As an investor it is important that you understand your choices when it comes to investments. One of these choices is derivatives, the most common of which are called options and futures. What are derivatives though? A derivative is simply a financial instrument that gets value from the underlying item such as gold, a specific currency, or other tangibles. The underlying asset and the derivative can be traded independently of each other, but the derivative price is tied to the price of the underlying asset. If the asset underlying the derivative changes price the derivative will follow suit.
Derivative Trading
Derivatives can be traded on an exchange or over the counter. Futures and options are exchange traded derivatives, and they are traded on an exchange like the stocks are traded on a stock market. Some derivatives are not traded on any exchange and are instead traded over the counter. These derivatives include swaptions, forwards, swaps, and others, and there are no standardized features in place for over the counter trading like there are for exchange trading.
Leverage is an important aspect of futures and options trading. Leverage allows you to invest a fraction of the investment amount, sometimes as little as1/100th of the amount you are investing. Leverage can be a double edged sword though, because when a trade goes well you can significantly increase your gains but when a trade fails the amount lost is also exponential. Many traders avoid using leverage, while others use it frequently but cautiously.
What Are Futures And How Are These Traded?
Futures refer to contracts that specify the right to purchase or sell the asset underlying the derivative at a specified time in the future. If you purchase futures you enter into a contract that says you will pay for the asset on the specific date in the contract and you will pay the specific price listed in the futures contract for the asset. When futures are sold you are agreeing to sell the asset and transfer it to the contract buyer for the price specified on the date determined by the contract. These contracts are commonly used with underlying assets that include currency, equity stocks, commodities, and popular indexes.
With futures options the change in value of the underlying asset can significantly change the value of the derivative as well.
Every futures contract will specify:
The buyer
The seller
The futures being traded, such as the S&P 500 stock index or another underlying asset
The contract value
The tick size,which is the percentage that shows the minimal price change intervals for the contract
The delivery date of the underlying asset
The last trading day for the contract
The acceptable settlement type for the contract, such as cash
The price of the asset underlying the futures contract in the futures market will be different from the price of this asset in the spot market. The spot market price is the price paid for the asset when immediate delivery will be taken, and the difference between the spot market prices and future market prices is called a Basis. When the price is higher in the spot market the Basis will be negative, and when the price is higher in the futures market the Basis is positive.
The futures market price is typically higher because the asset seller must cover expenses that can include storage fees, insurance coverage premiums, and interest rate costs. When the Basis is negative this is referred to as Contango. If the Basis is positive this is referred to as Backwardation, and this condition normally occurs if the asset price is expected to decrease shortly. As the maturity date of the contract nears the gap between the spot market price and the futures market price of the asset will close, so the Basis is generally zero on the contract expiration date.
What Are Options And How Are These Traded?
If the buyer of a call option chooses to purchase the underlying asset then the seller of the asset can not refuse, but the buyer may choose not to enforce the contract and can let the contract expire instead. If the buyer of a put option chooses to sell the underlying asset then the second party to the contract can not refuse to buy the asset, but the buyer may choose not to sell the asset can let the contract expire instead. Options contracts allow investors to hedge against price fluctuations for short time periods.
When the contract expires the option will not be exercised in some cases. If the option is a call option and the asset price in the spot market is lower than the strike price agreed on. Instead of exercising the call on the contract the buyer can purchase the asset on the spot market for less. With a put option the option will not be used and the contract will expire if the spot market price is higher than the strike price agreed on. This is because the underlying asset can be sold on the spot market for a higher price.
Every options contract will specify:
The buyer
The seller
The underlying asset for the option
The contract value
The tick size,which is the percentage that shows the minimal price change intervals for the contract
The delivery date of the underlying asset
The last trading day for the contract
The acceptable settlement type for the contract, such as cash