The fundamental risk, of course, is price uncertainty. No one knows for sure whether GOOG (the symbol for Google stock) will be higher tomorrow or lower.

Options, like futures or bonds, carry an additional risk – at some point, from a day to several months or years, they expire. On or before that date, the holder has to decide whether to sell the contract, exercise the option to buy or sell the underlying asset, or simply let the option expire.

Each of these choices carries implications for gain or loss and all are uncertain (to some degree) with respect to the size of that outcome.

Complicating the price and timing risks of options is their volatility risk. It’s uncertain, on any given day, how much the price will vary and how rapidly.

Ironically, options themselves are forms of risk management. Since the underlying asset, say a stock or bond, has risks as an investment buying options allows holders to compensate for them.

Leverage is one form in which options help to manage risk. Leverage is the ability to control more than you own. Suppose you want to purchase a 100 shares of Google. At the current market price that’s an outlay of around $40,000 (excluding commission). That’s a hefty sum for the average investor.

But you can control 100 shares of GOOG without owning them for less than 1/10th the cost – currently around $2800 – the price of one option. (One options contract typically is written on 100 shares.)

How is that a form of risk management? The reason is there’s another kind of risk: principal risk. I.e the risk of losing (all or part of) your investment. (Actually this is a form of price risk.)

Purchase a 100 shares of GOOG and you stand to lose $40,000 in the (very unlikely) case that Google goes bust. (Unlikely, but not impossible. Rapid shifts in technology or other factors have tanked more than one high-tech stock. 3Com and Cisco are two good examples. Though not zero, their shares experienced considerable declines in the past few years.)

Purchase one option instead and your principal risk is limited to the – painful if lost, but much smaller – amount of the premium: $2800, the cost of the options. (Excluding commissions.)

Of course, the example is a little unfair since the odds of Google stock going to zero is itself close to zero. But there are companies for whom the odds are not so favorable and the principle (pun intended) is the same.

So, how do you manage these risks? Simple. Simple, but not easy.

Start by identifying all the known risk factors and quantifying them. (Simple in that identifying and measuring them is straightforward, but minimizing them is anything but easy.)

Fortunately, there are several different software product offerings that will help you do that. It’s no longer necessary to be a finance and mathematics wizard. The software incorporates the algorithms used by experts to measure various factors – such as delta, theta, vega, volatility and others – that can affect your potential profit or loss.

Post from: Finance Market Investment

Risk Management

An option is a contract conferring the right to its buyer to purchase an underlying asset at a fixed price (the ‘strike price’). The right – not the obligation. A futures contract, by contrast, obligates the buyer (the ‘long position’) to purchase and the seller (the ‘short position’) to deliver some asset by a set date.

That underlying asset, in either case, can be a commodity (such as wheat, oil, gold), shares of stock, or some more nebulous instrument such as an index. Since an index is just a number no physical delivery is possible, such trades are settled in cash.

Futures have value as a mechanism for trading risk, publishing prices, and (like options) taking speculative advantage of leverage.

A farmer may not know in April precisely how much wheat he can deliver. Insect damage, droughts and other kinds of crop failure are even today very much real supply problems. Similarly, he can’t predict in April exactly how much demand will exist in October. (In part, that depends on the supply.)

Selling a futures contract allows him to offload that risk to someone willing to bear it. He obtains a set price commitment today in exchange for a promise to deliver a good by a certain date in the future. On the other side of the contract, the buyer offers a promise today to accept delivery of the good in the future.

Neither knows with certainty what the market price will be on the expiration date of the contract, only what the market price is on the day it’s entered.

For the contract buyer, a future offers several values in exchange for accepting the obligation to take delivery of (and pay for) a set amount of goods at a pre-set price.

One major value is, as in the case of options, the use of leverage. While options require paying of a premium (usually around 5%-10% of the current market price), futures have no in-built cost (apart from a small commission).

The buyer is required, though, to put up a ‘good-faith’ deposit, also in the neighborhood of 5% of the total. But that margin deposit allows the trader to control 10-20 times the amount of good he would otherwise have to pay for. That ‘multiplied control’ is leverage.

[Note: Though it's called a 'margin', it's NOT the same as buying stocks 'on margin'. In the latter case, that is a form of borrowing - with the broker lending the trader the amount needed to purchase all the shares the trader then owns.]

As a practical matter, a very small percentage of futures contracts actually result in the buyer accepting delivery of, say, 1000 barrels of oil. While the behind-the-scenes mechanics are somewhat complicated, at expiration the goods are ultimately transferred to brokers who sell them to those who actually make use of them.

To the traders the exchange is simple, though. Any change in prices is reflected in the accounts of the trading partners at the end of each day’s trade. At some point the contract is either sold (the most frequent result) or expires.

Post from: Finance Market Investment

Risks and Advantages of Futures