Futures and Options. Quick Start.
Lessons 3-4

Contributed by  Bruce Gould,  BruceGould.com

Lesson 3

Never row a boat where the oars are fixed in place and one them is missing.

You are now about to travel down the Imaginary River and you will need to select a boat for use on your journey. There are only two boats available, each for the same price for the same amount of time. You carefully look them over and discover that both boats have their oars bolted in place so that one cannot pick up the oar on the port (left) side and move it to the starboard (right). On closer inspection, you discover the first boat has both oars bolted down and intact. The second boat, however, is missing one oar. There are no replacement oars available and the boat is for rent "as is". Which boat would you rent? Can you imagine trying to row down the Imaginary River in a boat with fixed oars and only one available for rowing? How long would it take you to run ashore on the nearest shoal of land?

It rains a lot in Seattle. On days when it does not rain, it is often cloudy. Let's assume for the sake of a hypothetical that the sun shines in Seattle on 182 days of every year, that no sun is to be seen on 182 days per year and that 1 day of each year is a mystery. Can I can interest you in a little game. The game is this. You are to make a $1000 bet as to what the weather will be like in Seattle tomorrow. You must make this same bet every day for the next 365 days. There is only one rule to this game. You must always bet that tomorrow will bring sunshine. Would this be a fun game to play? How much money would you win where the statistics were 182/182/1? Who would want to play this game every day for the next 365 days?

Don't buy boats with only one oar. Don't be forced to bet that the sun will shine every day in Seattle.

Let's suppose that you buy 100 shares of stock in a company called "The Imaginary River" corporation. You buy your shares at $10 each and you bet the price will rise. Somewhat later, you buy more shares at $100 each and still you bet that the price will rise. Eventually you buy more shares at $1,000 each, betting again on higher prices. Finally, at $10,000 a share, you make your final purchase betting on still higher prices. What are you doing? Are you always betting that prices will continue to advance? Isn't this like buying a boat with one oar or every day betting on sunshine in Seattle? Do you really want to find yourself in such a situation?

Rule Number 3. To succeed in stocks, bonds, futures or options, you need to be able to bet once in a while that prices will go down. If you can only bet that prices will go up, you are like an investor in a boat with only one oar and that oar being fixed in place.

If you own stocks or mutual funds or equities (you can be said to be "long") you can simply sell your ownership when you feel prices will decline and no longer be long. This is what most people do most of the time when they do not wish to weather a price decline.

When trading futures contracts, however, one does not have to be always "long" a market. One can actually be "short". The opportunity to be "short" a market applies to stocks and equities too but it is not as commonly used in those markets as it is in futures. In the futures market everyone is either "long" or "short". And this means everyone.

Let's suppose that it is now January of 2000 and the price of wheat for delivery in December of 2000 is $3 a bushel. Now assume that you are interested in making some money in the wheat market and here are your alternatives as to how to proceed,  

1. The only bet you can make is that wheat prices will rise - you are like the investor with the one oar boat or the person who is betting on sunshine in Seattle tomorrow.

2. You can bet that wheat prices will rise - or you can bet that wheat prices will decline.

Which alternative would you select? Maybe when wheat is priced at $3 a bushel, you don't mind selecting the first choice. But what if wheat was $10 a bushel, or $20 a bushel, or $100 a bushel. Would you want to be so restricted that you could only bet that wheat prices would continue to rise, or would you want to be able to bet that maybe wheat price might fall. Would you like to be in a boat with two oars or a boat with only one?

In the futures and options markets, (and even in stocks, though it is less commonly done), you are always allowed to bet that prices will decline. This is the concept known as "being short" a market.

Isn't this exciting. To know that there is a market where you can bet prices might decline? Isn't it nice to have two oars in your boat so you can row to either shore or perhaps simply stay in the middle of the stream? How does the concept of going "short" work? Let's start with a futures contract. In the futures market, not only can you bet that prices will go up or down, but there is no futures contract unless one entity is betting that prices will go up (said to be long) and another entity is betting that prices will go down (said to be short). In futures, not only can anyone bet either side of the market, go "long" or "short", but there is no futures contract unless both sides of the market are bet by someone.

