Futures Investments – Risky but Rewarding

The whole point of this financial derivative used to be to enable companies to buy resources they needed or sell resources they produced while limiting the effects of volatile market environments on the price. A company that turns crude oil into plastics may want to ensure that they can buy a specific amount of crude oil by the time they need it for production, while the oil trader may want to make sure they have a buyer at a decent price at that point in time. They agree on a specific price for the trade, so the plastic producer doesn't need to worry about rising oil prices in the future, while the oil trader doesn't risk having to sell their oil cheap because prices drop suddenly.

Since futures are available to all investors, this has quickly led to private investors using futures to essentially make bets on changing prices for goods and commodities without ever physically taking possession of the assets they're speculating with.

What Are the Differences Between Futures and Options?

Importantly, futures are legally binding obligations. This means that you have to honor the contract by the specified date or settle it with the trader in another way – this is usually a cash settlement whereby you pay the trader the difference between the current price of the asset and the price you promised to pay for it. This effectively works as if you had bought the assets from the trader and sold them back at a loss. The benefit is that you don't need to actually take possession of the assets – such as the 1,000 barrels of oil from our example.

In contrast, options do not require you to actually make the trade. If you invest in options, you're paying a premium for the right to buy or sell assets at a later date at a pre-determined price – but you don't actually have to exercise that right. This means if the value of the assets linked to your option drops below the price at which you're allowed to buy them, you are free to not make the trade, losing only the premium you paid for the right to buy.

What Are the Advantages of Investing in Futures?

New investors, in particular, may look at their choice of options or futures investments and think, "why would I invest in a future if I can invest in an option?" Aside from the fact that the assets you're looking for simply may not be available for investment via options, there are several advantages that futures have over options:

• Futures tend to be very liquid, while options may not offer the same amount of liquidity, especially for expiration dates far into the future.
• Options suffer from time decay – their value diminishes over time as you wait for a reasonable price while expiration draws near. This is not the case with futures investments, as the date on which you have to buy or sell an asset is set in stone.
• Futures typically have high leverage levels, allowing private investors to use borrowed capital to invest in markets that might have been much too expensive otherwise.
• Options premiums are largely determined due to the market's volatility, so it's not always easy to determine premiums before buying options. Meanwhile, the initial margin you have to pay for futures can be easily calculated beforehand since margin rates have not changed much in many years.

Naturally, as different futures markets and traders offer futures with varying parameters, the distinct advantages and disadvantages of futures over options can change dramatically depending on the circumstances. The main point here is that you shouldn't ignore futures as an investment option simply because options have the advantage of allowing you to withdraw from the trade if you wish.

Generally speaking, traders who issue futures will do so because they want to hedge their bets against declining prices. If they can sell futures to an investor at a specific price and the price goes below that point in the future, they can sell their assets at a profit since the investor has to pay the price specified in the futures contract. Naturally, this carries the risk that the price may increase, and they may end up selling their assets at a loss. Investors, meanwhile, bet on the value of the asset going up, so the trader has to sell it to them cheaper than they normally would.

In short, making money out of futures usually depends on you making a better call than the trader issuing the future on how the value of the underlying asset will change over time. This is relatively difficult to achieve if you're a private investor since the trader likely has more resources and perhaps even more insight into the market than you. Hence, their predictions are typically more informed than yours may be. This is why many investors instead pool their money into hedge funds to benefit from the hedge fund management team's professional expertise and experience.

However, even professional hedge fund managers may misjudge the value of an asset and make faulty predictions about how its value may change over time. After all, not many people can have a thorough understanding of all market movements at all times, not to mention the impact which completely unforeseen macro-scale events may have. That's why CARL is opening up the world of quantitative hedge funds for private investors.