Futures and Options
These derivatives have their own unique characteristics that make them different from stocks, bonds and other traditional investment products.
A futures contract or simply futures is a standardized and tradable contract which involves the delivery of the underlying asset at a specific price and at a specified future date. The future date is referred as the delivery or final settlement date while the pre-set price is known as the futures price. The settlement price, on the other hand, refers to the underlying asset''s price on the delivery date.
Futures are different from options in that buying a futures contract gives a trader the obligation to buy the underlying asset. There is a greater risk involved.
Different kinds of futures exist as there are various kinds of tradable assets. Different futures markets also exist in specific underlying commodity markets such as the foreign exchange, money market, bond market, equity index market and soft commodities market.
Futures were first introduced as an insurance mechanism for farmers and manufacturers who wanted to set a fixed price for crops at a future date. The contracts on financial instruments, however, were introduced in the 1970s courtesy of the Chicago Mercantile Exchange (CME). As they were highly successful basing on trading volume and accessibility to global markets, these instruments eventually overtook commodities futures.
This development resulted in the introduction of a wide range of new futures exchanges around the world. These include the London International Financial Futures Exchange introduced in 1982 as well as the Deutsche Terminborse and the Tokyo Commodity Exchange. Today, trading takes place in more than 75 futures and futures options exchanges globally.
Some major advantages of futures are its leverage, lower initial outlay, and profit from rising and falling markets, flexibility, transparency, variety and lower transaction fees.
Options can be traced to the development of the law of contract in the medieval period. Since then, they have been used to improve trade involving agricultural produce, imports and manufactured products.
An option enables a trader to buy or sell the underlying asset without the need to buy any obligation. The right to buy an underlying asset is known as a call option while the right to sell is referred as a put option.
An option contract stipulates the price at which you can buy or sell the underlying asset, also called the strike price and the expiry date. After the expiry date, the option is no longer valid. In Indian markets, for instance, they have a fixed expiry date which is the last Thursday of every month.
Options are categorized in to the American and European. American options can be exercised at any time before the expiry day while the European can only be exercised at the expiry date.
Huge risks and extreme volatility are involved when dealing with futures and options. It is, therefore, best for traders not to be always complacent even when using the most advanced trading systems. Investment decisions should be based on different sources instead of just a single one. Additionally, extensive research and analysis from various sources are vital before making a final decision.