Futures and options are very similar financial investments. Basically, these two investments are the result of financial uncertainty. They are used for speculation and for hedging against losses from other areas. A futures contract is the right to buy or sell some commodity or financial instrument. The purchase or sale occurs sometime in the future. The date of the sale or purchase is fixed, and this is the settlement date. The price of the sale or purchase is also fixed at the time the contract is purchased. The purchaser of the contract must buy or sell the commodity or financial instrument by the settlement date (Euromoney 80).
For example, an importer in the United States may have a bill due in England in 90 days. The importer will need British pounds to pay the bill. In order to stabilize his business, he needs to know now how much this will cost him in dollars. To do this he purchased the right to buy pounds in 90 days. The price in dollars is fixed now. Whether the exchange rate goes up or down does not matter anymore. The importer has essentially fixed the exchange rate for his future debt. This may not always work out to his advantage.
If the dollar goes up in value during the 90 days, he has probably paid too much for the pounds. The price he fixed today would probably be lower in 90 days. That is, it would take fewer dollars to purchase pounds in 90 days than the rate in effect when he took out a future contract. Where there is uncertainty about what the value of the contract will be on the settlement date, options may be a better deal. An option is similar to a futures contract.
The importer can still purchase pounds in 90 days. However, with an option, there is no requirement that the purchaser of the option execute the deal. The importer would not have to buy the pounds at the fixed rate if the value of the dollar increased relative to the British pound. Under this type of deal, each side is betting against the other for economic gain (Euromoney 81). There are actually two methods employed for determining when the trade will execute. Under the European method, the trade can only be executed on the settlement date. The American Option allows the option buyer to execute any time up to and including the settlement date. This gives the option buyer more room to speculate (Euromoney 31).
For example, a 90-day option to buy pounds for dollars at a fixed exchange rate could be executed anytime between the purchase date and the settlement date. If the dollar rises in value for 45 days and falls on the 46th day, the option buyer could exercised on the 46th day. The importer might do this if he feels the value of the dollar will continue to Options are either put or call options. A call option is the right to buy. A put option is the right to sell. What is being bought or sold is the right, but not the obligation, to deliver at an agreed upon price, one specified instrument for another.
The agreed upon price is called the strike price. This is the price at which a purchaser can buy the financial instrument or commodity, or it is the price at which a seller can sell the financial instrument or commodity. If our importer example was arranged so that the importer wanted to buy pounds in 90 days for dollars, this would be a call option. He has the right to buy pounds. In exchange, he will give dollars. However, he could also have arranged this so that he could sell dollars for pounds. In this case, he would have a put option. This would give him the right to sell a certain amount of dollars for pounds in 90 days. Whether you buy or sell depends on what you think the value of the underlying financial instrument or commodity will be on the settlement date. Obviously, there is a lot of room here for gambling. There is one more interesting twist to this.
The underlying security does not have to be something tangible like dollars or corn. There are also futures contracts and options in stock market indexes. There is a major difference here when the underlying security is an index. All options, if the option is exercised, and futures contracts are settled by delivering the financial instrument or commodity. However, when the underlying security is an index, the deal is settled in cash. This brings up the question of value.
The option price can be somewhat speculative. There are two parts to option pricing: intrinsic value Suppose we had a call option to buy 100 British pounds in 90 days for 50 U.S. dollars. The strike price would be 1 British pound for 50 cents U.S. However, this is not the same as the market price. If on the settlement date the market price was 1 pound for 60 cents U.S., there would be intrinsic value to the option if 10 cents U.S. for each pound. The purchaser has a paper profit of 10 cents per pound. The real key is what the market price will be on the settlement date.
If pounds are selling for more than 50 cents, the option has a positive intrinsic value. Obviously, the purchaser in this example expects the dollar to drop relative to the British pound. If the dollar rises, there will be a negative intrinsic value. The option purchaser would probably not exercise In line with the above example, if the market price for pounds is 50 cents on the purchase date, but the strike price is 45 cents, this means there is a time value of 5 cents. Time value is the measure of how much the underlying instrument is expected to increase or decrease in value over the contract or option term. The real price of the option is the sum of its intrinsic value Trading in options and futures has grown in the U.S. during the last couple of years. Tax rate changes have reduced short-term capital gains taxes from 50% to 28% (McFadden 188).
Thus, it less costly to engage in speculation. And, the volatility of the markets has forced many people to use options and contracts to hedge against losses in other areas. There are several mutual funds that use options extensively. Dreyfus and Zweig are two such firms. These funds appeal to investors who think the market will go down. Essentially, they use their own predictions of what they feel stocks will be worth in the future to make bets.
If their long-term view is correct they can make a lot of money. Between February 1984 and November 1986, Zweig Increased the value of its fund by 121%, while the S&P index went up only 63%. However, these are risky investments. They are not for the small investor, and certainly not for the unskilled investor. Many firms used sophisticated computer models to arrive at the strike price. This is something the ordinary inventory should probably stay away from.
- “A Guide to the Insider’s Jargon,” Euromoney , October 1986, Supplement, p. 80-81.
- “The International Options Market,” Euromoney , October 1987, Supplement, p. 31.
- McFadden, M. “These Mutual Funds Have Safety Nets, “ Fortune , November 24, 1988, p. 188
- Nelson, J. F. “An Unforgiving Business,” U.S. Banker , Zvi, Bodie. Kane, Alex. Marcus, Alan. Essentials of Investments . New York: NY, 1998, p. 437-498.