A Comprehensive Guide to Future and Option Trading

Trading is like a fun game where people guess if the price of something will go up or down. Two popular ways to trade are called futures and options. Let’s easily learn about these.

What is Future Trading?

Future trading is like making a promise. Imagine you promise your friend that you will buy their toy in one month for $10. In future trading, people promise to buy or sell things like stocks or gold at a set price on a future date.

How Future Contracts Work

Promises: When you buy a futures contract, you promise to buy something at a set price later. The seller promises to sell it to you at that price.

Leverage: You only need a small amount of money to make this promise, but you could win or lose a lot more money based on what happens with the price.

Daily Checks: Each day, the game checks if you’re winning or losing and adjusts your money based on that.

Example of Future Trading

Let’s say you think the price of chocolate will go up. You make a promise to buy chocolate for $5 per bar in three months. If the price goes up to $7, you can buy it for $5 and sell it for $7, making a $2 profit. If the price goes down to $3, you lose $2.

What is Options Trading?

Options trading is like having a special ticket. This ticket gives you the choice to buy or sell something at a set price within a certain time, but you don’t have to if you don’t want to.

Types of Options

• Call Options: This ticket lets you buy something at a set price if you think the price will go up.
• Put Options: This ticket lets you sell something at a set price if you think the price will go down.

How Option Contracts Work

Premium: You pay a small fee (premium) for the ticket. This fee is the most you can lose.

Strike Price and Expiry: The strike price is the set price on your ticket. The expiry date is the last day you can use your ticket.

Example of Option Trading

Imagine you buy a ticket to buy a toy at $10, paying $1 for the ticket. If the toy’s price goes up to $15, you can buy it for $10 and make a $4 profit (after subtracting the $1 ticket fee). If the toy’s price stays below $10, you don’t use the ticket and lose the $1 fee.

Key Differences Between Future and Option Trading

• Promises vs. Choices: Futures are like promises to buy or sell. Options are like choices where you decide if you want to use your ticket.
• Risk and Reward: Futures can be riskier because you must stick to the promise. Options are safer for buyers because you only lose the ticket fee.
• Leverage: Futures let you control a big amount with a little money. Options have a smaller risk because you only lose the fee.

Strategies in Future and Option Trading

Future Trading Strategies

Hedging: Protecting what you already have by making promises to cover any losses. For example, if you own toys and worry the price might drop, you can make a promise to sell them at today’s price.

Speculation: Guessing what will happen with the price to try and make money. For example, if you think the price of toys will go up, you might promise to buy them now at a lower price.

Spread Trading: Making promises to buy and sell different things to make money from the difference. For example, buying a promise to get toys at $5 and selling a promise to get them at $6.

Option Trading Strategies

Covered Call: Owning something and selling tickets to others to make extra money. For example, if you own a toy, you can sell a ticket to someone else for the right to buy it from you at a higher price.

Protective Put: Owning something and buying tickets to protect against losing money. For example, if you have a toy and think the price might drop, you can buy a ticket that lets you sell it at today’s price if needed.

Straddle: Buying both types of tickets (to buy and to sell) to make money from big price changes. For example, buying a ticket to buy and another to sell a toy if you think the price will change a lot.

Iron Condor: A complicated way to make money from small price changes by using several tickets. This is like setting up a few tickets to earn from small moves in the price.

Risks in Future and Option Trading

Leverage Risk: Both futures and options can lead to big wins or big losses because of the borrowed money. It’s like betting a small amount to win or lose a lot.

Market Risk: Prices can change suddenly, leading to unexpected losses. For example, if the toy price drops suddenly, you could lose money.

Liquidity Risk: Sometimes, buying or selling is hard because not many people are trading. This is like having a toy that no one wants to buy.

Time Decay (Options): The ticket’s value can go down as it gets closer to its expiry date if the price doesn’t move as expected. It’s like having a coupon that loses value the closer it gets to expiring.

Conclusion

Future and option trading are games where you guess if prices will go up or down. Futures are promises to buy or sell, while options are special tickets that give you the choice to buy or sell. Both ways can help you make money but also come with risks. Learning the basics and having a good strategy to play the game well is important.