1. Introduction: The world of futures and options.
A. Explanation of futures contract.
A. Explanation of options contract.
C. Intrinsic value and time value of contracts.
4. Conclusion: Risky investments.
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.
Cite this OPTIONS AND FUTURES
OPTIONS AND FUTURES. (2018, Jun 07). Retrieved from https://graduateway.com/options-and-futures/