The ChoosaBroker Trading Academy
2.8. Futures and Options
Futures and options have drawn plenty of academic flak ever since their inception. The critics often claim that these instruments are inherently speculative and therefore add unwarranted risk to financial markets. These concerns might make sense in a perfect world, but are at best broad generalizations in a dynamic and fluctuating marketplace.
Futures and options offer a fast and cost-effective way to trade both the equity and commodity markets. Traders worldwide have successfully used them to not just generate profits, but also reduce risk in their portfolios.
What are Futures?
Futures are standardized legal agreements that obligate the buyer to purchase an underlying asset or the seller to sell an asset at a predetermined price and future date. Futures trade on regulated exchanges, and the underlying asset transacted is usually a commodity, or a financial instrument like stocks, indices or foreign currencies.
Futures contracts were originally developed to help farmers hedge their crops against fluctuations in prices. Established in 1697, the Dojima Rice Exchange in Osaka, Japan, is widely believed to be the earliest futures exchange in the world. In the west, the Chicago Board of Trade (CBOT) listed the very first grain futures contract in 1864. With time, the futures market far outgrew its humble agricultural origins, as exchanges began to offer diverse contracts in foreign currencies, U.S. Treasury bonds and eventually stock market indexes. In 2008, the Chicago Mercantile Exchange (CME), with its acquisition of the New York Mercantile Exchange, became the biggest futures market in the world.
Futures Contracts explained
Futures contracts are regulated by the exchanges on which they trade. These exchanges specify the different contract parameters:
- Size – The contract size is the deliverable quantity of the underlying asset being tracked by the futures contract. The contract size is standardized so that the buyers and sellers know exactly what quantity of the asset they are buying and selling. For example, the contract size of a gold futures contract on the COMEX is 100 troy ounces. Thus, every $10 change in the price of the underlying asset, which in this case is gold, translates in to a $1000 move in the value of the futures contract.
- Delivery Date – It refers to the date when the futures contract expires and the underlying asset must be delivered. Some futures contracts expire every month of the year, while some others have expiration during certain months only. The exchange on which the contract is listed will also specify a delivery location. Typically, exchange trading in a futures contract is halted a few days prior to the designated delivery date. However, not all futures contracts result in physical delivery, with an overwhelming majority being settled in cash.
- Deliverable Grade – In case of commodity futures, the exchange determines the quality that the underlying asset must meet to be accepted for delivery upon expiry of contract. This brings about uniformity in the market. For example, WTI Crude futures at the CME Group are for a grade of crude oil known as “light, sweet,” which represents the amount of hydrogen sulphide and carbon dioxide that is included in the oil.
- Pricing Unit – When tracking the price of a futures contract, an investor must know what the value represents. Soybean futures on CBOT, for instance, are priced in cents per bushel. Initial Margin –
It is the amount of money that is required to initiate a buy or sell position on a futures contract. The exchange sets this initial margin, and an investor must deposit this amount in to his or her trading account. Initial margin rates for futures contracts generally vary between 5% and 15% of the total contract value. For example, if one wheat futures contract on the Chicago Board of Trade is currently valued at around $20,000 (5,000 bushels X $4); an investor may only need about $1,500 in initial margin to enter a long or short trade.
Who trades Futures?
There are two broad categories of futures market participants – hedgers and speculators.
– Hedgers utilize futures contracts to protect against adverse price movements in the underlying asset. They are often producers and consumers of commodities. The rationale behind hedging with futures is based upon the demonstrated propensity of cash prices and futures prices to move in tandem. Let us look at an example to get a better insight in to the process. An airline company wanting to shield against any unexpected spike in the price of jet fuel, buys a futures contract agreeing to purchase 1 million gallons of fuel at $4 per gallon. The delivery is 60 days in to the future. Someone else, perhaps a fuel distributor, wants to protect itself against any surprise decline in the price of jet fuel. It goes ahead and agrees to sell that 1 million gallons of fuel to the airline company, delivering it in 60 days, at a price of $4 per gallon. By entering in to this agreement, both the airline company and the fuel distributor have hedged themselves against the risk of unfavourable swing in the price of jet fuel.
