If you are wondering what are futures and options, you may be looking at the derivatives market to make an investment. Well, these can be highly profitable investments but can also come with risks associated with them.
Derivatives are financial instruments which are valued as per the underlying asset on which it is based on. If you are looking at commodities market, then derivative have underlying assets as commodities such as gold, crude oil, food grains and so on. Then again, price indices, market indices can also be the underlying assets of derivatives.
Two main forms of derivatives are futures and options.
Those who are involved with futures and options trading, usually dapple in commodity markets. Futures are tradable contracts which are formed between buyers and sellers who wish to determine the price of a commodity in a future date. The contract binds the seller to sell at the price decided no matter what the future market scenario will be while the buyer agrees to buy a certain amount of commodity from the seller at a pre determined price no matter what the actual market conditions are at the future date so fixed.
Futures trading can be done in three principal ways – by squaring off your contract, by making actual delivery or by making a cash settlement. When you square off a futures contract, you take a position opposite to your initial stance. Such as, if you have purchased a gold futures contract then you square it off by selling a similar contract. In case of actual delivery, it signifies physical delivery of the goods as agreed on the specified date. Cash settlement means the difference that one has to pay when selling a contract, that between the futures price and the spot price of the asset on that day.
Options amongst futures and options trading is a safer financial instrument to play with. It signifies the right to sell or buy an underlying asset but poses no obligation on one to actually buy or sell the asset. There are two types of options – the call option is the right to sell at the strike price at which the contract is bought; the put option is the right to buy the asset at the strike price. Options are again classified into the American style and the European style. The previous style means that such an option can be exercised any time before the expiry date while the European style represent options which can be exercised only after the expiry date.
These are the main defining characteristics of these financial instruments if you want to know what are futures and options.