Understanding Futures and Options
Futures and Options (F&O) are the common jargons often used together in the derivative world. Let us dive into the key areas of both concepts to understand the basic nature of the popular derivative instruments
Futures and Options (F&O) are the common jargons often used together in the derivative world. Let us dive into the key areas of both concepts to understand the basic nature of the popular derivative instruments:
An investor can essentially commit to the purchase or sale of an underlying asset at a predetermined price by entering into a futures contract, with delivery and payment deferred until a specified settlement date. A futures contract can be "bought" or "sold" but no money exchanges hands upfront, except from depositing initial margin to lower the risk of non-payment. A futures contract's buyer assumes a long position and pledges to purchase the underlying asset or security at the agreed-upon price and time. A futures contract's seller, who has a short position, agrees to sell the underlying asset or security at the agreed-upon price and time. The seller incurs an opportunity cost in receiving payment because the future price for transacting is negotiated now but delivery and payment are delayed until the settlement date. As a result, the negotiated price for future asset delivery differs from the current cash price by an amount equal to the cost of waiting to be paid.
Whereas, call options and put options are the two basic types of options. A call option grants the holder the right to purchase the underlying security at a specified price and within a specified time frame. A put option grants the owner the right to sell the security at a predetermined price within a specified time frame. What distinguishes options from futures contracts is the right, rather than the obligation, to buy or sell the underlying security. In addition to purchasing an option, an investor may sell a call or put option that the investor has not previously purchased, a practise known as writing an option. As a result, the two fundamental option positions can be expanded into four alternative positions.