Knowing and minimizing the risks of derivatives trading
Traders can raise the bar on the leverage they’re allowed by opening the door to the derivatives markets. Derivatives are any financial instruments that get or derive their value from another financial security, which is called an underlier. This underlier is usually stocks, bonds, foreign currency, or commodities. The derivative buyer or seller doesn’t have to own the underlying security to trade these instruments.
You may unwittingly encounter derivatives if you trade those exchange‐traded funds (ETFs) that offer to return two or even three times the value of an underlying stock index. Those ETFs use derivatives to amplify the reward — and the risk. And you may recall that derivative trading, especially those derivatives tied to the value of underlying mortgage assets, exacerbated the mortgage mess that started the financial collapse of 2008.
Derivatives traders use futures and options, which are the two most common types of derivatives, to make money in a highly risky venture. In this chapter, we introduce you to a variety of derivatives, how they’re traded, and the risks involved in trading futures and options. However, you need to seek additional training before jumping into this kind of trading.
Types of Derivatives: Futures and Options
Derivatives are marketable instruments, which over time acquire and relinquish value based on an underlying asset (see the later section “Options lingo”), including such commodities as coffee or soybeans, bonds, and even stocks. They are commonly used by commercial and institutional organizations to hedge against the risks of financial losses suffered by the underlying assets that they hold. Trading a derivative, for example, can minimize your financial loss whenever a major change occurs in the price of an asset that you own. Hedging is a popular tactic used by growers, producers, portfolio managers, and users of the commodities.
The two basic and most common types of derivatives are contracts for options and for futures. Traders buy and sell them as a way to speculate on the direction that the volatile prices of underlying assets will take further down the road. If their hunches are right and the prices move in the directions they expect, traders can make a significant profit. If, on the other hand, they’re wrong, they can lose the amount they paid for an option or future and possibly even quite a bit more. Before we explain all the risks, we devote the next few sections to accurately defining futures and options.
Buy now, pay later: Futures
Futures are legally binding contracts between two parties, one of whom agrees to buy and the other who agrees to sell an asset for a specific price at a specified time in the future. The specific price is known as the futures price. The specified date in the future is known as the delivery date. Futures were first used in the 18th century in Japan as a means of trading rice and silk, but they didn’t appear in U.S. markets until the 1850s, when futures markets were developed for buying and selling commodities such as wheat, cotton, and corn.
Futures contracts are one of the most volatile trading instruments. Prices can change rapidly, causing traders to face sudden and sometimes huge losses or gains. Futures contracts are traded based on the prices of underlying commodities, indexes, bonds, and stocks. Most people who enter futures markets do so not to actually buy and sell the actual goods or underlying financial asset but rather to speculate on or to hedge the risks of the changing prices of the assets that they do hold.
Futures contracts are riskier than options because you actually have to come up with the underlying commodity, bond, stock, or currency to satisfy the contract, sell the future at a loss before the settlement date, or pay the difference in cash to settle the contract. Futures are binding contracts that require you to fulfill the obligations specified in the contracts. Options are less risky because they’re not an obligation to perform. Rather, they give the buyer of the option the right to exercise the option, but the buyer isn’t obligated to do so. We explain options in the later section “Wait and see: Options.”
What’s your position?
When people talk about futures, they’re bound to say something about their positions. Here’s what they mean:
Short positions: The party in the contract who agrees to deliver the commodity, stock, or bond holds a short position. Traders who take short positions are expecting the price of the underlying commodities to go down.
Long positions: The party in the contract who agrees to buy the commodity, stock, or bond in a futures contract holds a long position on the security. Traders who take long positions are expecting the price of the underlying commodities to go up.
Making money using futures
Traders can make money from trading futures on the basis of the daily movements of the markets for the various types of underlying commodities, stocks, bonds, or currencies involved in the contracts they buy and/or sell.
For example, typical futures contracts for wheat are signed between wheat farmers and bread producers. On one side of this contract, farmers agree to sell a specific amount of the wheat they grow at a specific price and a specified time, and on the other side, producers agree to pay that price for the contracted amount of wheat to be delivered to them by the specified time. Farmers benefit by ensuring that they can get a specific price or income from their wheat, and bread producers benefit by knowing how much they have to pay for the wheat they need to make the bread that they, in turn, sell to earn a living.
