negative The pitfalls for retail
investors around any cash-settled option like SPX often come back to settlement
and expiration. For instance, SPX options stop trading on the close of Thursday,
then settle on the open of Friday, so you run the risk of a market move between
Thursdays close and Fridays open. This can work against or for the investor,
depending on the move, but you are left somewhat helpless overnight. SPX futures
and options settle on the opening print on expiration Friday. This is a
calculated price based on the opening quote in each of the 500 stocks that
comprise the index. This is another unpredictable number that can work for or
against the investor. To me, these are both outsized bets on a rather random
outcome one I would never make. I would close out before the options stop
trading and let someone else roll the dice. Testing the Waters Keep in mind this
article is just one narrow comparison of futures to regular options. Futures
options come in many shapes and sizes and have all sorts of unique mechanisms.
As a general rule, it comes down to the terms of the futures themselves. If
it's gold and the future gives you delivery of a troy ounce of gold somewhere,
so will the options on that future. These trading products are all pretty
unique, and nowadays just about all have an ETF or ETN alternative, so use the
product that fits your needs the best. You may want to test the waters and
compare futures options on say, gold, crude oil, and Treasury bonds to ETFs and
ETNs like the SPDR Gold Trust (NYSE: GLD ), the U.S. Oil Fund (NYSE: USO ) and
the iShares Barclays 20 Year Treasury Bond (NYSE: TLT ). This is a good
opportunity to see how the game is played and if it's something that appeals
to you, you can start opening your own contracts to meet your own investment
style. Follow Adam Warner on Twitter at @agwarner .