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I have been reading articles on portfolios and options. It seems options are used to hedge portfolios for multiple risk factors.

  • I would like to know why options, and why not futures?
  • What is the main risk offset by an option?
  • How do we determine which option for what risk?
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Options are futures; they're futures options. The difference, succinctly, is that you have the option to say no to the agreed-upon transaction if the market gives you a better deal than the contracted price. A futures contract without an option locks you in. Options are therefore an insurance policy of sorts against a steep downturn; if the market tanks and takes a stock with it, but you have an option to sell that stock at a price agreed on long before the storm clouds gathered, then you simply exercise the option. –  KeithS Feb 21 '13 at 23:00

2 Answers 2

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Options are contractual instruments. Most options you'll run into are contracts which allow you to buy or sell stock at a given price at some time in the future, if you feel like it (it gives you the option). These are Call and Put options, respectively (for buying the stock and selling the stock).

If you have a lot of money in an index fund ETF, you may be able to protect your portfolio against a market decline by (e.g.) buying Put options against the ETF for a substantially lower price than the index fund currently trades at. If the market crashes and your fund falls in value significantly, you can exercise the options, selling the fund at the price that your option has specified (to the counter-party of your contract). This is the risk that the option mitigates against.

Even if you don't have one particular fund with your investments, you could still buy a put option on a similar fund, and resell it to another person in lieu of exercise (they would be capable of buying the stock and performing the exercise themselves for profit if necessary). In general, if you are buying an option for safety, it should be an option either on something you own, or something whose price behavior will mimic something you own.

You will note that options are linked to the price of stocks. Futures are contracts whose values are linked to the price of other things, typically commodities such as oil, gold, or orange juice. Their behaviors may diverge. With an option you can have a contractual guarantee on the exact investment you're trying to protect. (Additionally, many commodities' value may fall at the same time that stock investments fall: during economic contractions which reduce industrial activity, resulting in lower profits for firms and less demand for commodities.)

You may also note that there are other structures that options may have - PUT options on index funds or similar instruments are probably most specifically relevant to your interests.

The downside of protecting yourself with options is that it costs money to buy this option, and the option eventually expires, so you may lose money. Essentially, you are buying safety and risk-tolerance from the option contract's counterparty, and safety is not free. I cannot inform you what level of safety is appropriate for your portfolio's needs, but more safety is more expensive.

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Appreciate the input. So Is an option always link to a stock? Are there only stock options? Are there only commodity futures with only commodity underlyings? –  bonCodigo Feb 22 '13 at 6:24
    
There are a variety of options, but stock options which are linked to a stock or ETF are very common, relatively straightforward, easy to access through many brokerages, and directly useful for the risks you are trying to mitigate. There are also a variety of non-commodity futures, including currency futures, central bank interest-rate futures, heating-degree-day futures (for climate control costs planning), and futures linked to stock indexes (which could be relevant to your interests, but will generally be a less straightforward way of achieving your goals). –  fennec Feb 22 '13 at 18:37
    
Can you define your risk when you are using both options and futures? –  bonCodigo Feb 22 '13 at 19:12

As I stated in my comment, options are futures, but with the twist that you're allowed to say no to the agreed-on transaction; if the market offers you a better deal on whatever you had contracted to buy or sell, you have the option of simply letting it expire.

Options therefore are the insurance policy of the free market. You negotiate a future price (actually you usually take what you can get if you're an individual investor; the institutional fund managers get to negotiate because they're moving billions around every day), then you pay the other guy up front for the right of refusal later. How much you pay depends on how likely the person giving you this option is to have to make good on it; if your position looks like a sure thing, an option's going to be very expensive (and if it's such a sure thing, you should just make your move on the spot market; it's thus useful to track futures prices to see where the various big players are predicting that your portfolio will move).

A put option, which is an option for you to sell something at a future price, is a hedge against loss of value of your portfolio. You can take one out on any single item in your portfolio, or against a portion or even your entire portfolio. If the stock loses value such that the contract price is better than the market price as of the delivery date of the contract, you execute the option; otherwise, you let it expire.

A call option, which is an option to buy something at a future price, is a hedge against rising costs. The rough analog is a "pre-order" in retail (but more like a "holding fee"). They're unusual in portfolio management but can be useful when moving money around in more complex ways. Basically, if you need to guarantee that you will not pay more than a certain per-share price to buy something in the future, you buy a call option. If the spot price as of the delivery date is less than the contract price, you buy from the market and ignore the contract, while if prices have soared, you exercise it and get the lower contract price. Stock options, offered as benefits in many companies, are a specific form of call option with very generous terms for whomever holds them.

A swaption, basically a put and a call rolled into one, allows you to trade something for something else. Call it the free market's "exchange policy". For a price, if a security you currently hold loses value, you can exchange it for something else that you predicted would become more valuable at the same time. One example might be airline stocks and crude oil; when crude spikes, airline stocks generally suffer, and you can take advantage of this, if it happens, with a swaption to sell your airline stocks for crude oil certificates. There are many such closely-related inverse positions in the market, such as between various currencies, between stocks and commodities (gold is inversely related to pretty much everything else), and even straight-up cash-for-bad-debt arrangements (credit-default swaps, which we heard so much about in 2008).

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Othan than heding the risk, I assume options take advantage of being cheaper than futures.. –  bonCodigo Feb 22 '13 at 19:12
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But they aren't; with an option, you pay more now for the ability to say no later. A traditional future doesn't have this extra cost, because you're obligated to execute the trade whether you want to or not. –  KeithS Feb 23 '13 at 1:51

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