Derivatives - options and futures

Stocks and bonds are financial assets.

A derivative is also a financial asset but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.

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Options

Options are one of the most common types of derivative.

There are 2 main types of options - calls and puts.

A call option gives the buyer the right but not the obligation, to purchase a specified number of shares of a particular stock at a particular price (called the exercise price) within a specified time frame.

A put option does the reverse - it gives the buyer the right but not the obligation, to sell a specified number of shares of a particular stock at a specified price within a specified time frame.

A definite advantage for the buyer of an option - whether a call or a put option - is that there is no obligation to exercise the option.

A simple example of a call option.

Suppose that you want to own 1,000 Microsoft shares at $30 each.

If you are fortunate enough to have this large amount of money ($30,000) at hand, you can pay up right away and own the shares.

But suppose you do not have this sum of money to invest directly, and your roommate is willing to sell you the right to buy the 1,000 shares at $30,000 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In effect, your roommate has sold you a call option.

If you buy the call option, the value of your investment now depends on the underlying asset - the share price of Microsoft.

If the price of Microsoft goes up, so does the value your call option.

If the price of Microsoft goes down, your derivative falls in value.

When you buy a call option, you pay the seller $1,500 for the right, but not the obligation, to buy the shares at $30,000.

If you change your mind because you found a better deal elsewhere, you can just walk away. You will only lose $1,500, which is called the option premium.

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Futures

Suppose a coffeeshop owner wants to buy 5 metric tons (mt) of Robusta coffee in six months, and he worries that the price of coffee might increase threefold by that time.

One thing he can do now is to strike a deal today with a farmer whereby he promises to pay, say, $1,000 per mt in 6 months' time for 5 mt of coffee. In other words, the coffeeshop owner and the farmer agree that 6 months from now, the coffeeshop owner will exchange $5,000 for 5 mt of coffee.

The agreement that they have created is a futures contract.

With the futures contract, both the coffeeshop owner and the farmer have locked in the price of coffee six months from now.

Suppose that coffee is selling for $1,500 per mt in 6 months' time. If this happens, then the coffeeshop owner would have benefited from having entered into the futures contract.

However, if the coffee sells for only $700 per mt then, he would have made a loss of $1,500, because he is forced by contract to pay $1,000 per mt.

A futures contract is therefore a bet on the future price of whatever is being bought or sold.

An important feature of traded futures contracts is that they are standardised, meaning each contract calls for the purchase of a specific quantity of a particular underlying asset.

The contract specifies in detail what the underlying asset is and where it is to be delivered.

For example, with a Robusta coffee contract, the contrct would specify that a specified quantity of a particular type of coffee will be delivered at one of a few approved locations on a particular date in exchange for the agreed-upon futures price.