The value of that futures contract is adjusted daily. Assuming the farmer agreed in February to sell 10,000 bushels of wheat to the bread maker at $4 per bushel in July, and assuming that before the July settlement date the price of wheat rises to $5 per bushel, the farmer holding the futures contract has lost $1 per bushel of wheat, or $10,000. These types of price adjustments actually are calculated daily throughout the time that the futures contract is in force, and that means the farmer’s or bread maker’s account is credited or debited as wheat prices fluctuate.
The farmer and the bread maker will probably never actually exchange their goods. Instead, the obligations of the futures contract eventually are settled with cash. In this scenario, the bread maker will probably buy his wheat at the current price of $5 per bushel when he needs it, but because he speculated correctly on the price, it’s only really costing him $40,000 (instead of $50,000 at the current market price) to buy the wheat. Although the bread maker pays $50,000 for 10,000 bushels of wheat, he has saved $10,000 because of the money he made on the wheat futures contract. The farmer, on the other hand, sells his wheat at $5 per bushel and gets $50,000 cash but actually keeps only $40,000 because he has to cover his loss from the futures contract.
You can see from this example that futures contracts are actually financial positions. This financial position, or the buying and selling of futures contracts, is what traders are speculating about. If futures traders believe the price of wheat is rising, they buy futures contracts so they can benefit from the gain made by the price. But when the situation is reversed and the price of wheat drops to $3 per bushel, then the trader who buys can be on the losing side of that futures contract and be liable for a $10,000 loss. The buyer puts up a margin, which is only a small percentage of the price of the actual commodity, stock, bond, or currency underlying the contract.
Commodities futures
People who buy commodities futures basically are agreeing to buy a certain amount of a commodity at a set price at some point in the future. Conversely, people who sell those same futures are agreeing to provide a certain amount of a commodity at the agreed‐upon price by the agreed‐upon time. The example of the farmer/bread maker in the preceding section illustrates this type of future. Buyers or sellers can enter into futures contracts on many commodities, including farm products (pork bellies, wheat, corn, and soybeans), precious metals (gold, copper, and silver), and many others.
Traders usually don’t get directly involved as buyers and sellers of the actual commodities because they usually get out of their futures contracts before the underlying commodities on which their trades are based ever change hands. Instead, they’re speculators, buying and/or selling futures contracts based on which way they think the commodity price is going to move. Speculation, as you know, is wrought with risk, and the reason the risk is so great is that a commodity contract controls a large amount of the commodity (or commodity value) compared with the relatively small margin that it takes to enter into a contract. The result is extensive leverage, which means controlling a large position with only a small cash deposit. If the price moves in a direction that’s the opposite of what the trader anticipates, he or she may have to take a huge loss to get out of the contract.
Index futures
Index futures are based on the expected direction of the value of indexes like the S&P 500 and the New York Stock Exchange Composite indexes. They can be the riskiest types of futures. No underlying commodities, stocks, or bonds ever change hands with these futures contracts. Any differences in these contracts must be settled with good old cold, hard cash. Margin also is high on these types of futures. For example, a Dow Jones Industrial Average contract has a value that’s 25 times the value of the underlying DJIA Index.
Smaller index futures contracts, known collectively as e‐minis, are targeted at individual traders. These mini contracts are available for indexes such as the S&P 500, the NASDAQ 100, the S&P mid‐cap, and the Russell 2000. Their respective individual values range from 20 times to 100 times those of the underlying indexes.
The S&P 500 e‐mini contract, for example, is 50 times the value of the S&P 500 index. In other words, if a trader takes a position in the S&P 500 e‐mini contract, every time the underlying S&P 500 index moves one point, the value of the S&P 500 e‐mini contract changes by $50. Another way to think about this is for every 0.25 point, the value of the S&P 500 e‐mini contract changes by $12.50. If you take a long position in the S&P 500 e‐mini contract when the underlying index is at 1,500, and the index moves to 1,510, you have a $500 profit. The trader who took the other side of this trade, the short position, is in exactly the opposite position, losing $500.
Bond futures
Bond futures are based on the price of future delivery of a specific type of bond in a specific denomination at a specific interest rate on a specified date. Speculators basically are betting on whether the price of that bond goes up or down. Changes in interest rates have a big impact on bond values. In general, when interest rates fall, bond prices go up, and when interest rates rise, bond prices go down. Speculators in bond futures basically enter positions based on whether interest rates will go up or down. For example, a speculator who thinks interest rates will go up sells contracts for the future delivery of bonds. If interest rates indeed go up as expected, the price for the underlying bonds goes down, and speculators can do one of two things:
Buy the lower‐priced bonds and, in turn, earn a profit by selling them to the buyer to settle at the higher price named in the original futures contract.
