Instrument background

General

This part of the site focusses on some general background on stocks and derivates. Derivatives are, as the name implies, products derived from some underlying value. This underlying value could be a stock for instance, an index or maybe a currency. All derivatives have in common that they provide you with leverage with respect to the underlying value.

Why use any kind of instrument besides stocks?

The answer to this question depends on your style of investing. If you are for instance a longterm investor, you would probably be best off focussing on stock and good information on stock basics. Also see www.learnstockmarketlegends.com to see how some of Wall Street's great traders operated. The next step could be hedging your portfolio to minize risk and protect your assets from crashes and such. Options would be a good way to do that (expect to see more on hedging your portfolio on this site shortly). If you have a great feel on what the market will do on short terms I would suggest either futures and/or options. It all boils down to a risk/reward/effort trade off.

Remember: you get paid to expose your money to risk and you pay for reducing risk in your portfolio!

So what kind of instruments should I use?

First off, please always keep in mind that this should be a question of which instrument gives you the best reward/risk/effort characteristic. This should always be in the back of your mind. More complex instruments like options expose you to risk on various factors (i.e. volatility, interest, sentiment, ...) but then again, you could also benefit from these factors. For instance, selling a future will not allow you to benefit from a decrease in volatility, but selling an option will! Then again, if you expect the market to rise, but you don't want to be bothered by volatility considerations, buy a future! This site will allow you to analyze option structure once you start working with option as an instrument and also choose a trading strategy like for instance Index Options Trading Systems.

Summary

The previous considerations illustrate very briefly which instrument you could and should use. The following questions provide a bit of a sanity check to see if a certain instrument is correct depending on your considerations. This list of questions should of course not be taken as the alpha and omega of instrument selection, far from it, but could provide you with a starting point to research the various instruments further to see what they can do for you. Examples of considerations for stock, options and futures are given to illustrate a train of thought.

1. What is my timeframe and how much time can I spend on investing?
   The answer should tell you if you should be primarily using buy/hold strategies, if you could also more actively hedge your position or if you could engage in actual derivatives trading. Stock doesn't have any time components, you can buy/sell stock intraday or keep them for years. Options and futures have an expiration date and therefore by definition have a limited time span. If you can spend a number of hours investing per week, perhaps use buy/hold strategies and maybe option/futures that expire a few to many months from now. If you can spend an hour every day, maybe option structures with weekly options or monthly options/futures are a good instrument for you. Hard question though, because this requires expirience.
2. How large is my portfolio?
   For instance, a deep in the money AEX option will vary 500€ in value per 1% movement when the index is 500. That is equivalent to a stock investment of 50.000€ (note that 50.000€ = 100 (number of options/contract) x 500 (index)). So it will not make much sense hedging a 5.000€ stock position correlated with the AEX with an AEX option, in essence you are then option trading and not hedging. Always relate movement in the instrument to corresponding movement in stock and relate this back to your portfolio. If you feel you are using too much leverage, use another iinstrument.
3. What are the factors I know and care about?
   As mentioned before, if you do not want to be bothered by worrying about a factor like volatility, use an instrument that has no volatility considerations. If you do not want to be bothered too much by getting the timing right, long term stock trading would for instance be better than short term option trading. But here's the fun part, if you don't want to be bothered by which way the market is going but are anticipating volatility, large movements or no movement at all, options are the key for you. Here's a table illustrating the various factors the example instruments are sensitive to:
   

    

   Instrument	Value sensitive towards changes in:	Profits possible when prediction is right on:
   Stock	Market direction.	When market goes up.
   Futures	Market direction.	When market goes up or when market goes down.
   Options	Market direction and volatility. (also some sensitivity towards interest)	When market goes up or down. If markets move less than expected or more than expected. Estimation of range for underlying value at expiration.