Comparing Trading Options to Other Securities - dummies

Comparing Trading Options to Other Securities

By Joe Duarte

Options are a form of derivative, a type of security that derives its value from an underlying security. Stock options derive their value from the underlying stock. In order to better understand option valuations, it makes sense to know more about other derivatives and exchange traded mutual funds (ETFs), which are quasi‐derivatives:

  • Commodities and futures contracts: Like options, commodity and futures contracts are agreements between two parties. The major difference between a commodity or futures contract and an options contract is that the former obligates you, whereas an options contract gives you rights as an owner. This is because commodities and futures contacts set the price for a predetermined quantity of a physical item to be delivered to a particular location on a predetermined date.

    Options have no delivery date. On the other hand, commodities and futures contracts are similar to options in that they lock in the price and quantity of an asset. However, in both cases, you can trade away your rights and obligations if you exit the contract before expiration.

  • Indexes: Think of indexes as collections of assets whose value is pooled together to measure the price of the group. Stocks, commodities, and futures are all index components. Here is the important difference: Indexes are not securities. That means you can’t buy an index directly. Instead, you buy securities that track the value of the index, such as mutual funds that own the stocks in a particular index — for example, Standard & Poor’s 500 Index.

  • Exchange traded funds (ETFs): ETFs are mutual funds that trade like stocks on an exchange. Most ETFs are designed to track an index or an underlying sector of a particular market. ETFs can be considered quasi‐derivatives because they don’t always hold the exact same securities of the index that they track.

    For example, some leveraged ETFs use more exotic securities known as swaps to mimic the action of the underlying index while adding leverage. Two of the most popular ETFs are the S & P 500 SPDR (SPY) and the Powershares QQQ Trust (QQQ), which tracks the Nasdaq 100 index. These two popular ETFs let you trade their underlying indexes, directly or through options.

  • Stocks and bonds: Stock ownership gives you part of a company, whereas bond ownership makes you a debt holder. Each dynamic has its own set of risks and rewards. Comparison of the three assets, stocks, bonds, and options, yields a fairly straightforward picture. All three asset classes can lead investors to total loss of their investment.

    And though stocks give you a piece of the company, and bonds offer you income, options offer you no ownership of any tangible assets. Stocks offer indefinite holding periods, and bonds have a maturity date and options have a limited life.

A swap is an insurance contract whose terms are privately agreed upon by the participants. They can be thought of as non‐exchange traded options and they can be used to bet on the direction of just about anything that the two parties agree upon. By design, swaps are very sophisticated securities that are not available to individual investors because of the financial requirements and the specific agreements required to be signed before you trade them.

When you own shares in a leveraged ETF, check the prospectus carefully to see if this is what you are buying. We’re not suggesting that you don’t consider leveraged ETFs if they make sense for your portfolio. We use them often in our personal trading. It’s important for you to always know what you are investing in, even if it’s an indirect investment such as an ETF.

When swaps get out of control, the markets can suffer. This is what happened in 2008 as lots of big money players bet (correctly) that subprime mortgage holders would not be able to make their monthly mortgage payments. They were right, and the rest, as they say, is history.