What are futures and options?

A futures contract is a legally binding contract to buy or sell a standardised product, at a fixed price, for cash settlement (or physical delivery) on a given date in the future.

Options provide the buyer the right but not the obligation to buy or sell an asset at a fixed price in the future. This price is called the 'exercise (or strike) price'.

There are two types of options:

A call option gives the holder the right but not the obligation to buy the underlying asset at the exercise price; and
A put option gives the holder of an option the right but not the obligation to sell the underlying asset at the exercise price.

One of the easiest ways to understand futures and options is to use the example of buying a house.

Futures

Imagine Jane is keen on purchasing a property but does not want to take possession of the property for 6 months. Jane and the vendor agree on a price today of $700,000 and agree that possession date will be in 6 months from now. To help ensure her obligations are met, Jane is required to deposit a percentage of the total purchase price now, with the balance of the funds transferred on possession or settlement date. In this case both parties are obligated to meet their requirements to buy and sell.

Options

Imagine Jane likes a property but is not 100% sure she wants to buy it now or even at all, however does not want to miss out should she choose to buy it in the future. Jane offers the vendor a fee or premium (a non-refundable sum of money) for the right to purchase the property for $700,000 anytime between now and 6 months time. Jane now has the right but not the obligation to purchase the property, or, if she chooses not to purchase the property she can let the contract lapse with Jane's cost being the premium paid. In this example Jane can exercise her right under the contract at whatever date prior to the 6 month expiry, this is known as an American style option. Some options are European style where the option can only be exercised on expiry date. Note that these examples are for the purposes of illustrating the basics of a futures and options contract. In both of these examples the contracts are between two counter parties, whereas exchange traded derivatives are traded through a central counterparty - The Clearing House.

Physical delivery vs cash settlement

In the examples of Jane purchasing property the contracts are physically delivered i.e. there is the exchange of the actual physical product - the house. Many contracts, particularly commodity contracts, are physically delivered, however many are also cash settled. If, in Jane's case, the contracts were cash settled she would receive the cash difference between the price agreed on day one and the value of house on possession date. The value would be set to a reference price as detailed in the terms of the contract, let's say that reference price is a registered valuation. If that valuation was $730,000 on possession date, then Jane would receive $30,000, if the valuation on possession date was $670,000 then Jane owes the counter party to the contract $30,000. This is the difference between physical delivery (settlement) and cash settlement of derivatives contracts.

Why use derivatives?

In either example above what Jane has achieved is price certainty, she has hedged her position. In the case of the futures contract she has set her price in advance. In the case of the options contract she has also assured herself future price certainty if she wants it. If she does not want the house because she has changed her mind or the value of the property has fallen over the 6 month period and so exercising her right would mean she is overpaying, she would let the options contract lapse, losing only the premium paid.

Of course in modern markets contracts can be sold and bought many times over prior to expiry of that contract.

The ability to create certainty by setting a sales or purchase price in advance is invaluable to better managing a business, managing margins and protecting against market movements. The use of derivatives for managing risk is essentially using the same rationale used by those who in whole or part fix their mortgage interest rate - the desire for certainty. This is known as hedging. Hedging is not speculation, hedging is for the purpose of mitigating market movement where a loss in the physical market is offset by a profit in the futures market and vice versa. Further explanation can be found in the introductory brochures on this page.

Exchange Traded Derivatives vs Over the Counter (OTC)

Derivatives around the world are used on a daily basis by those who wish to manage price risk, whether that price risk is in equity markets, commodities, bonds or money markets. Examples of globally traded derivatives are contracts such as FTSE Futures, S&P 500 Futures, Cocoa Futures & Options, Corn Futures and Options and many more.

One point to note is that exchange traded or 'listed' derivatives contracts operate in quite a different way to Over the Counter or 'OTC' derivatives contracts. Listed contracts operate in a regulated market and are cleared through an independent central counter party called a clearing house. The fact that listed contracts are 'cleared' means that participants are protected from the risk of their counter party failing or backing out of the trade, this is achieved by margin or a deposit being posted to the clearing house when a contract is entered into (initial margin). In addition, positions are revalued on a daily basis to ensure any profits or losses are attended to on that day (variation margin). This is different to the OTC derivatives market where there is no central counter party and no independent regulated entity revaluing positions and collecting initial and variation margin.