What are futures and options?

August 01, 2007 14:36 IST

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Futures and options represent two of the most common form of "Derivatives".
Derivatives are financial instruments that derive their value from an 'underlying'. The
underlying can be a stock issued by a company, a currency, Gold etc., The derivative
instrument can be traded independently of the underlying asset.

The value of the derivative instrument changes according to the changes in the value of
the underlying.

Derivatives are of two types -- exchange traded and over the counter.

Exchange traded derivatives, as the name signifies are traded through organized
exchanges around the world. These instruments can be bought and sold through these
exchanges, just like the stock market. Some of the common exchange traded derivative
instruments are futures and options.

Over the counter (popularly known as OTC) derivatives are not traded through the
exchanges. They are not standardized and have varied features. Some of the popular OTC
instruments are forwards, swaps, swaptions etc.

Futures

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-
determined time. If you buy a futures contract, it means that you promise to pay the price
of the asset at a specified time. If you sell a future, you effectively make a promise to
transfer the asset to the buyer of the future at a specified price at a particular time. Every
futures contract has the following features:

• Buyer
• Seller
 • Price
• Expiry

Some of the most popular assets on which futures contracts are available are equity
stocks, indices, commodities and currency.

The difference between the price of the underlying asset in the spot market and the
futures market is called 'Basis'. (As 'spot market' is a market for immediate delivery) The
basis is usually negative, which means that the price of the asset in the futures market is
more than the price in the spot market. This is because of the interest cost, storage cost,
insurance premium etc., That is, if you buy the asset in the spot market, you will be
incurring all these expenses, which are not needed if you buy a futures contract. This
condition of basis being negative is called as 'Contango'.

Sometimes it is more profitable to hold the asset in physical form than in the form of
futures. For eg: if you hold equity shares in your account you will receive dividends,
whereas if you hold equity futures you will not be eligible for any dividend.

When these benefits overshadow the expenses associated with the holding of the asset,
the basis becomes positive (i.e., the price of the asset in the spot market is more than in
the futures market). This condition is called 'Backwardation'. Backwardation generally
happens if the price of the asset is expected to fall.

It is common that, as the futures contract approaches maturity, the futures price and the
spot price tend to close in the gap between them ie., the basis slowly becomes zero.

Options

Options contracts are instruments that give the holder of the instrument the right to buy or
sell the underlying asset at a predetermined price. An option can be a 'call' option or a
'put' option.

A call option gives the buyer, the right to buy the asset at a given price. This 'given price'
is called 'strike price'. It should be noted that while the holder of the call option has a
right to demand sale of asset from the seller, the seller has only the obligation and not the
right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have
a right.

Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the
buyer. Here the buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the
contract. The seller of the contract has only the obligation and no right. As the seller of
the contract bears the obligation, he is paid a price called as 'premium'. Therefore the
price that is paid for buying an option contract is called as premium.
The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of
the asset in the spot market is less than the strike price of the call. For eg: A bought a call
at a strike price of Rs 500. On expiry the price of the asset is Rs 450. A will not exercise
his call. Because he can buy the same asset from the market at Rs 450, rather than paying
Rs 500 to the seller of the option.

The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of
the asset in the spot market is more than the strike price of the call. For eg: B bought a
put at a strike price of Rs 600. On expiry the price of the asset is Rs 619. A will not
exercise his put option. Because he can sell the same asset in the market at Rs 619, rather
than giving it to the seller of the put option for Rs 600.

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What is an option?

An option contract gives the buyer the right, but not the obligation to buy/sell an
underlying asset at a pre-determined price on or before a specified time. The option buyer
acquires a right, while the option seller takes on an obligation. It is the buyer’s
prerogative to exercise the acquired right. If and when the right is exercised, the seller has
to honour it. The underlying asset for option contracts may be stocks, indices, commodity
futures, currency or interest rates

What are the types of options?

Broadly speaking, options can be classified as ‘call’ options and ‘put’ options. When you
buy a ‘call’ option, on a stock, you acquire a right to buy the stock. And when you buy a
‘put’ option, you acquire a right to sell the stock. You can also sell a ‘call’ option, in
which, you will acquire an obligation to deliver the stock. And when you sell a ‘put’
option, you acquire an obligation to buy the stock.

