Posted in Finance Articles, Total Reads: 4531
, Published on 30 October 2010
Options and futures are most common terms of derivatives that are often used interchangeably. The following article will explain the two in very lucid terms.
A future is a contract to buy or sell the underlying asset at predetermined date at a predetermined price. If you buy future, then you are promising to pay the price of the asset at a specified time. If you sell future, then are promising to transfer the asset to the buyer of the asset at a specified price at predetermined date. So futures market is place where buyers and sellers meet and act today to make sure what they want to do in the future. Futures market arose from the need to reduce price risk.
Example: Suppose the current price of Infosys is Rs 300. You are interested in buying shares of Infosys. You find somebody called Hari who is willing to 500 shares of Infosys. You tell Hari that you will buy 500 shares of Infosys at later point of time, for example last Friday of the month. The agreed date is called expiry date of the contract or agreement. Now Hari will have to go through trouble of keeping Infosys shares for entire one month. Also if outsourcing business is booming, then it is likely that price of Infosys at the end of the month will not be Rs 300 but something more than that. So Hari says instead of striking the deal at Rs 300 lets strike it at Rs 305. The agreed price is called strike price of the contract. Now Rs 5 can be thought of his charge for keeping the shares until expiry date. The difference between current price and strike price is called cost of carry. The total contract size is Rs 305 for 500 shares i.e. Rs 152500. Now there is risk for both you and Hari. For example, if tomorrow price of Infosys falls to 290, then it more profitable to buy from market than from Hari. There is a possibility that you may not honor the agreement. Then it will be a loss of Hari. Similarly if price increases then you are at risk if Hari does not honor the contract. So both of you decide to keep Rs 30000 each with a common friend in order to take care price fluctuation. The money paid by each of you is called the margin money for the futures contract. Finally if you decide that the future contract is cash settled then at expiry date instead of handling over the 500 shares Hari will pay you the money if price increases or you pay Hari if price falls. If at expiry date price is Rs 310, then Hari will pay you (310-305) = 5 per share. You can then purchase the share from market Rs 310. Since you will get Rs 5 from Hari you will effectively buy the share at Rs 305 from the market. Similarly, Hari can directly sell his shares in the market at 310 and give you Rs 5 which means he effectively sold the share at Rs 305, the agreed price.
Options are different from futures. Options contract convey the right, not the obligation, buy or sell the underlying asset at a specific strike price any time before the option expires. Options can of two types call option and put option.
A call option gives the buyer, the right to buy the asset at a given price. Here buyer has the right but no obligation to buy but seller has obligation to sell. A put option gives the buyer, the right to sell the asset at a given price. Here buyer has the right but no obligation to sell but seller has obligation to buy. So right to exercise the option is vested with the buyer of the option. Seller of contract has only the obligation but no right. Since seller bears more risk and has an obligation, he is paid premium by the buyer. So price that is paid at the time of buying option contract is called option premium. There is no premium in case of futures.
The buyer of call option will not exercise the option if current price is less than strike price. For example you bought a call option at a strike price of Rs 500. Suppose at expiry the price is Rs 450. You will not exercise the option. If the price is Rs 550 then you will exercise the option.
The buyer of put option will not exercise the option if current price is higher than strike price. For example you bought a put option at a strike price of Rs 500. Suppose at expiry the price is Rs 550. You will not exercise the option. If the price is Rs 450 then you will exercise the option. The premium paid in case of option is not refundable.
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