How to Minimize the Risks of Trading Options and Futures - dummies

How to Minimize the Risks of Trading Options and Futures

By Michael Griffis, Lita Epstein

Trading in options and futures is risky business, and regulations governing those trades are stringent, even with regard to allowing you to open an account. Before opening an account for you, a broker must provide you with a disclosure document that describes the risks involved in trading futures and options contracts.

Topics that must be covered in the disclosure statement include the risks inherent in trading futures contracts or options and the effect that leveraging your account can have on potential losses or gains. The statement also must include warnings about trading futures in foreign markets, because those types of trades carry additional risks from fluctuations in currency exchange rates and differences in regulatory protection.

Commodities options and futures also can be risky, because many of the factors that affect their prices are totally unpredictable. Because positions in futures and options are so highly leveraged, even a small price movement against your position can result in at least the loss of your entire premium payment and possibly even much greater liability for additional losses.

After you begin trading options and futures, you can’t close your account until all open positions are closed — if, that is, you’re trading through an account with a commodities exchange. This restriction does not apply to options traded in a stock brokerage account. Any accruals on futures contracts are paid out daily.

Any funds in your margin account that are beyond your required margin or account-opening requirements can be withdrawn, but other such funds have to remain in the account until all your positions are closed. Any restrictions on the withdrawal of your funds are stated in the original disclosure document.

After opening your account, your broker usually mails or e-mails confirmation of all purchases and sales, a month-end summary of transactions that show any gains or losses, and an evaluation of your open positions and current account values. You need to be able to get information from your broker on a daily basis after you begin to trade.

Brokers are required to segregate any money you deposit in your account from the brokerages’ own funds. The amount that is segregated either increases or decreases depending on the success of your trades. Even if the brokerage firm segregates your funds, you still may not be able to get all your money back if the brokerage firm becomes insolvent and is unable to cover all the obligations to its customers.

Whenever problems with your broker arise and you can’t resolve them without help, you have several dispute-resolution options. You can contact the reparations program of the Commodities Futures Trading Commission (CFTC) and ask for an industry-sponsored arbitration, or you can take your broker to court.

Before deciding how you want to proceed, you must consider the costs involved with each option, the length of time it may take to resolve the problem, and whether you want to contact an attorney. You can get more information about dispute-resolution alternatives by contacting the CFTC or by calling 202-418-5250.

The best way to minimize the risks of derivatives trading is to take the time to find out as much as you can about the inherent risks of the derivatives you’re trading. First, check out the firms or individuals with whom you plan to trade. All firms and individuals that offer to trade options or futures must be registered with the CFTC and be members of the National Futures Association.

You can check out firms and individuals online at the NFA site by using its Background Affiliation Status Information Center (BASIC). On BASIC, you’ll find the status of the firm or individual and any disciplinary actions taken by the NFA, the CFTC, or any U.S. exchanges. You can start a search on BASIC from the Investor Information page.

Next, be sure that you’re familiar with the firm’s commission charges and how they’re calculated. Compare one firm’s quotes with those of other firms you’re considering. Whenever a firm has unusually high commission charges, ask for a detailed explanation for the higher charges and what additional services justify the higher cost.

Always make sure that you calculate the break-even price for any option you’re thinking about purchasing, because you have to know at what point the option you’re planning to buy will be profitable and whether the data you’ve collected justifies the option’s premium costs.

You also need to understand the market for the underlying asset of the option or future you plan to buy and what can impact the market price of that asset. Be sure that your expectations for the potential profits from the option or futures contract you choose are reasonable.

You don’t ever want to buy an option without first coming to a full realization that you can lose the entire value of your trade. If you want to take the riskier position as an option writer, be sure you can accept the possibility that your losses may exceed the premium you initially received for the option. Option writing comes with the potential of unlimited losses, as does futures trading.

Develop a plan before you buy that first option or future and stick with that plan, and be sure to diversify your holdings not only by asset types but also by time of expiration.

You don’t want to overexpose your cash position on one trade and risk the possibility that you won’t have the money you need when the next opportunity comes along. By exposing your capital to a variety of markets, you also have a better chance that some of your trades will end up succeeding.

Be wary of firms that lead you to believe you can make lots of money trading options or futures with very little risk. That’s never true. If a firm is using high-pressure tactics to get you to trade, that’s a sure sign of a problem, so don’t allow yourself to be rushed into a trading decision.