Close the contract to realize a profit.
Stock futures
Stock futures are contracts in which you agree to either deliver or purchase upon delivery 100 shares of a particular stock on or before a designated date in the future (known as the expiration date). For example, a trader who enters into a contract to buy 100 shares at $30 a share for a total of $3,000, and who expects the price of that stock to go up, can lock in the lower price and then buy the actual stock at that lower price on the expiration date or close the contract and realize a profit. Traders who enter into this type of contract generally must have about 20 percent of the cash value of 100 shares of the underlying stock in their brokerage accounts, so a trader in this example would have to have $600 in a brokerage account.
Foreign currency futures
Future currency contracts are contracts that involve the future delivery of certain foreign currencies. We discuss these types of futures in Chapter 20.
Wait and see: Options
Options are financial instruments that give the buyer the right, but not the obligation, to buy or sell a particular asset at a predetermined date in the future at a specified price.
Although futures have been available in the United States since the 1850s, options did not become available until 1968, when they were part of a government pilot program. The Chicago Board of Options Exchange opened in 1973. The big advantage that options have over futures is that you buy the right to exercise the option contract, and yet you still can decide to allow the option to expire without ever exercising that right. When you let an option expire, you lose only the amount you paid for the option and not the full amount that otherwise can be lost in trading the underlying asset. Option sellers take the riskier stance because they can lose the value of whatever asset they promised to sell or buy if the option buyer decides to exercise the option.
Options lingo
Trading in options has a language all its own, and you need to understand it before we get into the mechanics, so here are some key terms:
Puts: A put option is a contract that gives the buyer the right to sell a particular asset at a specified price at any time during the life of the option.
Calls: A call option is a contract that gives the buyer the right to buy a particular asset at a specified price at any time during the life of the option.
Option grantor: The person who writes or sells any option is called the option grantor. This person or financial entity must come up with the underlying asset promised in the option, even if doing so means a loss, whenever an option buyer decides to exercise an option. For example, if an option grantor agrees to sell you 100 shares of ABC stock for $50 per share on or before May 1, and the stock price rises to $60 on April 20, then the grantor must sell you that stock for $50 and take the $10‐per‐share loss. You get to sell ABC at the current price and reap the benefits.
Covered calls: If an option seller holds an equivalent position, or owns the same number of shares of the underlying asset that is offered in the call, then the contract is considered a covered call. Options traders selling covered calls are trying to take advantage of a neutral or declining stock. If the option expires unexercised, the writer (seller) of the option keeps the premium. If, on the other hand, the holder (buyer) of the option exercises it, the stock must be delivered. However, because the option writer already owns the stock, the risk is limited. The opposite scenario is an uncovered call, which is when the writer sells a call for a stock that he or she doesn’t own. The seller of an uncovered call is taking virtually unlimited risk.
Covered puts: When the seller of a put option also has sold short an equivalent amount in the underlying security, then this option is considered a covered put. If the writer has neither established a short position in the underlying security nor deposited a corresponding amount of cash equal to the value of the put, then the put is called a naked put. The seller of a naked put also is taking virtually unlimited risk.
Option holder: The person who buys the option is called the option holder. If the option buyer buys the right to sell an asset at some time in the future, then he or she buys a put option. If the option buyer buys the right to purchase an asset at some time in the future, then he or she buys a call option. The most an option holder can lose is the amount paid for the option contract.
Underlying asset: An option contract is based on an underlying asset — usually either a futures contract or specific number of shares of stock — that can be bought or sold.
Premium: The actual price paid for the option is called the premium, which is what the option holder pays to the option grantor to gain the right to either buy or sell the underlying asset. Premiums for options are set by the open market. Option buyers must pay the premium plus whatever fees their brokers charge for such transactions.
Expiration date: The expiration date is the last day that an option buyer can exercise the rights specified in the contract. Options based on futures contracts usually expire one month before the settlement date of the underlying futures contract. After an option expires, the option holder no longer has any rights, and the option has no value. So option buyers lose whatever premium they paid plus any commissions or transaction costs that had to be paid when the option was purchased. In that case, the option is said to expire worthless.