– Speculators are the other dominant group in the futures market. The vast majority of retail traders and investors fall in to this category. Unlike hedgers, they don’t seek to minimize risk or take delivery of the asset, but rather profit by correctly anticipating the direction of prices of futures contracts. Speculators analyze an underlying asset and if they expect prices to rise, they initiate long positions in the corresponding futures contract. Contrarily, if the asset price is projected to fall, a trader can opt to short sell the futures contract and ideally buy it back at a lower price. Since futures are highly leveraged instruments, they carry substantial market risk. Successful speculators always employ proper risk management techniques to avoid being hit by the big losses. Check out the review of top brokers for more information and support to facilitate these transactions.
WHAT ARE OPTIONS?
An option is also a derivative instrument, whose price is intrinsically linked to the price of an underlying asset. There are two kinds of options: Call Option – A call option grants an investor the right, but not the obligation to buy an underlying asset at a pre-determined price, called the “STRIKE PRICE,” on or before a fixed date. If the investor thinks the underlying asset’s market price will appreciate above the strike price before the expiry of the contract, he or she will buy a call option. Put Option – A put option endows an investor with the right, but not the obligation to sell an asset at a specified strike price on or before the expiry of the contract. So, if the investor expects the spot price of an asset to dip below the strike price before expiry, he or she will buy a put option. The buyer of the call option or the put option pays the seller a “PREMIUM” to acquire the rights of the contract. For stock options, the premium is quoted on a per-share basis, and contracts typically represent the commitment of 100 shares.
Basics of Options Trade
All investors should ideally have a portion of their portfolios set aside for options. Not only do they enable to play both sides of a market, but also afford the opportunity to do so with a relatively smaller cash outlay. Profit from a rise in stock price with limited risk and lower cost than out rightly buying the stock:Example: You pay a premium of $1 to buy one Intel (INTC) call option with a strike price of 25 when the stock is trading at $25. INTC gains to $28 and your call option premium climbs to $2, yielding a 200% return versus a 12% appreciation in the price of the underlying stock. Profit from a drop in stock price with limited risk and lower cost than out rightly shorting the stock: Example: You pay a premium of $0.80 to buy one Oracle (ORCL) put option with strike price of 20 when ORCL is trading at $20. ORCL declines to $18 and the put option premium jumps to $1.20, giving you a 50% gain versus a 10% profit in the case you short-sold the stock.
Difference between Futures and Options
In a futures contract, both the buyer and the seller are obligated to honour the contract.
The options contract buyer has the right but not the obligation to buy (or, sell) the underlying asset.
Requires higher margin payment than options.
Requires lower margin payment than futures.
Preferred by speculators.
Preferred by hedgers.
Unlimited profit, unlimited loss potential.
Unlimited profit potential. Loss for an options buyer is limited to the premium paid.
Other Derivative Products
The derivatives market involves more than just futures and options. Two other widely-used derivative instruments are listed below:
- Forward – Unlike futures, forward contracts are non-standardized agreements between two parties to buy or sell an underlying asset at a specified future date and at a pre-determined price. In case of forwards, the two parties involved directly transact with each other without using an exchange. Since a forwards agreement is tailored, the price of the asset, size of contract and terms of delivery are all negotiable. In contrast to futures, forwards are mostly executed on maturity, whereby delivery of the underlying asset is made.
- Swaps – Swaps are recent innovations in the derivatives markets. They are contracts between two parties to exchange sequences of cash flows for a fixed period of time. Most swaps are traded over-the-counter. Let us walk through an example of a “plain vanilla” interest rate swap, which is a financial agreement between two parties, in which one party agrees to pay a fixed interest rate, while the other pays a floating interest rate. The party paying the fixed rate believes the general interest rate will rise and wants to lock in its interest payments with a fixed rate. On the other hand, the party paying the floating rate projects the interest rate to fall, in which case, its interest payments will go down as well.
Importance of Derivatives
The two most recognized benefits attributed to derivative instruments are enumerated below:
- Risk Management – Risk management is vital for optimal portfolio returns. The derivatives market helps to transfer risk from those who have low risk appetite like hedgers to participants with higher risk appetite like speculators.
- Price Discoverys – It is the process of determining the price of an asset through the interaction of buyers and sellers in a marketplace. Since the transaction cost in derivatives is much lower than in spot assets, the derivatives market is usually the first to react to any new information, assisting in better price discovery.
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