Finance > Investing / Trading

Future and Options: What no one is talking about?

What are the future and options?

Future and options are derivatives whose value depends on (or derives from) the values of others.

For eg: If we choose options in stock then its derivative is a value that depends on the stock price.

But, this derivative needs to define by the exchange to trade at the derivative exchange as contracts. 

Not to mention, future and options are the two most popular derivatives in the financial world.

Thus, we discuss it more to get clarity on the concept of derivatives.

1. Future contract

In the first place, it is a simple derivative as an agreement that is agreed between two parties to buy or sell an asset at a certain future time for a certain price.

But, in order to make such trading possible, the exchange specifies the features of the contract.

Further, the two parties to the contract don’t know each other. Thus, the exchange provides a system and guarantee to the buyer and seller to execute the contract.

2. Options

Options give the right to the contract holder to decide but the holder doesn’t have to right to operate it.

Likewise other insurance instruments, options also has a fee to charge to the contract holder.

There are two types of options. These are:-

1. CALL OPTIONS

A call option gives the holder the right to purchase the underlying asset on a specific date at a specific price

2. PUT OPTIONS      

A put option gives the holder the right to sell the underlying asset on a specific date at a specific price

There are four types of participants in Options. These are:-

  1. Buyers of calls
  2. Sellers of calls
  3. Buyers of puts
  4. Sellers of puts

In fact, buyers of calls/puts are taking long positions whereas sellers of calls/puts are preferring short positions.

It is important to know the terms used in the contract such as the price of the contract can denote by the exercise price or strike price and the date of the contract defines the expiry or maturity of the contract to dissolve on a specific date.

The major difference between futures and options is that futures don’t involve any cost to enter it whereas to get the options, the cost as premium has to be borne by the contract holder.

Who are the major users of future and options?

Hedge fund operators are the major user of derivatives for hedging, speculation, and arbitrage.

Although, the hedge fund is like a mutual fund that is investing funds on behalf of clients they are not needed to register under Security federal law.

In fact, their securities are not available publicly, and only selected financiers may invest in their securities.

We all know that mutual funds are subject to regulations and follow the rules such as

  • 1. Shares in the funds be fairly priced
  • 2. The shares can be redeemable
  • 3. Investment policies should be clearly disclosed to the regulatory body and their investors.
  • 4. The use of leverage should be limited
  • 5. The experts cannot take short positions of the money invested by their clients.

But, hedge funds are relatively free of those regulations which allow them to take independent decisions to develop and implement unique investment strategies.

The fees charged by hedge fund managers depend on the funds’ performance and are relatively higher than the mutual funds.

Specifically, It is 1% or 2% of the invested amount and 20% on the profits earned by the managers.

Hedge funds are labeled as different classes to ease the investors to choose the various available trading plans. These are:-

1. Convertible arbitrage

Under this strategy, the fund manager takes a long position in convertible bonds combined with an actively managed short position in the underlying equity.

2. Distressed securities

It is one strategy that involves high risk-high returns. A manager buys the securities issued by companies in or close to bankruptcy.

3. Emerging markets

The funds can invest in the debt and equity of companies in developing countries and in the debt of the countries themselves.

4. Macro or global

It requires immediate watch over the interest rate and foreign exchange movement because it uses leverage and derivatives to speculate on changes in interest rate and foreign exchange rate.

5. Market neutral

The investment is done in the financial instruments when the purchase securities are considered being undervalued and short securities are considered being overvalued.

Under this strategy, the exposure to the overall direction of the market is zero.

Type of traders in the future and options trading?

One of the major reasons for the fame and success of derivatives markets is that they have appealed to many types of traders and have a great deal of liquidity.

As a result, it allows an investor to take any side of a contract without any problem in finding the other side of the contract.

The type of traders involved in options and futures trading are:-

  • 1. Hedgers
  • 2. Speculators
  • 3. Arbitrageurs

1. Hedgers

These types of traders believe to play safe and use derivatives to reduce the risk that they may face from potential future changes in a market variable.

There is no guarantee that the outcome with hedging will be better than the outcome without hedging but one point is clear that the losses will be minimal to the hedgers.

2. Speculators

They have likely more risk-taking capacity and use derivatives to bet on the future direction of a market variable

3. Arbitrageurs

They are doing excessive research to find the offset position in two or more instruments and use the difference to lock in a profit.

All three types of traders have defined a set of rules for their specific trading style using derivatives but it is very difficult to judge that which is more profitable than others.

Summary:

  • 1. The largest exchange in the world for trading stock options is the Chicago Board Options Exchange.
  • 2. Hedge fund managers are the biggest users of derivatives.
  • 3. Future and options trading is riskier and volatile than stock trading because of its nature to derive value from the underlying assets.

Nishant Anand

author

I am a value investor and passionate to identify undervalued businesses using well-proven techniques and methods.

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