IInvesting: Stocks, Options and Futures
by Gary Foreman

Gary,  I was wondering if you might be able to help sort out how futures and stocks and options etc work.I'd like to get into investing but I'd prefer to have a little bit of an understanding before I sit down with an investment consultant--I'd prefer that the person teaching me not have a financial interest in which avenue I choose. Thanks! - Don

If Don wants to begin investing he will need to know the difference between stocks, options and futures. And, he'll need to know how they work. But chances are pretty high that he won't ever get involved in either options or futures.

We'll begin by defining what each type of investment is and how they work. Starting with stocks. A stock is a share of ownership of a company. Let's create a simple example. Suppose you own a lemonaid stand 50/50 with your brother. You each own half of the lemonaid stand company. If there were 2 shares of stock, you'd each own 1 share. That share of stock would entitle you to participate in any cash distributions that the company made and also in any of the profits.

A share of stock in any publicly traded company is the same thing. The only difference is that you have thousands of partners (not just your brother). Suppose you own shares of stock in the local electric company.  If they make a cash distribution (also known as a dividend) you'll receive your proportionate share of the distribution. If the electric company has profits that they don't distribute as dividends, then that money will increase the 'book value' of the company. That increased 'book value' should translate into higher prices for shares in the company that are bought/sold. The reason is simple. People are willing to pay more for a company that's doing well and making money. So you can benefit two ways from owning stock: dividend checks and an increase in share price.

You can own stocks by purchasing shares in the company (typically from another investor using a broker & exchange, but occasionally from the company itself) or through a mutual fund (where a manager invests your money).

So much for stocks. Next let's look at options and futures. Most investors never buy or sell an option or a futures contract. And, with rare exceptions, most investors never have the need to buy or sell an option or futures contract.The reason is that they're both designed for a specific purpose and most investors never get near that situation.

An option is just what it's called: an option to buy or sell a specific number of shares of a specific company at a preset price until a specific date (a lot of specifics, huh?). For instance, it could be the right to buy 100 shares of Ford at $4 per share until October 17, 2008. The right to buy shares is termed a 'call' because you can 'call' for your shares. The right to sell shares is termed a 'put' because you can 'put' your shares into someone else's hands. Just because you own the option does not mean that you have to 'exercise' it. In other words, you could have the right to buy Ford shares at $4 per, but decide that you'd rather not. Typically that happens when they're selling on the exchange for less than $4. No sense exercising your call when you could buy them cheaper on the exchange if you wanted to.

There are some situations where owning a put or call makes financial sense. But most investors will live a lifetime and never get into any of those situations. Some, however, will use options as a way to try to leverage their investment. Let's make up an example. Take our Ford call. Suppose that you thought that they were about to announce a major breakthrough in gas mileage. Something that could double their stock in short order. You don't need to buy the stock to bet on that announcement. All you have to do is to buy calls on the stock. Much cheaper than buying the shares. If the stock pops you exercise your calls and make a bundle. On the other hand, if the announcement doesn't happen or happens and doesn't move the stock, all you're out is what you paid for the calls. Not nearly as expensive as buying the stock and watching it decline when the expected move doesn't happen! Another way to make money on puts & calls is to buy and sell them before they expire. Because they have a limited life they tend to be much  more volatile that the stock that they represent.

Now, some would argue that that's a legitimate reason to buy an option - to gamble on a short-term move without risking a bunch of money. And, to that extent, they're right. But, Don described himself as an 'investor' not a 'speculator'. There is a difference. A speculator is looking for the quick buck. Bascially gambling. If you're into gambling there's nothing wrong with that. But, an investor is looking for good companies that he/she would like to own a part of. Not the same thing.

Futures contracts are somewhat similar to options. They're a contract that commits you to buying/selling a certain amount of a commodity at a set price on a specific future date. I believe that originally they were created for farmers that wanted to know for sure what price they'd get for their crop at harvest time. And, they work well in that situation. They can also allow large consumers (think cereal producers who use tons of product) to know what they'll pay for a commodity regardless of how big this year's crop is. In fact, one airline managed to lock in it's price for jet fuel for most of the past year because they had futures contracts at prices that were set up before the latest round of oil price jumps. Great use of futures.

But, for the individual investor there's not much reason to put a futures contract into your college fund or retirement portfolio. Unless you're like the farmer or the airline, the only reason that an individual would be involved is because they can leverage their money to make very large bets on price swings. Not that people don't make big gains (and losses) in the futures market. I recall back when I was a broker with Smith Barney in the 80's we had a commodities broker who claimed that he could teach anyone to make money buying and selling commodities. But, he told them up front that they'd probably lose about $40,000 in the learning process. In today's dollars that's probably 4 times as much.

So for Don, it's really a matter of learning more about stocks. Unless he has some special needs or is looking to make a quick buck, there's no need to consider options or futures for his portfolio.

Keep on Stretching those Dollars!
Gary

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Gary Foreman is a former financial planner who currently edits The Dollar Stretcher.com website and newsletters. You'll find hundreds of ideas to help you live better on the money you already make. Visit today!