Definition of a Derivative
A derivative is a financial instrument whose value is dependent upon or derived from the value of an underlying asset, index, or rate.
The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes.
Derivatives are typically used for hedging risk or for speculative purposes.
The main types of derivatives include futures contracts, options contracts, swaps, and forwards.
Futures Contract
A futures contract is a standardized agreement between two parties to buy or sell an asset at a predetermined price on a specified future date.
The underlying asset could be a commodity, a currency, an interest rate, or a financial index.
Futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME) and are subject to daily settlement, meaning any profits or losses are settled daily based on market price movements.
Key characteristics of a futures contract:
- Standardization: Futures contracts are standardized in terms of contract size, delivery dates, and conditions, which means every contract on a particular commodity or asset is identical.
- Leverage: Futures contracts are highly leveraged instruments, meaning that a trader only needs to post a margin (usually a small percentage of the contract’s value) to control a large amount of the asset.
- Delivery vs. Cash Settlement: Some futures contracts involve the actual delivery of the underlying asset (e.g., commodities like oil or gold), while others are cash-settled (e.g., futures on financial indices).
- Marked-to-Market: Futures contracts are marked-to-market daily. This means gains or losses are credited or debited to the trader’s margin account based on the closing price of the contract each day.
- Expiration and Settlement: At the expiration of the contract, there is either physical delivery of the underlying asset or a cash settlement based on the asset’s current market value.
Example: A gold futures contract might involve a commitment to buy or sell 100 ounces of gold at a price of $1,900 per ounce on a specific date.
Exchange-Traded Option Contract
An exchange-traded option contract gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a specified price (known as the strike price) before or on a specified expiration date.
Unlike futures, options contracts give the holder a choice, not an obligation, to execute the trade.
Key characteristics of an options contract:
- Call Option: A call option gives the holder the right to buy the underlying asset at the strike price within a certain time frame.
This is used when the buyer expects the price of the asset to increase. - Put Option: A put option gives the holder the right to sell the underlying asset at the strike price within a certain time frame.
This is used when the buyer expects the price of the asset to decrease. - Premium: The buyer of an option must pay a premium to the seller (also known as the writer) of the option.
This premium is the cost of acquiring the option contract. - Expiration Date: Options have a specific expiration date by which the option must be exercised or it expires worthless.
- Strike Price: The price at which the option can be exercised (the underlying asset can be bought or sold) is called the strike price.
- Risk/Reward Profile: The buyer of an option can only lose the premium paid if the option is not exercised.
However, the potential profit is unlimited for a call option and substantial for a put option, depending on the movement of the underlying asset.
The seller, on the other hand, has limited profit (the premium received) but faces potentially unlimited loss (in the case of a call option). - Underlying Assets: Common underlying assets for options include stocks, stock indexes, bonds, currencies, and commodities.
Example: Suppose an investor buys a call option on 100 shares of a stock with a strike price of $50 and a premium of $2 per share.
If the stock price rises to $60 before the option expires, the investor can exercise the option to buy the shares at $50 and either keep the stock or sell it for a $10 per share profit (minus the $2 premium per share).
Comparison of Futures and Options
- Obligation vs. Right:
- A futures contract obligates the buyer and seller to execute the trade at the contract’s expiration.
- An options contract gives the buyer the right, but not the obligation, to execute the trade.
- Leverage:
- Both futures and options offer leverage, but futures contracts generally have higher leverage because the trader only needs to post margin, and there’s no upfront premium like in options.
- Risk:
- In futures, both buyers and sellers are exposed to the risk of unlimited losses if the market moves unfavorably.
- In options, the buyer’s risk is limited to the premium paid, while the seller of an option may face unlimited loss.
- Settlement:
- Futures are marked-to-market daily, and contracts can be settled through physical delivery or cash.
- Options can be exercised, expire worthless, or closed out before expiration.