Finance Futures and Options

Financial futures and options are derivatives, meaning their value is derived from an underlying asset. These instruments allow investors to speculate on the future price movements of various assets and manage risk.

Futures

A futures contract is an agreement to buy or sell an asset at a predetermined price on a specific date in the future. This agreement is legally binding. The underlying asset can be anything from commodities like oil and gold, to financial instruments like currencies, stock indices, and interest rates.

• Contract Specifications: Standardized, outlining quantity, quality, delivery location, and delivery date.
• Margin: A performance bond (not a down payment) required to open and maintain a futures position.
• Mark-to-Market: Daily settlement process where gains and losses are credited or debited to the trader’s account based on price fluctuations.
• Hedging: Businesses use futures to protect themselves from adverse price changes. For example, an airline might use fuel futures to lock in a price for jet fuel.
• Speculation: Traders can profit from accurately predicting price movements, but also risk significant losses.

Options

An option contract gives the buyer the *right*, but not the obligation, to buy or sell an underlying asset at a specified price (the strike price) on or before a specific date (the expiration date). In exchange for this right, the buyer pays the seller a premium.

• Call Option: Gives the buyer the right to *buy* the underlying asset at the strike price. Buyers expect the price to rise.
• Put Option: Gives the buyer the right to *sell* the underlying asset at the strike price. Buyers expect the price to fall.
• American vs. European Options: American options can be exercised any time before expiration, while European options can only be exercised on the expiration date.
• In the Money (ITM): A call option is ITM when the underlying asset’s price is above the strike price; a put option is ITM when the underlying asset’s price is below the strike price.
• At the Money (ATM): When the underlying asset’s price equals the strike price.
• Out of the Money (OTM): A call option is OTM when the underlying asset’s price is below the strike price; a put option is OTM when the underlying asset’s price is above the strike price.

Key Differences & Considerations

Futures obligate you to buy or sell, while options give you the right, but not the obligation. Options have limited downside risk (the premium paid), while futures have potentially unlimited downside risk. Both are leveraged instruments, meaning small price movements can result in large gains or losses. Therefore, both futures and options require a thorough understanding of the underlying market and disciplined risk management strategies.