Futures and Options

Futures and options represent two of the most common form of "Derivatives". Derivatives are financial instruments that derive their value from an 'underlying'. The underlying can be a stock issued by a company, a currency, Gold etc., The derivative instrument can be traded independently of the underlying asset.

The value of the derivative instrument changes according to the changes in the value of the underlying.

Derivatives are of two types -- exchange traded and over the counter.

Exchange traded derivatives, as the name signifies are traded through organized exchanges around the world. These instruments can be bought and sold through these exchanges, just like the stock market. Some of the common exchange traded derivative instruments are futures and options.

Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not standardized and have varied features. Some of the popular OTC instruments are forwards, swaps etc.

Futures 

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features:

Buyer

Seller

Price

Expiry

Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency.

Options 

Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a 'call' option or a 'put' option.

A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is called 'strike price'. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right.

Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as 'premium'. Therefore the price that is paid for buying an option contract is called as premium.