Exercise: Option buyers can exercise the rights they purchase with the option any time before the expiration date — if, that is, the option they purchased is an American‐style option. European‐style options, on the other hand, can be exercised only on their expiration dates. Exercising a call option means the option buyer buys the underlying asset at the price set in the option, regardless of the current market price for the asset. Exercising a put option means the option buyer sells the underlying asset at the price set in the option. An option buyer can always decide not to exercise the rights set forth in his or her option and simply let it expire. The option holder also can sell the option contract at its current market value.
Strike price: The strike price is the price of the underlying asset at which the option can be exercised.
Offset: If option buyers or sellers want to realize their profits or limit their losses, they can offset their option through a sale or purchase that is called liquidating an option or closing an option. When an option is liquidated, no position is actually taken in the underlying asset. Offsetting is usually done on the same exchange where the buyer first bought or sold the option. If she can sell the option for more than she bought it, then she will realize a profit. If she sells the option for less than she paid, then she will take a loss.
In the money: An option is said to be in the money when it is worthwhile to exercise the option and buy or sell the underlying asset. A call option is in the money when the market price for the underlying asset is above the strike price set in the option contract. A put option is in the money when the price for the underlying asset is lower than the strike price set in the option contract.
At the money: An option is deemed to be at the money when the strike price for the option is the same as the market price for the underlying asset.
Out of the money: An option is said to be out of the money when exercising the option isn’t worthwhile. A call option is out of the money when the strike price is higher than the market price for the underlying asset. A put option is out of the money when the strike price is less than the market price for the underlying asset.
Option pricing
The three factors affecting the price of an option premium are as follows:
Date of expiration: As the option moves closer to its date of expiration, the value of the option declines, and that’s why an option is considered a wasting asset. The more time that you have until an option expires, the greater possibility you have for the option to reach the point of being in the money. Longer options therefore have higher premiums.
Strike price: For out‐of‐the‐money options, when the current market price moves more and more out of the money and away from the strike price, the premium price gets lower and lower for put options and higher for call options. The premium for an in‐the‐money call option, on the other hand, rises in value if the underlying asset moves further into the money in relationship to the strike price.
Volatility: The more volatility that’s expected by the market for the underlying asset, or stock, the greater the chance that the option will become worthwhile to exercise. When the market for an asset is volatile, premiums for options on that asset are higher.
Option‐pricing techniques are considered to be among the most mathematically complex of all applied areas of finance. One common example, the Black‐Scholes option‐pricing model (named for its developers Fischer Black and Myron Scholes), takes into consideration the stock’s price, the option’s strike price and expiration date, the risk‐free return, and the standard deviation of the stock’s return, which are all measures of volatility.
When you get a quote for an option, you may have to choose from numerous strike prices and expiration dates that are available. When you’re thinking about buying a call option, and its strike price is low and yet close to becoming worthwhile to exercise, the premium price (the price you pay for the option) will be much higher than for an option with a higher strike price. If you’re thinking about buying a put option, then you’ll pay more of a premium for an option with a high strike price than you will for one with a lower strike price.
Just to give you an idea of how the pricing of options is affected by strike price and time, Table 19‐1 is an options quote for an imaginary stock we call ABC. Settle is the time of expiration for the option.
TABLE 19‐1 ABC Stock Sample Option Quotation (In Dollars)
Strike Price
Calls/Settle
Puts/Settle
Apr
May
June
Apr
May
June
$50
4.50
4.60
5.40
0.25
0.50
1.50
$52
3.50
3.60
4.40
0.50
1.00
3.50
$54
2.50
2.60
3.40
0.75
2.00
5.50
$56
1.50
1.60
2.40
2.00
3.00
7.50
$58
0.50
0.60
1.40
4.00
5.00
9.50
You can see from the options quotes for ABC stock that a May call with a strike price of $54 commands a premium of $2.60 per share. To buy an option for 100 shares, the premium would be $260 plus whatever fees your exchange or broker charges. Buying a call is much less of a cash outlay than if you were to buy 100 shares of ABC stock at $54. That would cost you $5,400. The premium of $260 is paid to the option seller, minus any fees charged by the broker or exchange.
Fees include commission charges plus any costs involved in executing the order on the trading floor of the exchange. Commissions vary greatly from broker to broker, so be certain you understand all the possible fees before initiating a trade. Some brokers charge commissions per trade, but others charge on the basis of a round trip, including both the purchase and the sale of the option. Some brokerage firms charge per‐option transaction fees, while others charge on the basis of a percentage of the option premium that’s usually subject to a minimum charge.
