By Chris McKhann
For retail investors looking to broaden their horizon, the first step is usually options because they can be traded in the same account as equities. Many then take the next step into futures, but the two markets present very different opportunities and challenges--some of which have come to the forefront recently with the collapse of MF Global.
Futures trading originated in many respects as a way to hedge commodity prices. While that is still a key function, retail futures traders can now speculate on the price movements of a wide array of assets, including oil, gold, currencies, equities, and volatility.
And all this can all be done for a very small margin, allowing for huge amounts of leverage. For example, a futures contract on the S&P 500 worth roughly $60,000 can be controlled for as little as $2,500.
This amount of leverage is in some respects similar to that afforded options, but the two instruments are very different. Losses in futures can come very quickly because of their margin requirements, and it is entirely possible for traders to lose much more money than they even have in their accounts.
The same is true of selling options, but not buying them. Option buyers always know exactly how much they are risking and their maximum potential loss, but they still get significant potential leverage. In fact, the leverage is sometimes greater with options.
Depending on your outlook, for instance, you could buy an SPDR S&P 500 Fund call for as little as $50. That would give you control over 100 shares of the SPY, worth $12,750 at the time of this writing.
Futures traders face another important issue: An account must be opened that is different from your equity account, something that has scared off many traders since MF Global's downfall chilled the market. (I personally am not going to stop trading futures because of one bad apple, though it does raise a host of questions.)
On the other side of the equation, futures are in many respects easier to trade than options. If you think that oil or gold are going to rise in price, you buy the futures. The buying and selling is similar to trading equities, except that selling is much easier in the futures world because it is essentially treated the same as buying.
Options have a pricing model--a whole range of them, actually--and a volatility component that make valuing them more difficult. Option traders also need a thesis on the underlying, a view on volatility, and a timing projection. They need to pick a strike and an expiration. Of course, some of these issues are not so clear cut, as there are options on futures as well.
It used to be that futures were the only way to get access to some markets, and to a limited degree that is still true. But various exchange-traded products are now available that allow the retail equity or option trader access to such things as gold. The SPDR Gold Shares Fund (NYSEARCA:GLD) is one of the largest exchange-traded funds.
I trade futures and options. There are times when I lean toward one market or the other. But from a risk perspective, option vertical spreads provide unparalleled potential returns as well as risk management for all of those who are willing to put in the work to understand options basic mechanics.