What do you understand by the term option premium?

Option premium is the consideration paid upfront by the option holder (buyer of the
option) to the option writer (seller of the option). The option holder gets the right to buy /
sell the underlying.
What is the strike price or the exercise price of the option?

The right or obligation to buy or sell the underlying asset is always at a pre-decided price
known as the ‘strike price’ or ‘exercise price’, which is linked to the prevailing price of
the underlying asset in the cash market. Usually, option contracts are available on the
underlying asset on various strike prices (generally, five or more)-divided equally on
either side of its spot price.

How does an American option differ from a European option?

In ‘European’ options, a buyer can exercise his option only on the expiration date, that is,
the last day of the contract tenure. Whereas in ‘American’ options, a buyer can exercise
his option any day on or before the expiration date.In the Indian equity market context,
index options are European style, while stock options are usually American in nature.

How do options differ from futures?

In futures, both the buyer and the seller are obligated to buy and sell, respectively, the
underlying asset-the quid pro quo relationship. In case of options, however, the buyer has
the right, but is not obliged to exercise it. Effectively, while buyers and sellers face a...

A put option (usually just called a "put") is a financial contract between two parties, the
writer (seller) and the buyer of the option. The buyer acquires a short position by
purchasing the right to sell the underlying instrument to the seller of the option for a
specified price (the strike price) during a specified period of time. If the option buyer
exercises their right, the seller is obligated to buy the underlying instrument from them at
the agreed upon strike price, regardless of the current market price. In exchange for
having this option, the buyer pays the seller or option writer a fee (the option premium).

By providing a guaranteed buyer and price for an underlying instrument (for a specified
span of time), put options offer insurance against excessive loss. Similarly, the seller of
put options profits by selling options that are not exercised. Such is the case when the
ongoing market value of the underlying instrument makes the option unnecessary; i.e. the
market value of the instrument remains above the strike price during the option contract
period.

Purchasers of put options may also profit from the ability to sell the underlying
instrument at an inflated price (relative to the current market value) and repurchase their
position at the much reduced current market price.

A call option, often it is simply labeled a "call", is a financial contract between two
parties, the buyer and the seller of this type of option.[1] The buyer of the call option has
the right, but not the obligation to buy an agreed quantity of a particular commodity or
financial instrument (the underlying) from the seller of the option at a certain time (the
expiration date) for a certain price (the strike price). The seller (or "writer") is obligated
to sell the commodity or financial instrument should the buyer so decide. The buyer pays
a fee (called a premium) for this right.

The buyer of a call option wants the price of the underlying instrument to rise in the
future; the seller either expects that it will not, or is willing to give up some of the upside
(profit) from a price rise in return for the premium (paid immediately) and retaining the
opportunity to make a gain up to the strike price (see below for examples).

Call options are most profitable for the buyer when the underlying instrument moves up,
making the price of the underlying instrument closer to, or above, the strike price. The
call buyer believes it's likely the price of the underlying asset will rise by the exercise
date. The risk is limited to the premium. The profit for the buyer can be very large, and is
limited by how high underlying's spot rises. When the price of the underlying instrument
surpasses the strike price, the option is said to be "in the money".

The call writer does not believe the price of the underlying security is likely to rise. The
writer sells the call to collect the premium. The total loss, for the call writer, can be very
large, and is only limited by how high the underlying's spot price rises.

The initial transaction in this context (buying/selling a call option) is not the supplying of
a physical or financial asset (the underlying instrument). Rather it is the granting of the
right to buy the underlying asset, in exchange for a fee - the option price or premium.

Exact specifications may differ depending on option style. A European call option allows
the holder to exercise the option (i.e., to buy) only on the option expiration date. An
American call option allows exercise at any time during the life of the option.

