Basics of Future and Options

Derivative is a financial contract whose value is derived from the underlying asset.The value of the underlying assets keeps changing according to market conditions. The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in future.The commonly used assets are stocks, bonds, currencies, commodities and market indices.

Forward is a type of derivative contract. It is acustomised private agreement between two party’s buyer and seller that commits them to buy or sell an asset at an agreed price on a specific date in the future. Forward contracts are not traded on an exchange.

Sellers and buyers of forward contracts are obligated to fulfil their end of the contract at maturity.Mostly forward contracts are used when there is uncertainty and volatility in an attempt to lock in prices, gain control over costs and give them greater certainty.You have probably heard of farmers and other commodities producers entering into forward contracts. it’s a particularly common practice in the agricultural sector, because it helps to hedge against future price fluctuations.

Future contract
Future contracts are same as forward contracts, Futures are standardised contractswhich lets the holder to buy/sell the asset at an agreed price at the specified date. The parties are under an obligation to perform the contract. Future contracts are traded on the stock exchange. And the value is adjusted according to market movements till the expiration date it is also known as marked-to-marketed every day.

Difference between Forward and future contract

Forward and future contracts are almost same but there are some key differences in between them:

  • Future contracts are traded on exchange, that is they are standardized. Whereas forward contracts are not traded on exchange (not standardized) but on OTC, they are private agreements whose terms are customised to suit both parties. 
  • In forward contract bears more risk there is counterparty risk involved, risk is that one of the parties to a contract will default on its terms there is no clearinghouse involved that guarantees performance. Whereas in future contracts exchange clearing house acts as counterparty to both sides in the agreement. 
  • In forward contract settlement occurs at the end that means any profit or loss on a forward contract is only realised on settlement. Whereas Futures contracts are settled every day, they are marked-to-market on a daily basis. Means both the parties must have the money to ride the fluctuations in price over the life of the contract.
  • Usually in forward-contract prices often include premiums for the added credit risk. In the beginning both the parties are required by the exchange to put beforehand a nominal account as part of contract known as the margin. As the futures prices are certain to change every day, the differences in prices are settled on daily basis from the margin. 

    What are options

    Option is a derivative contract which provide right, not the obligation, to buy or sell a futures contract at a designated strike price (specified price) for a particular time.The buyer is not under any obligation to exercise the option.Whereas the seller of the options contract is under obligation to buy or sellbased on the option contract buyer’s decision.The option seller is known as the option writer.

    Options are divided into two types:

    Call options and put options

    Call options – The purchase of call option will provide the buyer right but not the obligation to buy the underlying asset specified in the option contract. That means, call option is a long position, the underlying future prices will move higher.
    Put options – The purchase of a put option will provide buyer the right, but not the obligation, to sell the underlying asset at the specified price in the contract. Put option is a short position, that the underlying futures price will move lower.

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Posted On: 11 Jul 2019 Home / Investing / Basics of Future and Options