Everywhere I'm reading is telling me to avoid futures and options as investments because they are too risky. Is this a blanket statement that is true for most people, or just the average investor? Are they ever good investments?
Futures have little use as an investment vehicle for the vast majority of investors, unless you happen to be a farmer or miner hedging your production (and I KNOW that the vast majority of Brightscope readers are farmers looking for advice on how to hedge their corn crop...or not).
Options, however, have several legitimate uses:
Buying puts for protection: If you are worried about a market fall but don't want to accept the tax consequences of selling an appreciated position, buying a put option can offer you downside protection from a market drop. Be warned though, puts are often punishingly expensive to buy when you feel you need them most.
Selling covered calls as an income strategy: When you sell a call option against a position you already own, the worst that can happen to you is that you will be forced to sell it; and you get to pocket the premium on the option contracts you sold. A covered call strategy is considered safe enough to be allowed in IRA accounts by U.S. regulators.
Selling puts while keeping cash on hand to buy if exercised: This is a little more controversial, but if you ever wanted to own a given stock "if only it fell to THIS price...," then selling a put is a way to make that happen while also pocketing the premium. The thinking behind this strategy is better explained here: http://charlessizemore.com/christmas-may-come-early-this-year/
Gabrielle, great question. Futures were originally created as a hedging vehicle. For instance, a farmer that wants to lock in a price for his corn crop could use the futures market to sell in the future at today's "spot" price. This is a relatively safe way to use the futures market. However, buying or selling futures as an investor to bet on the direction of a commodity or interest rates is very risky. Options can be used as a hedge or to generate income. This can be a relatively safe strategy. Options can also be used to gain leverage which generally speaking involves much more risk. So, futures and option have their place depending on what you are trying to accomplish as an investor, but until you are very familiar with how they work you should not attempt to utilize them without some expert advice.
There are some good answers here already but I'd just add that it's important to distinguish between an investment and a trade or speculation. I have traded options and futures mostly for my personal account for over a decade and I've never once used these tools as an investment vehicle. Every time I've used them it has been to trade or speculate (sometimes hedging) on shorter-term price movements. An investment, as defined by Ben Graham, "promises safety of principal and an adequate return." Because options and futures don't provide for safety of principal or adequate return they should be considered speculative. In light of this, my advice to new speculators is to only put that amount of money at risk that you're willing to lose completely. Many of the best traders in the world have lost everything at least once on the road to success. If you limit this amount to a tolerable level and view it as "tuition at the school of trading" (I think that's also from "Market Wizards") then you'll instantly leap ahead of 90% of the novice traders out there. Best of luck.
Gabrielle, Futures and options are risky as an outright investment, however if used as a risk management tool versus other assets calsses then it becomes very valuable. The way it is mostly used today is in various investment strategies to help mitigate the outright risk in other asset classes. Hope this helps. Dan
I think their "risk" depends on whom is using these instruments. Options & futures are widely used by professional investors to hedge risk. However, they can be add risk if used improperly or by the inexperienced. Confusing, I know, but my advice is that these are instruments are best left to the pros.
Futures and options are riskier than most investments because investors can lose MORE than their orginal investment. Not only could an investor lose the money they invested, they may have to place more money into their investment account.
If you are interested in learning more about futures and option trading, I suggest you read "The New Market Wizards" by Jack D. Schwager. It’s an enjoyable easy read about some successful traders.
Have a great day! Dave
As an investment manager who uses derivatives in practice, I can tell you that it’s not so much the derivative investment which is “risky”, but the strategy you use. In that sense, there are many dozens of commonly used and understood strategies for using options, some of them enhance the risk in a portfolio, while other reduce it… some produce income, while others are used for speculation.
The problem many investors have with derivatives is they don’t understand the strategy they are using, or how much risk they might be adding to their portfolio, and in turn, it can get them into trouble. Warren Buffet once called derivatives “weapons of mass financial destruction”. Very simply, if you are on the wrong side of a trade using some strategies, you can wipe out a lot of portfolio value very quickly.
Because derivatives can be used in so many ways, it is important to understand their uses and limitations before you commit any of your hard-earned capital to them, and if you decide to seek the help of an advisor with derivatives, make sure they have experience in that field, not just with derivatives, but with the strategies which are likely to produce the results you are looking for.
In his best-selling book "Outliers," Malcolm Gladwell presents The 10,000-Hour Rule which is roughly the amount of practice one must endure in order to develop an expertise in one's endeavor.
For what it's worth, I use options extensively in the management of my portfolios, and I can attest to the 10,000-hour rule (at least for my circumstances). That's about how long it took me to go from viewing options as risky and speculative instruments to utilizing them as a legitimate and more effective tool by which investment portfolio risk can be diversified.
Options are about as risky as gasoline. Treated with respect and care, gasoline can power your car and thus greatly improve your mobility. Treated carelessly, gasoline can be fatal.
Continuing with the transportation metaphor, I would advise that you be willing to devote as much time learning options as you have devoted to becoming proficient in driving a car (including cumulative time behind the wheel).
If you do not have the time or inclination to devote to this, then I would avoid using options in your portfolio (this definitely also includes any occasional "dabbling" in options that, for example, a broker might suggest).