Call options can be purchased on many financial instruments other than stock in a
corporation. Options can be purchased on futures on interest rates, for example (see
interest rate cap), and on commodities like gold or crude oil. A tradeable call option
should not be confused with either Incentive stock options or with a warrant. An
incentive stock option, the option to buy stock in a particular company, is a right granted
by a corporation to a particular person (typically executives) to purchase treasury stock.
When an incentive stock option is exercised, new shares are issued. Incentive stock
options are not traded on the open market. In contrast, when a call option is exercised, the
underlying asset is transferred from one owner to another.

Hedge (finance)
In finance, a hedge is a position established in one market in an attempt to offset
exposure to price fluctuations in some opposite position in another market with the goal
of minimizing one's exposure to unwanted risk. There are many specific financial
vehicles to accomplish this, including insurance policies, forward contracts, swaps,
options, many types of over-the-counter and derivative products, and perhaps most
popularly, futures contracts. Public futures markets were established in the 1800s to allow
transparent, standardized, and efficient hedging of agricultural commodity prices; they
have since expanded to include futures contracts for hedging the values of energy,
precious metals, foreign currency, and interest rate fluctuations.

A Beginner's Guide To Hedging

by Investopedia Staff, (Investopedia.com) (Contact Author |
Although it sounds like your neighbor's hobby who's obsessed with his topiary garden
full of tall bushes shaped like giraffes and dinosaurs, hedging is a practice every investor
should know about. There is no arguing that portfolio protection is often just as important
as portfolio appreciation. Like your neighbor's obsession, however, hedging is talked
about more than it is explained, making it seem as though it belongs only to the most
esoteric financial realms. Well, even if you are a beginner, you can learn what hedging is,
how it works and what hedging techniques investors and companies use to protect
themselves.

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What Is Hedging?
The best way to understand hedging is to think of it as insurance. When people decide to
hedge, they are insuring themselves against a negative event. This doesn't prevent a
negative event from happening, but if it does happen and you're properly hedged, the
impact of the event is reduced. So, hedging occurs almost everywhere, and we see it
everyday. For example, if you buy house insurance, you are hedging yourself against
fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to

reduce their exposure to various risks. In financial markets, however, hedging becomes
more complicated than simply paying an insurance company a fee every year. Hedging
against investment risk means strategically using instruments in the market to offset the
risk of any adverse price movements. In other words, investors hedge one investment by
making another.

Technically, to hedge you would invest in two securities with negative correlations. Of
course, nothing in this world is free, so you still have to pay for this type of insurance in
one form or another.

Although some of us may fantasize about a world where profit potentials are limitless but
also risk free, hedging can't help us escape the hard reality of the risk-return tradeoff. A
reduction in risk will always mean a reduction in potential profits. So, hedging, for the
most part, is a technique not by which you will make money but by which you can reduce
potential loss. If the investment you are hedging against makes money, you will have
typically reduced the profit that you could have made, and if the investment loses money,
your hedge, if successful, will reduce that loss.

How Do Investors Hedge?

Hedging techniques generally involve the use of complicated financial instruments
known as derivatives, the two most common of which are options and futures. We're not
going to get into the nitty-gritty of describing how these instruments work, but for now
just keep in mind that with these instruments you can develop trading strategies where a
loss in one investment is offset by a gain in a derivative.

Let's see how this works with an example. Say you own shares of Cory's Tequila
Corporation (Ticker: CTC). Although you believe in this company for the long run, you
are a little worried about some short-term losses in the tequila industry. To protect
yourself from a fall in CTC you can buy a put option (a derivative) on the company,
which gives you the right to sell CTC at a specific price (strike price). This strategy is
known as a married put. If your stock price tumbles below the strike price, these losses
will be offset by gains in the put option. (For more information, see this article on
married puts or this options basics tutorial.)

The other classic hedging example involves a company that depends on a certain
commodity. Let's say Cory's Tequila Corporation is worried about the volatility in the
price of agave, the plant used to make tequila. The company would be in deep trouble if
the price of agave were to skyrocket, which would severelyeat into profit margins. To
protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures
contract (or its less regulated cousin, the forward contract), which allows the company to
buy the agave at a specific price at a set date in the future. Now CTC can budget without
worrying about the fluctuating commodity.

