These trading strategies are confusing


Can someone explain what are futures, options and swaps?

In: Economics

Futures and options are basically bets that a security or commodity will be above or below a specific price by a specific date. The difference is that with options, you don’t actually have to fulfill your end of the contract (you have the *option* to not do so), so if you bet wrong you don’t lose anything beyond what you paid for the contract. With futures you don’t have that option – if you have a contract saying you’ll buy 100 barrels of oil at $50 a pop, and when the time comes oil’s only worth $2, sucks to suck, you’re still paying $50.

There’s not really an ELI5 explanation for swaps. They’re like futures but with stuff like interest rates, I guess. They can’t be traded by retail investors (that’s you) anyways so it doesn’t really matter.

They are 3 great ways to make your money disappear or appear on the stock market.

In futures and options – you make a “promise” to buy a stock or commodity at a certain price on a certain date in the future. Now on that date, if the market price of the stock or commodity is higher than your promised price – then you win (and you get to buy the stock or commodity at the erstwhile promised price). Now if that price is lower – hard luck – you need to break your piggy bank and buy that damn thing if you have a futures contract or you can refuse to buy it if its an option contract (but for the option contract you need to pay some money upfront (called the premium) – which is the money that disappears if you choose not to buy it).

Swaps are those where you exchange your contract (can be for a loan) with another entity. So you become responsible for the other entity’s contract terms of payment and they become responsible for yours. Swaps happen at institutional levels and not at retail levels.

A future is sorta like preordering something and hoping it’s worth more by the time you get it.

Like an oil future is preordering 100 barrels of oil and hoping the price goes up by the date on the contract. If oil is $50 a barrel when you buy then is suddenly $100 a barrel you double your money.

Options are contracts that give you the “option” to buy or sell a stock at a specific price(the strike) before a specific date (expiration date)

So an option would be like let’s say tesla is $400 a share now. And you buy an option that expires next week with a strike price of $410. You can at any time pay $410 for the stock as long as it’s before the week is over. So if tesla goes to $600 a share the next day you can use your option to buy the shares for $410.

Options are done in blocks of 100 shares. And the thing there makes options unique is the contract itself has value because it might go up or down. So that $410 option for tesla could cost you hundreds of dollars just to hold the contract, you can also sell the contract.

Usually options contracts can go up or down much faster than the stock itself so it’s a good way to use less money to get more but it is more risky. The contract value after expiration is $0. So let’s say you have that $410 option and tesla is $409 and it expires. The option contract your bought is worthless. So those hundreds of dollars is gone.