Futures & Options

In finance, derivative means a security whose price is dependent on or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties, with a value determined by fluctuations in the underlying asset, which could be stocks, bonds, commodities, currencies, interest rates, and market indexes.

Futures contracts, forward contracts, options, and swaps are the most common types of derivatives. Since derivatives are contracts, almost anything can be used as a derivative's underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Derivatives generally are used to hedge risk but also can be used for speculative purposes. For example, a European investor purchasing shares of an American company on a foreign exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge that risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and conversion back into the foreign currency.

Futures contracts typically represent a larger investment in the underlying asset, from the standpoint of a legal obligation, if not actual money laid out. The contract requires the buyer to either purchase the 'goods' by the deadline (which is rare), or sell the contract to another party. So, the financial obligation is, at least in principle, potentially very large.

The risk in options is therefore lower, with the amount limited to the premium cost. Nevertheless, few traders actually take delivery of several tons of wheat or a few thousand barrels of oil. The contracts typically are actively traded until just before settlement time, at which time a buyer - one appropriate to that commodity - purchases the actual goods and re-sells them.

Similarly, only a small percentage of options traders actually take delivery of the underlying shares of stock, bond certificates, commodity or other instrument. (Some do, such as employees of companies granting options as part of employment compensation packages

Futures contracts exist on non-physical 'goods' as well - such as index futures, bond futures, even futures on options!

A futures contract gives its buyer the obligation to purchase the underlying asset and the seller to sell (and deliver) it at a preset date. (If the futures holder liquidates his position prior to expiration, the delivery clause is voided, obviously.)

By contrast, an options contract, whether a call (buy an asset) or put (sell an asset), grants the holder the right - but not the obligation - to exercise the option. The holder is entitled to simply let the option expire without investing further.

Investors can enter futures contracts without input of any funds (ignoring any commission), but an option always carries a cost - the 'premium'. (Note: This is only partially accurate since, in practice, futures contract buyers typically put down a deposit of around 10% of the price of the underlying asset. But the futures contract itself doesn't cost anything but a small commission.)