If the agave skyrockets above that price specified by the futures contract, the hedge will
have paid off because CTC will save money by paying the lower price. However, if the
price goes down, CTC is still obligated to pay the price in the contract and actually would
have been better off not hedging.

Keep in mind that because there are so many different types of options and futures
contracts an investor can hedge against nearly anything, whether a stock, commodity
price, interest rate and currency - investors can even hedge against the weather.

The Downside
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the
benefits received from it justify the expense. Remember, the goal of hedging isn't to
make money but to protect from losses. The cost of the hedge - whether it is the cost of
an option or lost profits from being on the wrong side of a futures contract - cannot be
avoided. This is the price you have to pay to avoid uncertainty.

We've been comparing hedging versus insurance, but we should emphasize that insurance
is far more precise than hedging. With insurance, you are completely compensated for
your loss (usually minus a deductible). Hedging a portfolio isn't a perfect science and
things can go wrong. Although risk managers are always aiming for the perfect hedge, it
is difficult to achieve in practice.

What Hedging Means to You

The majority of investors will never trade a derivative contract in their life. In fact most
buy-and-hold investors ignore short-term fluctuation altogether. For these investors there
is little point in engaging in hedging because they let their investments grow with the
overall market. So why learn about hedging?

Even if you never hedge for your own portfolio you should understand how it works
because many big companies and investment funds will hedge in some form. Oil
companies, for example, might hedge against the price of oil while an international
mutual fund might hedge against fluctuations in foreign exchange rates. An
understanding of hedging will help you to comprehend and analyze these investments.

Conclusion
Risk is an essential yet precarious element of investing. Regardless of what kind of
investor one aims to be, having a basic knowledge of hedging strategies will lead to better
awareness of how investors and companies work to protect themselves. Whether or not
you decide to start practicing the intricate uses of derivatives, learning about how hedging
works will help advance your understanding of the market, which will always help you
be a better investor.

by Investopedia Staff (Contact Author | Biography)

Investopedia.com believes that individuals can excel at managing their financial affairs.
As such, we strive to provide free educational content and tools to empower individual
investors, including thousands of original and objective articles and tutorials on a wide
variety of financial topics.

What are Hedging Strategies?

Hedging strategies are different forms of financial plans that allow a person to avoid
unwanted price fluctuations in one market by establishing an opposite position in a
different market. The overall goal is to limit the amount of risk faced when investing in
different types of securities. A number of financial vehicles exist to benefit investors
interested in hedging the chances of a large loss in markets. These include different types
of options, forwards, swaps and insurance. Generally, hedging strategies involve the
establishment of hedge funds to prevent the loss.

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Hedge funds are designed for shorter-term investments with the goal of making the
largest return on investment in the shortest time. Instead of making a small amount of
money over a long period of time, these diversified portfolios generally leverage
successful securities against less successful ones, providing a large return with minimal
risk. The main component of a hedge fund is the risk-return ratio, which can be analyzed
by tracking the performance of certain markets over a specific period of time. Generally,
hedge funds are only available to investors with a large percentage of financial assets at
risk.

One of the primary components of hedging strategies is the concept of options. This
enables investors to take a position that gives them the right to either buy or sell a certain
asset at a specific price. The bonus of the options method is that the investor is not
obligated to either sell or buy the financial security. Two types of options exist within this
investment format: a put option and a call option. A put option gives the investor the right
to sell at a given price, while a call option allows the investor to buy at a given price.

Related topics
Trading Strategy
Hedging Strategies
Hedge Funds Strategies
Forex Strategies
Stock Hedging Strategies
Option Hedging Strategies
Equity Hedge Strategy

The concept of hedging strategies were formulated in 1949 by financial writer and
sociologist Alfred W. Jones. He established the first hedge fund which focused on buying
assets for the portfolio that would perform better than market expectations and sell
products that did not meet his minimum criteria. This system essentially created a
situation in which investors were more likely to generate a profit, while mitigating the
likelihood of a loss. Over the years, additional research has shown that adding other
components to the mix could also benefit the success of hedging strategies. Also, by
taking out insurance plans on parts of the package against other financial securities, risk
is further limited.