Commission charges can have a major impact on whether you’re able to earn a profit or have to suffer a loss on an option. A high commission charge reduces your potential for making a profit and can even drive what little profit you make into a loss. So be careful. Know what charges you have to pay and compare them with other brokers before you trade.
Options and futures are quoted with bid and ask prices just like stocks, and the spreads with options can grow pretty wide as a percentage of the option’s premium, which, in turn, can have a significant impact on the profitability of your option position. The wider the spread, the harder it is for you to make a profit. As an option trader, you typically buy at the ask, the higher price, and sell at the bid, the lower price. That means that any trade must recover the difference between the bid and the ask before you can earn a profit. As with stock trading, you can use a limit order to put your order between the bid and the ask, but there is no guarantee that your order will be filled. See Chapter 15 for more about bid‐ask spreads.
Buying Options and Futures Contracts
All types of options and futures are traded on a commodities exchange. In addition, some types of options can be traded on stock exchanges. More than 20 different exchanges are available for trading either options or futures contracts or both in North America. The chart at https://www.interactivebrokers.com/en/index.php?f=1562 from Interactive Brokers lists all the exchanges and the types of contracts in which they trade. The chart also provides trading hours.
At the top of this chart, you’ll find links to exchanges in Europe, Asia/Pacific, and Global Exchanges.
You can trade stock options and some index options in a traditional stock account. You must sign special risk‐release forms, but otherwise, the account remains the same. (For more about establishing an account, see Chapter 3.) Naked short positions require a margin account.
Opening an account
If you want to trade futures or options on futures, you must do so through an individual account that you open with a registered futures commission merchant (FCM) or through your stock broker. Your broker transmits any transactions through an FCM as an introducing broker. Your broker won’t collect the funds from you for your options trades. You have to deposit them directly with the FCM.
You have the choice of opening either a discretionary account or a nondiscretionary account. A discretionary account is an account in which you sign a power of attorney over to your FCM, your broker, or a commodity trading advisor (CTA) so he or she can make trading decisions on your behalf. A nondiscretionary account is an account in which you make all the trading decisions.
You also may want to consider trading through a commodity pool. When trading through a commodity pool, you purchase a share or interest in a pool of other investors, and trades are executed by an FCM or CTA. Any profits or losses are shared proportionately by the members of the pool.
When you open an individual account, you need to make a deposit that amounts to a margin payment or performance bond for the futures you trade. This payment is relatively small compared to the size of your potential market position, and it gives you the opportunity to greatly leverage your money. Small changes in options and futures prices can result in large gains or large losses in relatively short periods of time.
Your broker calculates the values of the futures and option contracts in your account on a daily basis, and you need to maintain a margin level that’s approximately 50 percent of the amount required when you originally enter your positions. If your holdings fall below that level, you’ll be asked to come up with the cash to restore your margin account to the initial level, a situation that’s known as a margin call. If you can’t meet the margin call in a reasonable period of time, which can be as little as an hour, your brokerage firm closes out enough of your positions to reduce your margin deficiency. If your positions are liquidated at a loss, you can be held liable for that loss, which sometimes can be substantially more than your original margin deposit.
Calculating the price and making a buy
Before buying an option, you first must calculate the break‐even price, but you must know the option’s strike price, the premium cost, and the commission or other transaction costs to be able to do it. With those three details in hand, you can determine a break‐even price for a call option using this formula:
Using the example in Table 19‐1, here is the per‐share break‐even price for buying a May call option with a strike price of $54 and a commission of $25, or 25 cents per share:
To make a profit on this call option, the stock price of ABC has to rise above $56.85. If the stock price doesn’t rise above $56.85, you won’t make a profit on this option purchase (unless you’re somehow able to sell the option for more than $2.85 before the expiration date — see the next section). These calculations are correct only when your broker has one fee for a round‐trip option exchange. If you have to pay fees in both directions, which is common, then you need to double the fee in the calculation.
When calculating the break‐even price for a put option, you subtract the premium, commission, and transaction costs. Here is the break‐even calculation for a May put option for ABC stock at a strike price of $54 with a commission of $25, or 25 cents per share:
In this scenario, ABC stock has to drop below $51.75 for this put option to be worthwhile.
