Options and futures are the two most common forms of derivatives that are traded at organized exchanges. Derivatives are
financial instruments that derive their value from the underlying asset.
Options: Options are those financial instruments that provide its holders the right to trade the underlying asset at a
predetermined price. A ‘call’ option gives a trader the right to buy the underlying asset at a given price. A ‘put’ option gives a
trader the right to sell the underlying asset at a given price. This given price is known as the ‘strike price.’ The owner of an
option has the right, but not the obligation, to buy or sell an asset.
Futures: These refer to contracts to buy or sell an asset on or prior to a specified date in the future at a predetermined
price. Buying a futures contract would mean that you have agreed to pay a predetermined price for the underlying asset at a future
date. Similarly, selling a futures contract would mean that you have agreed to transfer the underlying asset to the buyer at a
specified price at a future date. Currency, indices and commodities are some popular underlying assets on which the futures
contracts are available. The difference between the price of the underlying asset in the spot market (market for immediate
delivery) and the futures market is called 'basis.' The price of the asset in the futures market is typically higher than the
spot price on account of factors such as interest cost, insurance and inflation. Hence, the ‘basis’ is usually negative.
How are Options and Futures Traded?
Since options and futures are forms of derivatives, their values change according to changes in the value of the underlying
asset. Options and futures are the most common type of exchange traded derivatives. These are traded on organized exchanges and
can be bought or sold the way stocks are traded on a stock exchange. In contrast, over the counter (OTC) derivatives, such as
forwards and swaps, are not bought or sold through exchanges.
Benefits of Options and Futures
The benefits of options and futures are:
- Hedging: Options and futures are hedging tools, used especially in a bearish market.
- Low transaction costs: They give investors the same exposure with lower transaction cost than other debt instruments.
- Standardized contract: Options and futures are exchange traded. Hence, their pricing and volume transacted are transparent.
- High liquidity: Buyers and sellers of options and futures can be found easily.
Risks of Options and Futures
The risks associated with options and futures are:
- Counterparty risk: This refers to the owner of the contract refusing to buy or sell the asset as agreed.
- Market risk: This refers to the risk of adverse price movements resulting in losses.