A Quick Look: Futures & Options. An Introduction to Derivatives

The concept of derivatives can be a little hard to understand at first, but once you familiarize yourself with them, they can be a great addition to your portfolio as they are considered to be a great tool for hedging (limiting risk). Derivatives are trading instruments whose value is DERIVED from their underlying assets, hence the name derivatives. It is a contractual agreement between two parties to buy or sell a predetermined amount of an underlying asset (ex: stocks, bonds, gold) at a predetermined price within a predetermined period of time.

There are four major types of derivatives: Futures, Options, Forwards and Swaps. Forwards and Swaps are contractual agreements between private entities and are not available for trading on exchanges. Hence they are not of significance to most investors, especially retail investors. Let’s look at Futures and Options.

Futures

History: Several hundred years ago, farmers and businesses needed a way to protect themselves from fluctuating prices of commodities. Farmers needed a way to ensure that they received a certain price for their harvest, and businesses that buy raw materials from farmers (ex: corn, coffee beans etc.) needed a way to lock in prices so they could accurately estimate their costs. The Futures contract enabled these two entities to lock in a certain price and certain quantity for a commodity, that would be delivered at a specified date. Regardless of the market price of the commodity on this specified date, the transaction would be completed at the pre-set price and quantity.

Now futures have developed into a instrument that investors can use to speculate and potentially profit from, as well as balance risk from other parts of their portfolio. Futures and Options can be bought and sold through an exchange. As an investor, you will not be engaging in actual physical settlements of the transactions i.e. don’t expect hundreds of bushels of corn to show up at your door, the transaction is simply settled financially and money is added or removed from your trading account based on the outcome of the trade.

Here are the different aspects of a futures contract

1) Underlying instrument and quantity: The underlying instruments can be stocks, bonds, commodities, currencies etc. And each contract represents a certain quantity of the underlying commodity. ex: A Crude Oil future typically represent 1,000 barrels of crude oil, and will be priced at 1,000 x Price per barrel. This quantity depends on the exchange through which you are buying and selling these contracts.

2) Expiration date: This is the day on which the contract is settled.

3) Execution price: This is the price at which the transaction will take place.

You would buy a futures contract if you feel the price of the underlying asset will be higher than the current price, on the day of expiration. Conversely, you would sell a contract if you feel the price will go lower. The amount it would cost you to buy or sell a futures contract depends on the market price on the day you are buying/selling the contract.

Options

Options contracts are very similar to futures, except for a few key differences. There are two types of Options, a Call Option and a Put Option. A Call option gives the buyer the right to buy and the seller the obligation to sell, the underlying asset at the predetermined price at any point before or on expiration. A PUT option gives the buyer the right to sell and the seller the obligation to buy the underlying asset at the predetermined price at any point before or on expiration. The buyer of these contract have the option to exercise this contract only if it’s beneficial to them, and in exchange for this privilege to choose, the buyer will have to pay a certain sum of money up front called the option premium.

Let’s consider a company ABC who’s stock price is currently trading at $100. You have researched the company well and feel that the stock is undervalued, and it’s price could go higher within the next month. Instead of purchasing actual stocks of the company for $100 a share, you could buy an options contract (of lets say 1 month) at a fraction of the cost (called the premium). If at any point during that period, your predictions are right, you can exercise the option and buy at a price lower than the market price and immediately sell for a profit. If your analysis was wrong and the stock price went lower, you simply wouldn’t exercise the contract (It doesn’t make sense to pay $100 for a stock when it is trading for lower prices in the open market). The only amount you would lose is the premium you paid, which will go to the seller of the contract.

The cost of the options contract (premium) depends on a number of factors including time left until expiration, volatility, and whether it is “in the money” or “out of the money”. “In the money” means the prices have already moved in a favorable direction, hence your chances of profiting will be greater. “out of the money” contracts, which as you would have guessed, have a lesser chance of ending with a profitable outcome as prices have moved unfavorably since the contract was created.

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