Difference between options and futures pdf

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difference between options and futures pdf

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Why Zacks? Learn to Be a Better Investor. Forgot Password. Investors are typically acquainted with the popular types of investments like stocks, bonds and mutual funds. However, there are other types of financial investments that provide their own unique risk and reward profiles.

Options vs. Futures: What’s the Difference?

In finance , a futures contract sometimes called futures is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date.

Because it is a function of an underlying asset, a futures contract is a derivative product. Contracts are negotiated at futures exchanges , which act as a marketplace between buyers and sellers. The buyer of a contract is said to be the long position holder, and the selling party is said to be the short position holder. A stock future is a cash-settled futures contract on the value of a particular stock market index.

Stock futures are one of the high risk trading instruments in the market. The first futures contracts were negotiated for agricultural commodities, and later futures contracts were negotiated for natural resources such as oil. Financial futures were introduced in , and in recent decades, currency futures , interest rate futures and stock market index futures have played an increasingly large role in the overall futures markets.

Even organ futures have been proposed to increase the supply of transplant organs. The original use of futures contracts was to mitigate the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions.

This could be advantageous when for example a party expects to receive payment in foreign currency in the future, and wishes to guard against an unfavorable movement of the currency in the interval before payment is received. However, futures contracts also offer opportunities for speculation in that a trader who predicts that the price of an asset will move in a particular direction can contract to buy or sell it in the future at a price which if the prediction is correct will yield a profit.

In particular, if the speculator is able to profit, then the underlying commodity that the speculator traded would have been saved during a time of surplus and sold during a time of need, offering the consumers of the commodity a more favorable distribution of commodity over time.

The Dutch pioneered several financial instruments and helped lay the foundations of the modern financial system. Among the most notable of these early futures contracts were the tulip futures that developed during the height of the Dutch Tulipmania in The Chicago Board of Trade CBOT listed the first-ever standardized 'exchange traded' forward contracts in , which were called futures contracts.

This contract was based on grain trading, and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world. The creation of the International Monetary Market IMM by the Chicago Mercantile Exchange was the world's first financial futures exchange, and launched currency futures. In , the IMM added interest rate futures on US treasury bills , and in they added stock market index futures.

Although futures contracts are oriented towards a future time point, their main purpose is to mitigate the risk of default by either party in the intervening period. In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. Margins, sometimes set as a percentage of the value of the futures contract, must be maintained throughout the life of the contract to guarantee the agreement, as over this time the price of the contract can vary as a function of supply and demand, causing one side of the exchange to lose money at the expense of the other.

To mitigate the risk of default, the product is marked to market on a daily basis where the difference between the initial agreed-upon price and the actual daily futures price is re-evaluated daily. This is sometimes known as the variation margin, where the futures exchange will draw money out of the losing party's margin account and put it into that of the other party, ensuring the correct loss or profit is reflected daily. If the margin account goes below a certain value set by the exchange, then a margin call is made and the account owner must replenish the margin account.

On the delivery date, the amount exchanged is not the specified price on the contract but the spot value , since any gain or loss has already been previously settled by marking to market. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss.

This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts.

Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.

Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations.

Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day.

Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.

In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. Some U. The Initial Margin requirement is established by the Futures exchange, in contrast to other securities' Initial Margin which is set by the Federal Reserve in the U.

A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in their margin account. Margin-equity ratio is a term used by speculators , representing the amount of their trading capital that is being held as margin at any particular time.

The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract.

Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:.

Expiry or Expiration in the U. For many equity index and Interest rate future contracts as well as for most equity options , this happens on the third Friday of certain trading months. On this day the back month futures contract becomes the front month futures contract. During a short period perhaps 30 minutes the underlying cash price and the futures prices sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs.

At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions.

On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour. When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures , treasury bond futures , and futures on physical commodities when they are in supply e. However, when the deliverable commodity is not in plentiful supply or when it does not yet exist — for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures in which the supposed underlying instrument is to be created upon the delivery date — the futures price cannot be fixed by arbitrage.

In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract. Arbitrage arguments " rational pricing " apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rate —as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away.

We define the forward price to be the strike K such that the contract has 0 value at the present time. Assuming interest rates are constant the forward price of the futures is equal to the forward price of the forward contract with the same strike and maturity. It is also the same if the underlying asset is uncorrelated with interest rates. Otherwise the difference between the forward price on the futures futures price and forward price on the asset, is proportional to the covariance between the underlying asset price and interest rates.

For example, a futures on a zero coupon bond will have a futures price lower than the forward price. This is called the futures "convexity correction. This relationship may be modified for storage costs u , dividend or income yields q , and convenience yields y. Storage costs are costs involved in storing a commodity to sell at the futures price.

Investors selling the asset at the spot price to arbitrage a futures price earns the storage costs they would have paid to store the asset to sell at the futures price. Convenience yields are benefits of holding an asset for sale at the futures price beyond the cash received from the sale.

Such benefits could include the ability to meet unexpected demand, or the ability to use the asset as an input in production. Such a relationship can summarized as:. The convenience yield is not easily observable or measured, so y is often calculated, when r and u are known, as the extraneous yield paid by investors selling at spot to arbitrage the futures price.

In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections transaction costs, differential borrowing and lending rates, restrictions on short selling that prevent complete arbitrage.

Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price. When the deliverable commodity is not in plentiful supply or when it does not yet exist rational pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is determined by today's supply and demand for the underlying asset in the future.

In an efficient market, supply and demand would be expected to balance out at a futures price that represents the present value of an unbiased expectation of the price of the asset at the delivery date.

This relationship can be represented as [16] By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants an illegal action known as cornering the market , the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down. The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability.

In other words: a futures price is a martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.

The situation where the price of a commodity for future delivery is higher than the expected spot price is known as contango. Markets are said to be normal when futures prices are above the current spot price and far-dated futures are priced above near-dated futures. The reverse, where the price of a commodity for future delivery is lower than the expected spot price is known as backwardation.

Difference Between Futures and Options

An important difference between the two is that futures trading takes place in a centralized open market where all participants can see exchanges, quotes and rates. Investors have a wider selection of instruments in the futures markets, so there are more opportunities to cover positions in relation to the broker, which is the counterpart of the. A key fundamental difference between an equity security and a futures contract is the way in which the market determines prices. An equity security is always priced on what the market believes it is worth today. A futures contract will always be priced based on what the market expects it to be worth in the future, at expiration. If an asset is.

Futures vs. Options

In finance , a futures contract sometimes called futures is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date.

Differences Between Futures & Options

The biggest difference between options and futures is that futures contracts require that the transaction specified by the contract must take place on the date specified. Options, on the other hand, give the buyer of the contract the right — but not the obligation — to execute the transaction. Options can be exercised at any time before they expire while a futures contract only allows the trading of the underlying asset on the date specified in the contract.


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