An exchange is a marketplace where various assets are traded in an organized manner. Types of assets are basic and derivative. Underlying assets can be stocks, bonds, commodities, stock indices, currencies, and interest rates. Derivatives are contracts that entitle or oblige parties to perform specified actions on the underlying asset.
The actions include the ability to buy, sell, grant, or receive goods or securities. Derivatives are traded on the futures market.
Why would an investor need derivatives?
To try to reduce market risks arising from transactions in underlying assets – that is, to use a hedging strategy whereby a transaction can be made on pre-agreed terms. The derivatives market provides ample opportunities for implementing various trading strategies, including speculative ones.
There are some additional possibilities: you don’t need to pay the full price of a contract to make a deal, you only have to provide the sum of guarantee (CS). For example, it may be 10-20% of the sum of the transaction. The size of the CS is set by the exchange.
By blocking only the CS there is a so-called leverage effect – in comparison with the purchase of the underlying asset for the same amount of money you can buy more derivatives. The risks and profitability increase proportionally.
Important: speculative and aggressive strategies involve increased risks. It is worth to evaluate carefully the amount of capital that an investor is ready to risk. An important prerequisite, especially for a beginning investor, is the ability to balance risks and manage them within the framework of your portfolio strategy. It is necessary to monitor the sufficiency of funds for CS so that the broker will not close the position forcibly.
With the help of futures market instruments you can not only speculate or hedge your liabilities (for example, currency credits), you can also use an arbitrage strategy. Arbitrage is several logically connected transactions with the purpose to profit from the price difference of the same (or related) assets: at the same time on different markets (spatial arbitrage) or on the same market at different points in time (temporal arbitrage).
- A futures is an agreement (contract) between a seller and a buyer to deliver an underlying asset after a specified period of time and at a predetermined price. The main thing: the futures are an obligation for both parties: the seller must sell, and the buyer must buy the asset at the agreed terms.
- An option is a contract in which the buyer of an option gets the right to buy/sell an asset (commodity, security, currency, etc.) at a certain point in time at a predetermined price.
Derivative financial instruments are suitable for whom
Derivatives offer investors a number of opportunities:
- to trade the “whole market” with the help of futures
- to invest indirectly in commodities that cost a lot to buy and keep (gold, oil, wheat, etc.)
- wagering world news
- wagering commodity price formation
- implement arbitrage strategies with world commodity and stock markets
- hedge equity investments
- hedge currency risks, etc.
According to the type of execution the futures are either deliverable or settled:
- Deliverable futures – on the contract execution date, the buyer must purchase and the seller must sell the quantity of the underlying asset set forth in the specification. The delivery is made after the expiration at the settlement price fixed on the last trading date. If a futures position is closed before the expiration date, delivery of the underlying asset does not occur.
- Cash-settled (non-deliverable) futures – there are only pecuniary payments between the participants equal to the difference between the contract price and the settlement price of the contract on the date of settlement without delivery of the underlying asset. It means that the investor is either credited with the profit or written off with the loss.
How futures work
Futures contracts are bought and sold on exchanges at a certain value, which can vary. The main purpose of trading futures contracts is for the trader to make money on the difference – to buy cheaper and sell dearer. Futures contracts make both parties – the buyer and the seller – liable, and the exchange acts as a guarantor.
When you buy a futures contract, the exchange freezes the amount of the contract value in the buyer and seller’s accounts. If there are insufficient funds in the account, the broker controls the replenishment of the account by the client. If this is not possible, the transaction will be closed under the rules of margin call – part of the transaction is closed by the broker at the market price.
Futures life cycle
Several futures for the same asset may be traded simultaneously – the nearest ones and the ones with a longer expiration date. The most liquid futures may have eight contracts with quarterly expirations. For Brent, there are 12 monthly contracts. As a rule, the further the expiry date, the less liquid the instrument is.
How Options Work
The key features of options are similar to futures. So to understand, let’s understand what the main difference between an option and future is. It is the unequal obligations of the parties to the transaction. For the seller of options, everything is identical, as for the transaction in the futures: it is the obligation to perform a transaction with the underlying asset in the future at a given price and on given conditions. As for the buyer – it is the right (not the obligation) to purchase or sell, at specified terms, a specific quantity of the underlying asset during the period specified in the terms. That is, the buyer may or may not agree to this right.
In order to balance the positions of the parties, the option has an additional characteristic that the futures do not have – this is the option price or the option premium. It is paid to the seller and remains with the seller regardless of whether the contract is exercised or not.
Option premiums are divided into two subspecies:
- Call option – the right to buy for the buyer and the obligation to sell for the seller
- Put option – the right to sell for the buyer of the option and the obligation to buy for the seller.
These options are traded differently. The point is that they have different premium, or rather – its size, the market value.
The main parameters of options
- Premium, or the value of the option – the market price at which the transaction takes place.
- Strike, or strike price – the price at which the rights and obligations under the option can be executed.
- Expiration date, or maturity date – the time until the contract expires.
- The volume of the contract is measured in units of the underlying asset.
Option premium is determined as a result of stock trading. It is formed of two main parts:
- Intrinsic value – occurs when the option’s underlying asset price exceeds the strike price (in the case of growth), and is the difference between the two values.
- Time Value – This is the expectation that the value of the underlying asset will change in the future. It depends on the volatility of the underlying asset and the date the option is exercised.
Options are more flexible than futures and stocks. They allow traders to reflect absolutely any market view: growth, decline, limited growth or decline, stagnation, increased volatility (fluctuations) of prices in the market without a significant final price change, other options of market behavior.
So, the seller is obliged to fulfill the conditions of the transaction. And it is important for the buyer to “want” to implement it. Let’s consider cases when it will be profitable for the buyer.
Depending on the ratio of the price of the underlying asset to the strike price, there are three types of options:
In-the-money option = the exchange executes them automatically
- for a Call option: when the current price of the underlying is higher than the strike price;
- Put option: when the current price of the underlying is lower than the strike price.
Option “in the money”: when the current price of the underlying is equal to the strike price = the exchange automatically executes it halfway.
Option “out of the money” = the exchange executes them only at the request of the buyer.
- for a Call option: when the current price of the underlying asset is less than the strike price;
- for Put options: when the current price of the underlying is greater than the strike price.
When buying options, the loss in this situation would be limited to the amount of the premium – that was the bargaining chip and strategy when you entered the option, increasing the predictability of the investment. That is, the seller’s financial result is a limited profit with potentially unlimited loss (!).
Options come in monthly and quarterly terms.
What options are used for
By purchasing an option, both parties assess the amount of risk of an unfavorable change in the price of the underlying asset, which is built into the premium.
Buyers, as a rule, use the option to hedge (reduce) risks or make a profit. Sellers pursue the goal – to earn on its implementation. To do this, they set (or calculated according to a certain formula) the fair premium on the option.
The differences between an option and a direct purchase (sale) of an asset:
- Limited risks for the buyer (no more than the size of the option price);
- fixed terms of mutual settlements;
- lower expenses for operations on the futures market.