Options & Futures
Besides the primary financial assets discussed in previous posts (stocks, commodities, exchange rate), many other financial instruments, such as options and futures contracts, are traded on organized markets (exchanges). These securities are generically called derivatives, because they derive their value from the price of some primary underlying asset. The most basic derivatives are options. An option is a contract that gives its holder the right, but not the obligation, to buy or sell a certain asset for a specified price at some future time. The other part of the contract, the option underwriter, is obliged to sell or buy the asset at the specified price. The right to buy (sell) is called a call (put) option. If the option can only be exercised at the future date specified in the contract, then it is said to be a European option. American options, on the other hand, can be exercised at any time up to maturity. Thus, options are “contracts” that give you the right, or the “option” (but not the obligation) to buy or sell a stock or commodity, at a specific price, over a specific period of time. So, you’re not really buying the stock. You’re buying a ‘contract’ - you’re making an agreement that allows you to buy or sell the stock. Getting options is a lot like paying for insurance. For example, if you pay auto insurance for next month and nothing happens by the end of that month, the money you paid is gone. You don’t get it back. If something does happen by the end of next month, you will receive a payout, depending on how major the incident was. Options offer you leveraged profit potential…
Another way to speculate on the variations of the major indices (as Dow Jones, NASDAQ, S&P500) is by dealing with “Futures” contracts. They are standardized contracts, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. A “futures” contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a “futures contract” must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations. Futures contracts, or simply futures, are exchange traded derivatives. The exchange’s clearinghouse acts as counterparty on all contracts, sets margin requirements.