Suppose that crude oil is priced at $25 a barrel.

You want to buy crude oil futures and bet that prices will rise. You simply open a futures account with appropriate margin, talk to your futures broker, decide upon a time period when you think that this will happen, and tell your broker to "buy you one contract of crude oil at $25 a barrel for delivery at the month you have selected". If you are able to buy crude oil at the price you have bid, you will said to be "long" crude oil at $25 a barrel.

But suppose you think crude oil at $25 a barrel is too high and you want to bet that prices will decline. You do everything the same as you did above, you open a futures account, talk to your broker, select a time period during which you feel prices will decline except that now you tell your broker to "sell one contract of crude oil at $25 a barrel for delivery at the month you have selected". If you are able to sell crude oil at the price you have offered it, you will be said to be 'short' crude oil at $25 a barrel.

How do you make money if you are "long crude oil" and how do you make money if you are "short crude oil", which can be translated into the question of how do you make money if you are long wheat or gold or stocks and how do you make money if you are short wheat or gold or stocks? I could answer this for you, but I am going to show you by example online. That should make it easier to understand. In general terms, you make money when you are "long" by buying at a lower level than you sell at. You also make money when you are "short" by buying at a lower level than you sell at. The only difference is that when you are long, you buy first and sell second. When you are short, you sell first and buy second. But you still make money the same way in both cases no matter whether you are "long" or "short". You make money by buying at a lower level than you sell at. That is how it is done. To see how this works with crude oil, click on this hyperlink and I will show you how exactly.

The important thing to remember from Lesson Number 3 is this. If you restrict yourself to always having to bet that prices will rise, eventually you are going to be wrong. If you always have to bet that the stock you bought at $20 or $200 or $2,000 will advance in price, one day you will find that for at least part of your shares, perhaps the stock you bought at $2,000 a share, you will have made the wrong bet. If you are trading only in stocks, mutual funds, or equities, you can always sell your ownership and get out. But if you are trading in futures contracts or options, (and even stocks, if you want to try it one day), you have the alternative of actually making a profit from declining prices.

Never handicap yourself so that you always have to bet that prices will rise. All prices come down from their peaks. One who bets that prices will never come down has made a fool's bet.

Lesson 4

What is the difference between owning a share of stock and owning a futures contract? That is a fair question. I think it is best answered in two parts. I will use Lesson Number 4 for the first part and Lesson Number 5 for the second part. To better illustrate the difference between these two parts, let me suggest a supplemental question.

What is the difference between a $100 bill and 400 quarters? I would answer this question in this fashion,

1. From one point of view, there is no difference. All currency is legal tender. If you buy something of value which costs $100, whether you pay with a single $100 bill or with 400 quarters is simply a matter of convenience. In either case, when the clerk rings up your payment the register will show $100 paid. No distinction is made between whether paper money was paid or coin. The same comparison can be made when looking at stocks and futures contracts. From one point of view only, it can be said that there is no difference between the two.

2. But from another point of view, there is a great deal of difference. Suppose you have washed your well used jeans and are now putting them into the dryer to dry. In one pocket there is a $100 bill and in the other 400 quarters. Which $100 in value would get your attention the quickest as the machine started to turn? What if your car happened to run out of gas and there was a single phone booth nearby but nothing else for fifty miles. What would you rather have in your purse or pocket, coin or paper money? What about at the start of a football game when it is decided by a coin flip which team will kick the ball and which team will receive. What is the best medium for making this decision?

When one looks at paper money versus coins in this fashion, there is a great deal of difference between the two. So it is with stocks and futures contracts and I will discuss this difference in the next issue.

Lesson Number 4 states that when looking at stocks and futures contracts from one perspective only, it may be stated that there is no difference between the two.

