There are a number of reasons why this form of trading makes sense, and the right answer depends largely upon the portfolio’s strategy and position.
Let’s look at the a few of the main reasons.
Firstly, futures allows investors to insure, or hedge, their portfolios.
Just as a homeowner buys insurance on his house in the event of a catastrophe, sophist acted investors know that they can buy insurance on their stocks.
This is particularly useful to investors who are highly leveraged, since it gives them an opportunity to reduce their exposure to risk and limit the potential downside of their investments.
This insurance comes at the price of buying options contracts. For example, an investor that already owns shares of Company XYZ might buy a put option on that company. This means that the investor thinks the stock price will go up (which is why he owns the shares), but buys the put option so that he can sell the stock at a preset price and limit his risk in the event the company crashes.
This is particularly common for companies who are naturally overexposed to an industry or commodity. A company whose primary business model relies on having a stable or rising price of coffee, for example, might buy put options on coffee, limiting their loss in the event of a crisis.
Another reason investors use options is to increase the leverage of their portfolio.
This is possible because the cost of buying the options contract is just a small fraction of the cost of buying the underlying stock. Then, if the stock goes above the strike price, the investor can buy the shares and make an immediate profit.
This provides a number of leveraging options. For example, let’s say an investors thinks that 3 stocks are all going to rise, but doesn’t have enough capital to invest in all 3. He might buy a call option on each of those companies (for a fraction of their share price). Then, when company 1 rises above the strike price, he can buy and sell their shares, turning a profit. Then he can buy and sell the shares of companies 2 and 3, in turn, and wind up with a profit on each of them, without needing to provide the underlying capital upfront.
Finally, many investors use options strategies to generate additional income from their portfolios.
Most commonly, these are the investors who write the options contract. This gives them an opportunity to effectively “rent out” the stocks that they hold. They earn a commission for writing the option contract, and continue to earn dividends on the stock they hold.
Structured correctly, this can provide a significant and consistent boost in one’s monthly investment income.