Futures and Options explained

admin — Wed, 28 Oct 2009 07:26:28 +0000

Futures and options are the derivative instruments in which the buyer and seller enter into an agreement or transaction which will get settled on a future date. In simple terms it is a promise between buyer and seller to transfer the actual underlying assets (commodities, gold, stock, currency etc) on a specific future date at a specific stipulated price as per the agreement.

To understand this in a better way, let’s have a look at the below comparison chart between futures and option:

Futures
In futures contract the buyer and seller enter into an obligatory agreement to exercise the contract at maturity.

Both the buyer and seller have the obligation to exercise the contract which means on maturity, seller will transfer the underlying securities and buyer will make the cash payment as per agreed price.

The buyer does not have to pay any amount for buying a futures contract because it is an enforceable agreement which will get settled on maturity date.

Example of future trading:

A person bought a futures contract to buy security A at a price of Rs 500 on a specific future date. On the expiry date, the price went up to Rs 600. So the deal is good for buyer who will get the securities at Rs 100 lesser than the actual market price. On other side, it is devastating for the seller who is obliged to sell them at lower price which has been agreed upon.

Options
In options contract the buyer is given an option to decide whether or not he wants to exercise the contract at maturity.
Buyer of the contract has the option to exercise it anytime on or before expiry but seller has the obligation to exercise it. If buyer demands to buy the asset, seller will have to sell it. Options are of two types:

Call option: It gives the buyer, the right to buy the asset at a strike price.

Put Option: It gives the buyer a right to sell the asset at the ‘strike price’ to the buyer

The buyer has to pay an amount called as “Premium” for acquiring an additional right of having an option to exercise the contract or not.

Example of option trading:

A person bought a call option at a strike price of Rs 100. On maturity the price falls to Rs 80. He will not exercise the contract because he can buy the same asset from the market at Rs 80. However if price rises, he will exercise the contract.

Similarly, a person bought a put option at a strike price of Rs 100. On maturity the price shoots up to Rs 150. He will not exercise the contract because he can sell the same asset in the market at Rs 150, rather than giving it to the seller at agreed upon price of Rs 100.

In both cases, he just lost his premium amount which is marginal.

From the above description, it can be inferred that be it future or an option; these are the ways of hedging the risk of investments. It provides a protection against unexpected rise or fall in the price by entering into an agreement to be executed in future date. The concept is very old when agreement used to be made by negotiating the price for harvest of season having been unaware whether harvest will be meager or plentiful. When harvest time came, demand would rise sharply and ultimately giving the holder of agreement a chance to earn more than what he had expected.

Whatever be the case, playing options and futures has always been a risky. So better be careful before you enter into the arena!!

Renuka Kinger

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Futures and Options explained