Futures and Options are both derivative instruments. Investors can use these instruments to speculate or to hedge risks. Both these instruments derive their value from the underlying index, security or commodity.
What are futures?
Futures are a derivative contract agreement to buy or sell a specific commodity asset or security at a set future date for a set price. Futures contracts, or simply “futures,” are traded on futures exchanges and stock exchanges and require a trading account with a licensed broker to trade futures. A futures contract involves both a buyer and a seller. When a futures contract expires, the buyer is obligated to buy and receive the underlying asset and the seller of the futures contract is obligated to provide and deliver the underlying asset.
Example of a futures contract
Traders A and B agree on a price of $50 per barrel on oil futures contract. If the price of the barrel moves to $54, the buyer of the contract makes $4 per barrel. The seller will lose money as he has to now sell the barrel at $50 when the market price is $54.
Type of futures contracts
There are many types of futures contracts available for trading. These include:
- Commodity futures – Oil, metals, natural gas, food grains, and other commodities are among the most popular commodities for which investors purchase futures contracts.
- Stock index futures – Stock futures are financial derivatives that create an obligation to buy or sell a stock at a certain price and on a specific date in the future.
- Currency futures – The contracting parties agree on an exchange rate for the exchange of two currencies at a future date.
- Interest rate futures – These are a type of hedging against the risk of a financial instrument’s rate of interest fluctuating at some point in the future
What are options?
An option is a contract that gives you the right to buy or sell a financial product at an agreed upon price for a specific period of time. Options are called ‘derivatives’ as the value of the option is ‘derived’ from the underlying asset. When you buy or sell option contracts, you are trading the obligation, to buy or sell the underlying stock. Owning an option, does not impart ownership in the underlying security. It does not entitle the holder to any dividend payments.
Types of options
- Call option – This gives the owner of the option the right to buy an underlying asset at the strike price on or before the expiration date.
- Put option – This gives the owner of the option the right to sell an underlying asset at the strike price on or before the expiration date.
- Index options – All options that have stock market index as the underlying are index options.
- American options – American options can be exercised on or before the expiration date.
- European options – European options can be exercised only on the expiration date.
- Naked options – When a trader exercises his right to sell and doesn’t hold the underlying asset, it is a naked option.
- Covered options – When a trader exercises his right to sell and holds the underlying asset, it is a covered option.
Key terms in options
- Strike price – the price at which the option contract can be executed.
- Expiration date – the last date by which the owner of the contract can exercise the right to buy or sell the underlying asset.
- Premium – the price at which the option is bought or sold. The buyer of the option pays the premium. It is income for the seller (writer) of the option.
