When we get into the futures and options basics, we need to know about derivatives first. Two common forms of derivatives are futures and options which obtain their value from the spot prices of underlying assets over a time series movement. For instance, those who produce wheat may want to have a contract to ensure the price of their harvest at a future date. This is asked for to eliminate the risk associated with price fluctuations of their produce. When such a transaction occurs it is called forward or futures transaction and takes place in a futures market.
While the important forms of derivatives are futures and options in which forms these are commonly traded, the underlying market assets can be various, from equity to treasury bills, commodities, real estate, foreign exchange and so forth.
Futures contracts in futures markets are governed by standard rules and the trading is done in a centralized manner. Hence, there is usually no counterparty risk that is involved due to the presence of a clearing house. A futures contract is an agreement form between the buyer and a seller to buy or sell an underlying asset at a pre determined price at a specific date. Such transactions in future markets take place in the presence of a clearing house which act as a counterparty to both parties in the transaction and hence guarantees that the trade will occur on expiry of the contract. Unlike forward markets, there is no increase of risk of counterparty due to extended periods of expiration.
On the other hand, options contracts offer rights and not obligations for someone to buy or sell an underlying asset at a specified date and at a stated price known as the strike price. While a call option offers one the right to buy, the put option contract offers one the right to sell an underlying asset. There can be two varieties of such contracts – European versus American. While in the European option the holder can exercise his right only on the expiry date mentioned, the American way envisages that the right can be exercised any time in the period between the purchase and the expiry dates.
Futures and options trading is lucrative, especially when it comes to futures trading. However, these contracts also come with a significant amount of risk but then again, one can be assured of high returns in a small span of time. From the security level, seen internationally, the trend is that, options are a safer bet than futures. Hence the options market is played by risk averse investors who do not want to dapple in the high risk-high return futures market.