If you’re expecting a stock price increase, you want to consider purchasing a call option, but if you expect a price decline, you want to consider purchasing a put option. In both scenarios, you need to check the fundamental and technical analyses information you gathered on the underlying stock or asset so you can be certain that any break‐even prices you’ve calculated reasonably match what your analysis indicates.
Options for Getting Out of Options
After you buy an option, you have to decide how you want to opt out of that position. You can choose one of the following three alternatives:
Offset the option.
Continue holding the option.
Exercise the option.
Offsetting the option
You offset an option by liquidating your option position, usually in the same marketplace that you bought the option. If you want to get out of an option before its expiration date, you can try to sell it for whatever price you can get. Doing so either enables you to take your profits or reduces your potential loss by the amount you receive for the option. As long as you bought your option in an active market, other investors usually are willing to pay for the rights your option conveys. The key, of course, is how much they’re willing to pay.
Your net profit or loss for this option is determined by the difference between what you originally pay in premiums, commissions, and other transaction costs minus the premium you receive when you liquidate the option after deducting commissions and other transaction costs.
Holding the option
If your option is not yet in the money but you still believe it may get there, you can continue to hold the option until the exercise date. If you’re right, you can exercise the option before the expiration date or liquidate at a later date, which means to buy or sell the option before the expiration date at some time in the future. If you’re wrong, you risk the possibility that you won’t find a buyer or that you’ll have to let the option expire and take a loss that is equal to the amount of the premium, commission, and transaction costs you paid. Some traders take an even riskier position by buying options that are deeply out of the money for just pennies a share. Even if these options never grow any nearer to being in the money, as long as they move in the right direction, the premiums will rise. Although we don’t recommend using this strategy, you can make profits as long as you’re able to sell the option before its expiration date.
Options decline in value as they get closer to their expiration dates, so if you think you’ve made a mistake and the market moves against your position, bite the bullet as soon as possible and try to liquidate your option to minimize your losses.
Exercising the option
You can exercise an option any time prior to its expiration date, as long as you’re trading in American‐style options. You don’t have to wait until the exercise date to exercise an American‐style option. (Some option contracts sold in the United States are European‐style, which can be exercised only on the expiration date.) Exercising an option means
Buying the underlying asset when you own a call
Selling the underlying asset when you own a put
In general, call options are exercised only when the trader plans to hold the underlying asset, and put options are exercised only when the trader owns the underlying asset and wants to sell it. Option traders are more likely to realize any gains or losses by closing their option positions rather than exercising them.
The Risks of Trading Options and Futures
Trading in options and futures is risky business, and regulations governing those trades are stringent, even with regard to allowing you to open an account. Before opening an account for you, a broker must provide you with a disclosure document that describes the risks involved in trading futures and options contracts. The document gives you the opportunity to determine whether you have the experience and financial resources necessary to engage in option trading and whether option trading is appropriate for meeting your goals and objectives.
Topics that must be covered in the disclosure statement include the risks inherent in trading futures contracts or options and the effect that leveraging your account can have on potential losses or gains. The statement also must include warnings about trading futures in foreign markets because those types of trades carry additional risks from fluctuations in currency exchange rates and differences in regulatory protection.
Commodities options and futures also can be risky because many of the factors that affect their prices are totally unpredictable, such as the weather, labor strikes, inflation, foreign exchange rates, and governmental policies. Because positions in futures and options are so highly leveraged, even a small price movement against your position can result in at least the loss of your entire premium payment and possibly even much greater liability for additional losses.
After you begin trading options and futures, you can’t close your account until all open positions are closed — if, that is, you’re trading through an account with a commodities exchange. This restriction doesn’t apply to options traded in a stock brokerage account. Any accruals on futures contracts are paid out daily. Any funds in your margin account that are beyond your required margin or account‐opening requirements can be withdrawn, but other such funds have to remain in the account until all your positions are closed. Any restrictions on the withdrawal of your funds are stated in the original disclosure document. Be sure that you understand those restrictions before committing your funds.
After opening your account, your broker usually mails or emails confirmation of all purchases and sales, a month‐end summary of transactions that shows any gains or losses, and an evaluation of your open positions and current account values. You need to be able to get information from your broker on a daily basis after you begin to trade.
Brokers are required to segregate any money you deposit in your account from the brokerages’ own funds. The amount that is segregated either increases or decreases depending on the success of your trades. Even if the brokerage firm segregates your funds, you still may not be able to get all your money back if the brokerage firm becomes insolvent and is unable to cover all the obligations to its customers. In other words, the money you put into your brokerage account is not insured.
