- Personal Finance
Beginner's Guide to Stocks, Options, and Futures
Understanding the Basics of Stocks, Options, and Futures
Do you know the difference between a stock, and option and a future?
These words get thrown around a lot by investors and the news media, but do you know that they are talking about? If not, then I will give you a quick introduction to what each of these investment options is about.
What is a Stock?
Stocks represent partial ownership of a company. Most companies you see traded on the stock market have millions of shares, so one stock doesn't mean you own very much of a company. (...and you don't get a lot of mileage when you try to convince your boss that he should be nicer to you because you "own" the company.)
There are two ways you might make money by owning stocks. The first is if the company does well and the price of the stock goes up. You can sell it later and make a profit. The other is by holding onto the stock and collecting dividends from the company year after year. Newer companies don't usually pay dividends. But older companies that have less dramatic growth will pay a percentage of their profits back to shareholders. This pay back is called a "dividend" and usually runs around 5-10% a year. Many long term investors look at the percentage of the dividend a company pays as a major consideration in what stocks to purchase.
What is an Option?
Options are different than stocks. You are not actually buying a part of the company, you are only buying the right to buy or sell stocks at a set price. It's more like a guarantee.
How Options Can Increase Your Profits
Options cost less than stocks. If you wanted to buy some Microsoft stocks today it might cost you about $28.00 per share. But you can purchase an option for just a$1-2 on that same share. The price of an option is roughly the difference between today's price and the price you are trying to lock in. So you might purchase the option to sell Microsoft shares at $30.00 next month. Instead of paying $28/share, you pay about $2/share. The return on your investment can be much greater with options. The risks are also much higher. If your option doesn't pay, then you lose everything you put into it.
The price of an option is not that straight forward. The general direction of the stock's price, the amount of volatility, and how long you are holding the option all play a part in the exact price as well.
Some people buy options as insurance for stocks they own. The guaranteed price can limit their losses if the stock performs badly. Others buy and sell options without ever owning the underlying stock. And still others make money by offering (or writing) the options. They are betting that the stocks will do well, and the options won't be exercised... meaning they get to keep all the money collected from the "insurance" others have purchased.
What are Futures?
Futures are a lot like options. The difference is that instead of guaranteeing the price of a stock, they guarantee the price of actual goods... a barrel of oil, or an ounce of gold. Buying a future means you have the right to buy or sell the product at a certain price, it does not mean you have to have the item, or that you will ever get the item.
For farmers, futures can lock in a price for their pigs or corn. This helps them plan their finances for the year. Oil companies can do the same thing. Buying futures allows them to figure out what it will cost to produce a product ahead of time.
Speculators, on the other hand, don't really want to buy the item, they are just hoping that the prices will go up (or down) so that they can make a profit.