Differences.
The purchaser of a futures contract is obligated to buy the underlying asset at the specified price (and the seller of a futures contract is obligated to sell).
The owner of a call option is not obligated to buy unless he wishes to do so; he has the right, but not the obligation.
The buyer of an option has a limited downside, but the buyer of a futures contract doesn't.
Similarities.
Options and futures contracts also share some common features. Both have standardised features that allow them to be traded quickly and "cheaply" on organized exchanges.
Ref: Make Your Money work for you, by Keon Chee & Ben Fok
Showing posts with label options. Show all posts
Showing posts with label options. Show all posts
Wednesday 29 October 2008
Tuesday 28 October 2008
Option returns
When you buy a call option, you are essentially betting that the price of the underlying common stock will rise, making the call option more valuable.
Conversely, put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable.
Returns are only in the form of capital gains.
Since you do not own the stock but only the right, dividends paid on the underlying stock do not benefit you.
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The seller receives a fee called an option premium for selling you a call or put.
Once an option is created and the seller receives the premium from the buyer, it can be traded in the secondary market.
The premium is the market price of the derivative, and the price will fluctuate along with changes in the underlying common stock.
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Put and calls allow both buyers and sellers to speculate on the short-term movements of common stocks.
Buyers obtain an option on the common stock for a small, known premium.
This known premium is the maximum that the buyer can lose.
If the buyer is correct about the price movements of the common stock, capital gains are magnified because only a small investment is committed.
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There are two particularly important types of derivatives - options and futures.
Many other types exist, but they can usually be created from these two basic building blocks, possibly by combining them with all sorts of other investment assets including stocka and bonds, stock indexes, gold and commodities such as wheat and corn.
Ref: Make your money work for you, by Keon Chee & Ben Fok
Conversely, put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable.
Returns are only in the form of capital gains.
Since you do not own the stock but only the right, dividends paid on the underlying stock do not benefit you.
-----
The seller receives a fee called an option premium for selling you a call or put.
Once an option is created and the seller receives the premium from the buyer, it can be traded in the secondary market.
The premium is the market price of the derivative, and the price will fluctuate along with changes in the underlying common stock.
-----
Put and calls allow both buyers and sellers to speculate on the short-term movements of common stocks.
Buyers obtain an option on the common stock for a small, known premium.
This known premium is the maximum that the buyer can lose.
If the buyer is correct about the price movements of the common stock, capital gains are magnified because only a small investment is committed.
-----------
There are two particularly important types of derivatives - options and futures.
Many other types exist, but they can usually be created from these two basic building blocks, possibly by combining them with all sorts of other investment assets including stocka and bonds, stock indexes, gold and commodities such as wheat and corn.
Ref: Make your money work for you, by Keon Chee & Ben Fok
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.
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.
------------
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.
--------------
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.
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