Whenever problems with your broker arise and you can’t resolve them without help, you have several dispute‐resolution options. You can contact the reparations program of the Commodity Futures Trading Commission (CFTC) and ask for an industry‐sponsored arbitration, or you can take your broker to court. Before deciding how you want to proceed, you must consider the costs involved with each option, the length of time it may take to resolve the problem, and whether you want to contact an attorney. You can get more information about dispute‐resolution alternatives by contacting the CFTC at www.cftc.gov/ConsumerProtection/ReparationsProgram/index.htm or by calling 202‐418‐5250.
Minimizing Risks
In a nutshell, the best way to minimize the risks of derivatives trading is to take the time to find out as much as you can about the inherent risks of the derivatives you’re trading and how others have dealt with them. The first step you can take is to check out the firms or individuals with whom you plan to trade. All firms and individuals that offer to trade options or futures must be registered with the CFTC (www.cftc.gov) and be members of the National Futures Association (NFA; www.nfa.futures.org). You can check out firms and individuals online at the NFA site by using its Background Affiliation Status Information Center (BASIC). On BASIC, you’ll find the status of the firm or individual and any disciplinary actions taken by the NFA, the CFTC, or any U.S. exchanges. You can start a search on BASIC from the Investor Information page at www.nfa.futures.org/NFA-investor-information/index.HTML.
Next, be sure that you’re familiar with the firm’s commission charges and how they’re calculated. Compare one firm’s quotes with those of other firms you’re considering. Whenever a firm has unusually high commission charges, ask for a detailed explanation for the higher charges and what additional services justify the higher cost.
Always make sure that you calculate the break‐even price for any option you’re thinking about purchasing, because you have to know at what point the option you’re planning to buy will be profitable and whether the data you’ve collected justifies the option’s premium costs.
You also need to understand the market for the underlying asset of the option or future you plan to buy and what can impact the market price of that asset. Be sure that your expectations for the potential profits from the option or futures contract you choose are reasonable.
You don’t ever want to buy an option without first coming to a full realization that you can lose the entire value of your trade. If you want to take the riskier position as an option writer, be sure you can accept the possibility that your losses may exceed the premium you initially received for the option. Option writing comes with the potential of unlimited losses, as does futures trading.
Just as with stock trading, you can limit your losses by carefully setting your risk limits before you start to trade. Don’t let yourself get caught up in the emotions of futures and options trading. Develop a plan before you buy that first option or future and stick with that plan, and be sure to diversify your holdings not only by asset types but also by time of expiration.
After you determine how much capital you want to put into trading derivatives, make sure that you know how much you can afford to lose on just one trade to be able to stay in business. You don’t want to overexpose your cash position on one trade and risk the possibility that you won’t have the money you need when the next opportunity comes along. By exposing your capital to a variety of markets, you also have a better chance that some of your trades will end up succeeding — how bad can that be?
Be wary of firms that lead you to believe you can make lots of money trading options or futures with very little risk. That’s never true. If a firm is using high‐pressure tactics to get you to trade, that’s a sure sign of a problem, so don’t allow yourself to be rushed into a trading decision. If you aren’t being given enough time to construct your own fundamental and technical analyses before you make a purchase, walk away from the deal.
The risks associated with trading futures and options can be more than you initially paid for the trade, so be careful out there! We’ve given you an overview of the options and futures trading arena, but before you jump in, be sure you get significantly more training.
Explaining how futures and options work
Derivatives traders use futures and options, which are the two most common types of derivatives, to make money in a highly risky venture. In this chapter, we introduce you to a variety of derivatives, how they’re traded, and the risks involved in trading futures and options. However, you need to seek additional training before jumping into this kind of trading.
When people talk about futures, they’re bound to say something about their positions. Here’s what they mean: 
After you begin trading options and futures, you can’t close your account until all open positions are closed — if, that is, you’re trading through an account with a commodities exchange. This restriction doesn’t apply to options traded in a stock brokerage account. Any accruals on futures contracts are paid out daily. Any funds in your margin account that are beyond your required margin or account‐opening requirements can be withdrawn, but other such funds have to remain in the account until all your positions are closed. Any restrictions on the withdrawal of your funds are stated in the original disclosure document. Be sure that you understand those restrictions before committing your funds.