Options and futures — what are they?

  On the securities exchange, there are such concepts as options and futures. They have much in common and only one serious difference, which is why the terms are often confused. To understand what options and futures are, you need to learn their differences as well as specific examples of use.

 

How do options differ from futures? 

  An option is a contract whose holder has the right, but not the obligation, to sell or buy the underlying asset (shares, currency, precious metals, minerals) at a fixed price. The option seller is obliged to buy or sell the asset at the specified price at the first request of the security holder, regardless of how much the actual value of the asset differs from the figure specified in the contract (strike price). Payment of the difference between the actual and strike price lies entirely with the seller. As a reward for the risk, he receives a one-time payment — the option premium. The security holder may choose not to exercise it, in which case the speculator remains in profit, since he keeps the premium.

  A futures contract is also an agreement to sell or buy an asset at a fixed price, but it imposes obligations on both parties. The contract specifies delivery dates, meaning one party undertakes to sell the asset at the agreed time at a fixed price, and the other party undertakes to buy it. The contract specification also describes other parameters of the asset: its quantity, quality, and so on.
  The difference between options and futures is significant: an option imposes obligations only on the speculator, who receives a premium for this, while a futures contract is a bilateral agreement with equal rights and obligations for both participants.
To better understand this difference, it is worth considering examples of how both securities are used.

 

When are options used? 

  Options are divided into call and put. A call option gives its holder the right to buy an asset at a fixed price, a put — to sell it.
  Call options are used to generate profit by both sellers and buyers. For example, an investor learns that the dollar exchange rate will rise significantly in the near future. The information is not fully verified, so converting savings into dollars would be too risky. The investor decides to buy an option to purchase dollars at the current rate for a term of three months. At the moment, the dollar rate is 36 rubles, and in the near future it will rise to 40 rubles. The cost of one option to exchange 100 dollars is 100 rubles. The person buys options to exchange $10,000 and pays 10,000 rubles, or $278. If the forecast is correct and the dollar rate does increase, the investor has the right to buy the agreed amount of foreign currency at 36 rubles. He will spend 360,000 rubles on purchasing the currency plus 10,000 for the options. He can then sell the dollars at the market price, that is, 40 rubles. From the sale, he will receive 400,000 rubles, of which 400,000 − (360,000 + 10,000) = 30,000 rubles is net profit. 

  Put options are used to insure investments in securities. Such a contract gives its holder the right to sell an asset at a fixed price. For example, an investor buys a package of shares at 100 rubles each to profit from possible future price growth. He is not fully confident in his investment: shares may either fall in price or rise sharply. To hedge his risk, he buys options costing 10 rubles, whose seller undertakes to buy the shares at a fixed price (100 rubles), regardless of their market value. If the shares rise, the option holder simply sells them at a more favorable price, but his profit is reduced by 10 rubles — the option cost. If the shares fall in price, he sells them at the same price and loses only the cost of the option. All expenses for compensating the difference between the market and strike price lie with the seller.
  Thus, an option is a tool for financial market speculation. The contract seller assumes certain risks in order to receive a one-time payment. Options trading is quite profitable, since losses from unsuccessful deals are easily covered by premiums from other contracts.

 

When are futures used?

  As you can see, options and futures are closely related concepts, but they differ significantly in practical use. When concluding a futures contract, both parties bear risk, since obligations are distributed equally.
  Futures are quite often used at the state level, for example, when it is necessary to conclude a contract between two countries or between the state and small or medium-sized businesses. Futures are especially important in agriculture due to the specifics of this sector. Investments in agriculture pay off only after harvesting and full sale of crops. During the growing period, many events may occur that affect the average price of the product, but the investments have already been made and cannot be recovered. Selling crops at market price may become unprofitable. That is why agricultural organizations conclude futures contracts with buyers. Such agreements protect both parties from financial losses in case of price fluctuations.
  For example, let us take an ordinary farmer. He decides to grow one ton of potatoes and later make a profit from selling them. He spends 10,000 rubles on soil preparation, seedlings, and fertilizers. To earn at least a 50% return, he needs to sell the ton for 15,000 rubles. A sharp drop in fertilizer prices is expected soon, which will reduce the average price of potatoes, but the farmer has already invested 10,000 rubles and bought fertilizers at the old price. If he sells without futures, he may suffer major losses. He signs a contract with a regular buyer, stating that when the crop is harvested, he must sell it for 15,000 rubles. The buyer, in turn, undertakes to purchase the potatoes at the agreed price regardless of their current market value. If during this period the market price does not fall but instead rises, the farmer will not receive additional profit, since he has already committed to sell at a fixed price. The buyer benefits.
  For large companies, futures agreements are a guarantee of long-term and productive cooperation. Sales contracts are concluded in advance, and both parties give up possible profits in case of fluctuations in the underlying asset’s price.
  As you can see, although the principles of operation and use of these two types of securities are quite similar, in practice they are very different. Options are widely used in currency and stock markets, while futures are a more global financial instrument.