WHAT ARE FUTURES AND OPTIONS ??
Futures and options represent two of the most common form of “Derivatives”. Derivatives are financial instruments that derive their value from an ‘underlying’. The underlying can be a stock issued by a company, a currency, Gold etc., The derivative instrument can be traded independently of the underlying asset.
The distinguishing feature of derivative instrument is that are legal agreements between two parties. In which they agree to trade an underlying asset at a date in the future.
A futures contract is a standardised, exchange tradable contract between two parties to trade a specified asset. Furthermore trade is done on a set date in the future at a specified price.
Futures are just like ready-made products, all the details are predetermined. And you only get futures in specific goods with specific delivery details. Therefore, they are standardised, and all futures are arranged with a clearing house. Futures are just like ready-made curtains available in all shapes and sizes.
LONG AND SHORT
If you ‘buy’ a futures contract, you have declared that you will pay an agreed price on some future day. Furthermore, the purchaser is said to be the long party. Because when the contract is settled the party will have much of the asset.
If you sell a futures contract, you have declared that you will receive the agreed price on some future date. Furthermore, the seller of the future is said to be the short party. Because when the contract is settled the party will be short of the asset.
A clearing house is self-contained institution whose only function is to clear futures trades and settle margin payments. Furthermore, the clearing house checks that the buy and sell orders match each other. Furthermore it acts as ” a party to every trade”.
Each party to a futures contract must deposit a sum of money known as margin with the clearing house. Furthermore, margin payments act as cushion against potential losses which the party may suffer from adverse price movements.
when the contract is first struck, “initial margin” is deposited with the clearing house. Additional payments of “variation margin” are made daily to ensure that the clearing house’s exposure to credit risk is controlled.
For example: suppose that party A agrees to pay party B $100 in 6 months time for a bond that is currently worth $100.
At the start of the agreement, both parties are required to submit returnable “initial margin”, say RS 5. In addition, margin can be paid in cash or in form of some securities. With time it is expected the value of the specified asset might change.
For example: suppose the price of the bond goes up by $102. This is a good news for the buyer as he has agreed to the specified amount which is less than it. The situation is opposite for the seller. this increase in value of the underlying asset makes it more likely that the seller will fail to honour the contract. To cover the expected loss clearing house demands a variation margin from the seller. Furthermore, the buyer can withdraw some of his initial margin.
DIFFERENT TYPES OF FUTURES IN THE MARKET
Index futures are the exchange of a fixed amount of cash for an index instrument related to a specific date in the future. Furthermore, they are the relative price for the future value of the index. Quotes for index futures are the anticipated value of the index at the maturity of the futures contract.
Stock futures are the exchange of a fixed amount of cash for a stock instrument related to a specific date in the future. Furthermore, they are the relative price for the future value of the stock instrument and can also be the price of the future spot exchange rate and the future risk-free spot interest rate. Quotes for stock futures are the anticipated value of the stock at the maturity of the futures contract. The dividend associated with such stock and the interest rate until the maturity of the futures depend on the current value of the stock.
Currency futures are the exchange of fixed amount of cash for currency instrument related to a specific date in future. Furthermore, they are the relative price for the future spot exchange rate and also the price for the future risk-free spot interest rate for both currencies.
there are many other kinds of futures available in the market such as bond futures, commodity futures etc.
An option gives an investor the right, but not the obligation, to buy or sell a specified asset on a specified future date.
Furthermore, options are contracts between investors to trade an underlying security at a given date at a set price.
there are two basic types of options:
- a call option, which gives the investor the right to buy a specified asset on a set date in the future for a set price.
- a put option , which gives the investor the right to sell a specified asset on a set date in the future for a set price.
from these two options, there four positions that an investor could hold:
- buying a call option
- buying a put option
- writing a call option (selling)
- writing a put option (selling)
when you write an option you collect a premium for giving the holder the right to exercise the option.
there two types of timing systems under options:
- american style, which is an option that can be exercised on any date before its expiry.
- european style, which is an option that can be exercised only at expiry.