Options and Futures
Options and futures are two of the most popular types of financial derivatives traded on organized exchanges. Derivatives derive their value from an underlying asset such as stocks, commodities, or currencies.
Options: These contracts give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a fixed price, known as the strike price. The buyer pays a premium for this right, and can choose to exercise the option or let it expire.
Futures: These are standardized contracts to buy or sell an asset at a predetermined price at a specific future date. Unlike options, futures contracts carry an obligation for both parties to fulfill the contract terms. Common futures markets include commodities, currencies, and stock indices.
The difference between the spot price (current market price) and the futures price is called the "basis." This difference accounts for factors like storage, interest, and inflation. The basis can be positive or negative depending on market conditions.
How Are Options and Futures Traded?
Options and futures are traded on regulated exchanges and behave similarly to stocks in terms of how they're bought and sold. Their prices fluctuate with the value of the underlying asset. Over-the-counter (OTC) derivatives like forwards and swaps, in contrast, are traded directly between parties without exchange oversight.
Benefits of Options and Futures
- Hedging: Useful for protecting investments in volatile or bearish markets.
- Lower Costs: Offer exposure at a lower transaction cost compared to some other investment methods.
- Standardization: Traded on exchanges, making pricing and volumes transparent.
- High Liquidity: Large trading volume makes it easy to find buyers and sellers.
Risks of Options and Futures
- Counterparty Risk: The risk that one party may not fulfill their part of the contract.
- Market Risk: Unpredictable market changes can lead to financial loss.
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