Futures and options are two common forms of financial instruments known as derivatives. Derivative is a financial instrument which takes its value from the underlying stock or commodity. Underlying assets can be of a vast category – from stocks to shares issued by listed companies, currency, commodities like gold, silver and so forth. Derivatives are traded in the financial markets independent of the assets themselves but the valuations change as per the value of the underlying assets.
There are two types of derivatives – those which are traded in stock exchanges and some which are exchanged over the counter. The two common forms of derivatives are futures and options.
If we talk about futures, it is a contract tradable in the market whereby an agreement is formed to buy or sell at a pre determined price at a future date. No matter what the market value of the commodity is at that time in futures, such a contract remains binding upon the buyer and seller. A futures contract comprises of the following features – a buyer, a seller, a price and an expiry date.
When we talk about options, these are contracts formed which provide the buyer of the contract the right to buy or sell an underlying asset of a derivative at a price specified within a period of time. Options contracts can be in the form of “call option” or “put option”. A call option is one which provides the buyer the right to buy the underlying asset at the strike price while the holder of put options can only exercise their right to sell at the strike price the underlying asset within the expiry period. In the American style of options contracts, such rights can be exercised at any time within the contract period while in European style of options contracts, the rights can be exercised only after the expiry date.
Thus in such contracts, the buyer has the right to exercise his rights but under no obligation to carry out the actual transaction. However, the seller of the options contract has the obligation to carry out the actual transaction. As the seller bears the obligation, he charges a premium from the buyer which comprises of the price of the option. When the spot price of an underlying asset is lower than the strike price, the buyer does not exercise his right to call. Similarly, when the asset’s market value is higher than the strike price, the buyer of the options contract does not exercise his or her right to sell the asset.
These are the common characteristics of futures and options and their trading in India.