By Stella Goh – Market Data Analyst | 10 March 2019
Derivatives are the securities which the value is derived from the underlying asset. Therefore, the underlying asset determines the price of the asset. If there are some changes in the price of the asset, the derivatives will also change along with it. There are few examples of derivatives, such as futures contracts, forward contracts and swaps contract which used by investors to hedge against risks. Today, we will look into the role of Future Contract and Options Contract.
A future contract is a binding agreement between 2 parties, buyers and sellers where both of the parties promise to each other of buying or selling the underlying asset at a predetermined price at a future specified date. It is a standardized and transferable contract which traded on stock exchange. The future contracts include currencies, commodities, or financial instrument such as FGLD, FKLI, FCPO, FPOL, FUPO, FM70 and so on.
Futures contract put an obligation on the buyers to honour the contract on the stated date, so he is locked into the contract. Companies enter into these agreements because they need to buy or sell the underlying products anyway, and just looking to lock in the price.
Both buyers and sellers in the future contracts face a lot of risks as the prices could move against them. Let us assume that the market value of the asset falls below the price specified in the contract. The buyers will still have to buy it at agreed upon price earlier and incur losses. In other words, future contracts could bring unlimited profit or loss.
A future contract comes with definite expiration dates. Most of the future contracts are not held until expiration, because some short-term traders close their position before expired and there are only a few people or companies who are really want to buy or sell the underlying products will continue to trade and hold their position until expired date. Short-term traders do not hold until expiration because they simply make or lose money based on the price fluctuations that occurred after they buy or short a contract.
There is no upfront cost except commission when investors entering into a future contract. However, the buyers for the future contract are bound to pay the agreed-upon price for the assets eventually. This is done for the purpose of locking the commitment made by the parties.
The execution of future contract can only be done on the pre-decided date as per conditions which have been mentioned in the contract. On this date, the buyer purchases the underlying asset.
An option is a type of derivative which provides holders with the rights but not obligation to buy or sell an underlying asset at a pre-determined price in the future. Investors can compare the current market price (spot price) and the price on the option (strike price) to determine whether is it profitable to exercise in the option. By comparing both prices, investors can decide either to exercise the option or let it expire.
There are three positions on which the holder can find it themselves.
Call Option is “in the money” if the market price is greater than the exercise price. This is because the call option buyer has the right to buy the stock below its current trading price.
Call Option is “at the money” if the market price and exercise price are the same. In this case, an option contract may be exercised.
A call option is “out of the money” if the market price is less than the exercise price. In this case, it will better to let the option expire and buy the commodity at the current market price.
The option seller (writer) can incur losses much greater than the price of the contract when compared to the option buyer (holder). The option buyers can opt out of buying it if the asset value falls below the agreed-upon price. This limits the loss incurred by the buyer. Option contract brings unlimited profits but it reduces the potential losses.
The expiration date in the option contract is important to investors because it affects the price of an option contract. The longer the time for the expiration date, the higher the price should be and the longer the time the holders have for the option to exercise and potentially to make a profit. After the put or call option expired, time value does not exist anymore. In other words, once the derivative expired, the investor does not retain any rights to get along with owning the call or put option.
In options trading, the options are either trade at a premium or discount offered by the seller of the option. The option premium is the price that you have to pay in order to purchase an option. The premium is determined by multiple of factors including underlying stock price, volatility in the market and days until the options’ expiration. The higher the premiums will be tied to the more volatile markets, even if the asset is priced less expensive, we also can see the premium rise when the market turns into a period of uncertainty.
The buyer in an option contract can execute the contract anytime before the date of expiry. So, investors are free to buy the assets whenever they feel the conditions are right.
In overall, both futures and options are derivatives contract which having its customization as per requirements of the counterparties. By reading this article, we will have more understand the difference between futures contracts and option contracts. As the name suggests, options come with an option (choice) while futures does not have any options but their performance and execution are certain.
|Agreement binding counterparties to buy and sell a financial instrument at a predetermined price and a specific date in the future
|A contract which allows investors rights to buy or sell an instrument at a pre-agreed price. It will be executed on or before the date of expiry
|Obligations / Rights
|A full obligation to execute the contract at the stated date
|Provides rights but not obligations to buy or sell
|Restricted to the amount of premium paid
|A degree of Profit / Loss
|Unlimited profit and limited losses
|On expiry date, buy/sell underlying assets
|On expiry date, do not retains any rights
|No advance payment
|Paid in the form of premiums
|Execution of Contract
|On pre-agreed date
|Any time before the expiry of agreed date