Let us suppose that you were to buy shares of stock in a corporation and these shares were selling for $25 a share. Suppose you were to give your stock broker these instructions,

1. Buy this stock for me at $25 a share.

2. If prices decline to $20 a share, sell my shares for a loss.

3. If prices rise to $30 a share, sell my shares for a profit.

You want to continue owning these shares until either (2) or (3) happens. Whichever happens first, you will accept.

Now let us suppose that you were able to buy crude oil in 2010 and you could do so for $25 a barrel. You might give your broker these instructions.

1. Buy crude oil for me at $25 a barrel.

2. If prices decline to $20, sell my holdings for a loss.

3. If prices rise to $30, sell my holdings for a profit.

You want to continue owning crude oil until either (2) or (3) happens. Whichever happens first, you will accept.

If you buy something for $25 and you sell that same thing for $20, you lose $5. If you buy something for $25 and you sell that same thing for $30, you make $5. It is the different price levels between the buying and the selling that results in the profit or the loss, not the thing itself. From this one perspective only, it makes absolutely no difference what is being bought and what is being sold as long as you are selling the same thing you bought and the end result is an increase or a decrease in the amount of money in your pocket.

How much money will you make, not considering any commissions that you might have to pay, if you buy some stock at $25 a share and sell the same stock at $30 a share? You will make $5 a share. How much will you make in total? It will depend on how many shares you bought and sold at these levels. If you bought ten shares and sold ten shares, you will make $50. If you bought one thousand shares and sold one thousand shares, you will make $5,000. How much money will you lose, not considering any commissions that you might have to pay, if you buy some stock at $25 a share and sell the same stock at $20 a share? You will lose $5 a share. How much will you lose in total? It will depend upon how many shares you bought and sold at these levels. If you bought ten shares and sold ten shares, you will lose $50. If you bought one thousand shares and sold one thousand shares, you will lose $5,000.

How much money will you make, not considering any commissions that you might have to pay, if you buy crude oil at $25 a barrel and sell the same crude oil for $30 a barrel? You will make $5 a barrel. How much will you make in total? It will depend upon how many barrels you bought and sold at these levels. If you bought ten barrels and sold ten barrels, you will make $50. If you bought one thousand barrels and sold one thousand barrels, you will make $5,000. How much money will you lose, not considering any commissions that you might have to pay, if you buy crude oil at $25 a barrel and sell the same crude for $20 a barrel? You will lose $5 a barrel. How much will you lose in total? It will depend upon how many barrels you bought and sold at these levels. If you bought ten barrels and sold ten barrels, you will lose $50. If you bought one thousand barrels and sold one thousand barrels, you will lose $5,000.

If you are interested in whether prices first go to $30 or to $20 does it really make any difference if you buy shares of stock at $25 or if you buy crude oil at $25? As far as the bottom line is concerned, should it make any difference? Suppose your financial advisor were to tell you, "you bought at $25 and sold at $30". You might ask him what it was you had bought and what it was you had sold. But if he were to call you day after day, month after month, year after year, don't you think you might eventually respond, "I don't care what it was, just give me the price levels".

If you buy a stock at $25 a share and sell it at $30 a share, you have made $5. If you buy crude oil at $25 a barrel and you sell it at $30 a barrel, you have made $5. The five dollar bill that you earn from buying and selling a share of stock for a profit will be identical to the five dollar bill that you will earn from buying and selling a barrel of crude oil at a profit.

This is why it is important to understand at the outset that when someone trades in futures contracts, they are not doing something strange or unusual. They are simply buying and selling. A person trading stocks or bonds or mutual funds is buying and eventually selling. A person trading futures contracts is doing exactly the same thing.

Lesson Number 4 states that when looking at stocks and futures contracts from one perspective only, it may be stated that there is no difference between the two.

What then is the primary difference between trading in stocks and trading in futures? I will explain the difference in the next lesson. It may surprise you.