What the Heck Are Futures and Options?

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If you had a crystal ball that could tell the future, how could you use it to make money? You could buy stock in a company you knew would have a good year. For example, if you had invested $10,000 in Nvidia stock a year ago, you would have around $23,000 today. However, that’s only a $13,000 gain, and you needed $10,000 to start with. There must be a more efficient way to use this crystal ball—it is magical, after all!

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Many investors share this desire for a more flexible way to bet on the future than simply buying stocks. Enter derivatives, financial instruments that derive their value from another underlying asset, like stocks or mortgages. Derivatives are considered advanced investing, and once we start explaining them, you’ll see why. They’re complex and abstract, making them challenging to understand—even with a crystal ball.

According to legend, the first recorded derivative was noted by Aristotle over 2,000 years ago. He told of Thales, a philosopher who used his knowledge of the heavens to predict a bountiful olive harvest. With no stock market in ancient Greece, Thales couldn’t buy shares in olive companies. Instead, he paid a small fee to reserve all the olive presses in the area for next season. When the massive olive crop arrived, Thales had cornered the market.

Thales’ strategy resembles the modern derivatives known as futures and options. In simple terms, a future is a contract to make a transaction at a specific price and time. For instance, let’s say lemons cost $2 a pound, but Tina worries the price will rise. She makes a deal with Sam, the grocer, to buy 100 pounds of lemons at $2 a pound one year from now. If she’s wrong and prices drop, she’ll buy above market price, but if prices rise to $3, Sam will have to sell to her at a below-market price, giving her a profit.

Most futures don’t end with physical delivery. Instead of delivering the lemons, Sam would pay Tina the difference in cash. Tina may not even hold the future until the end. If prices rise, she can sell it to someone else, and it might be resold multiple times, with its value fluctuating based on current lemon prices. Futures can resemble a bet on price changes rather than a traditional transaction.

Today, futures go beyond physical assets to include event-based futures, like bets on extreme weather or political events. However, not everything is allowed. Futures on terrorist events were blocked, fearing a "terror market," and election futures were recently proposed for a ban by the Commodity Futures Trading Commission.

Options, a close relative to futures, mostly apply to stocks. They give buyers the right, but not the obligation, to transact at a specific price in the future. This flexibility is why options differ from futures. For example, if Edgar suspects a new plant-based burger from Patty’s will fail, he buys a put option to sell Patty’s stock at $20 per share in three months. If Patty’s stock rises, Edgar can let the option expire and limit his loss to the premium he paid. Had it been a future, he’d be obligated to sell at the agreed price, facing a larger loss.

Originally, derivatives like futures and options helped reduce market risk, but now they’re also used for speculation. Some claim derivatives improve market efficiency by predicting asset values more accurately. However, derivatives can be perilous, especially for individual investors, as they involve complex risks. Warren Buffett famously called them "financial weapons of mass destruction."