1.5 Derivatives: Options and Futures

Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, commodities, currencies, or interest rates. Derivatives play a crucial role in financial markets by allowing participants to hedge risks, speculate on price movements, or gain access to markets with minimal capital outlay. Among the most common derivatives are options and futures, which provide investors with flexibility in trading and risk management.

1.5.1 Overview of Derivatives

Derivatives are contracts between two parties based on the future price of an underlying asset. The price of the derivative depends on fluctuations in the price of that underlying asset. Derivatives can be used for various purposes:

• Hedging: Reducing the risk of adverse price movements by taking an offsetting position.
• Speculation: Betting on future price movements to potentially profit from price changes.
• Arbitrage: Exploiting price differences between markets to generate risk-free profits.

Options and futures are two of the most widely traded derivatives in financial markets. Each offers distinct characteristics and trading mechanics.

1.5.2 Options

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (called the strike price) before or on a specific expiration date. The two main types of options are call options and put options.

1.5.2.1 Call Options

A call option gives the holder the right to buy the underlying asset at the strike price within a specified time frame.

• Potential Gains: Call options are typically purchased when the investor expects the price of the underlying asset to increase. If the asset’s price rises above the strike price, the option holder can buy the asset at the lower strike price, generating a profit.
• Example: An investor buys a call option for stock XYZ with a strike price of $50. If the stock’s market price rises to $60, the investor can exercise the option to buy the stock at $50, gaining $10 per share (minus the premium paid for the option).

1.5.2.2 Put Options

A put option gives the holder the right to sell the underlying asset at the strike price within a specific time period.

• Potential Gains: Put options are typically used when the investor expects the price of the underlying asset to decrease. If the price falls below the strike price, the option holder can sell the asset at the higher strike price, profiting from the difference.
• Example: An investor buys a put option for stock ABC with a strike price of $100. If the stock’s price falls to $80, the investor can exercise the option to sell the stock at $100, gaining $20 per share (minus the premium paid for the option).

1.5.2.3 Key Characteristics of Options

• Premium: The price paid by the buyer of the option to the seller (also known as the writer) for the rights conferred by the option. This is the cost of acquiring the option contract.
• Strike Price: The predetermined price at which the option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
• Expiration Date: The date by which the option must be exercised or it becomes worthless.
• Exercise Style: Options can be of two exercise styles:
  • American Options: Can be exercised at any time before or on the expiration date.
  • European Options: Can only be exercised on the expiration date.

1.5.2.4 Uses of Options

• Hedging: Investors use options to protect their portfolios from adverse price movements. For example, a put option can be purchased to hedge against a decline in the price of a stock.
• Speculation: Options allow traders to profit from price movements with limited initial investment. Since options offer leverage, the potential profit can be large relative to the premium paid, though the potential loss is limited to the premium.
• Income Generation: Investors can sell (or write) options to generate income from the premium collected. Writing options, however, comes with significant risk, as the seller has the obligation to fulfill the contract if the buyer exercises the option.

1.5.3 Futures

Futures are standardized contracts that obligate the buyer to purchase, or the seller to sell, an underlying asset at a predetermined price on a specified future date. Unlike options, which provide the right but not the obligation to trade the asset, futures contracts require both parties to fulfill the terms of the agreement.

1.5.3.1 Key Characteristics of Futures

• Standardization: Futures contracts are standardized in terms of quantity, quality, and delivery date. This ensures that the terms of the contract are consistent across all trades, facilitating easier trading in large markets.
• Underlying Assets: Futures contracts are available for a wide range of assets, including:
  • Commodities: Oil, gold, wheat, natural gas.
  • Financial Instruments: Stock indices, bonds, currencies.
• Leverage: Futures contracts allow traders to control large positions with a small initial margin. Leverage amplifies both potential gains and losses.
• Expiration Date: The contract specifies a future date for delivery or settlement, called the expiration date. At this date, the contract is either settled in cash or the physical asset is delivered.

1.5.3.2 Futures Markets

Futures contracts are traded on exchanges, with major futures markets including the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE). These exchanges serve as platforms for trading and ensure transparency and standardization.

1.5.3.3 Mark-to-Market and Margin

• Mark-to-Market: Futures contracts are marked to market on a daily basis, meaning gains or losses are settled at the end of each trading day based on the price movement of the underlying asset.
• Margin Requirement: Traders are required to post an initial margin, a fraction of the total contract value, when entering a futures position. If the value of the contract declines, the trader may face a margin call, requiring additional funds to be deposited to maintain the position.

1.5.3.4 Uses of Futures

• Hedging: Futures contracts are widely used by businesses and investors to hedge against price movements in commodities or financial instruments. For example, a wheat farmer may sell wheat futures to lock in a selling price for their crop, protecting against a potential drop in market prices.
• Speculation: Traders use futures to speculate on the price movement of assets. A trader might buy oil futures if they expect the price of oil to rise, allowing them to profit if the price increases.
• Arbitrage: Futures are also used in arbitrage strategies, where traders exploit price discrepancies between the futures market and the spot market to earn risk-free profits.

1.5.4 Differences Between Options and Futures

While both options and futures are derivatives used for hedging and speculation, they differ in key ways:

1.5.5 Risks of Options and Futures

Both options and futures come with their own risks, which traders and investors must carefully consider:

1.5.5.1 Options Risk

• Limited Lifespan: Options have a finite life, and they become worthless after expiration if not exercised.
• Leverage Risk: While leverage amplifies potential gains, it also magnifies potential losses, especially if the option moves out of the money.
• Time Decay (Theta): As the expiration date approaches, the value of an option, particularly out-of-the-money options, tends to decrease due to time decay.

1.5.5.2 Futures Risk

• Leverage Risk: Since futures contracts require only a margin deposit, small price movements can result in large gains or losses. This amplifies risk, especially in volatile markets.
• Margin Calls: If the market moves against the trader, they may face margin calls, requiring additional capital to maintain the position. Failure to meet margin calls can result in the position being liquidated at a loss.
• Market Volatility: Futures contracts are highly sensitive to price movements in the underlying asset, and volatility can lead to significant and rapid changes in the value of the contract.

Summary

Options and futures are two of the most widely used derivative instruments in financial markets. While both are used for hedging, speculation, and arbitr

age, they differ in terms of obligations, risks, and mechanics. Options provide the right, but not the obligation, to buy or sell an asset, while futures require the holder to fulfill the contract at the predetermined price and date. Understanding the intricacies of these instruments, including their uses, benefits, and risks, is essential for investors and traders aiming to manage risk or profit from market movements effectively.