The Dynamics of Options and Futures | MBA Business Analytics Bangalore

Posted by NSR Murthy On 25/06/2022 10:56:44

An Overview of Options and Futures

Introduction

An options contract gives an investor the right, but not the obligation, to buy (or sell) shares at a specific price at any time, as long as the contract is in effect. By contrast, a futures contract requires a buyer to purchase shares—and a seller to sell them—on a specific future date unless the holder's position is closed before the expiration date.

Options and futures are both financial products investors can use to make money or to hedge current investments. Both an option and a future allow an investor to buy an investment at a specific price by a specific date. But the markets for these two products are very different in how they work and how risky they are to the investor. MBA Business Analytics Bangalore

Major Differences between Options and Futures

Options and futures are similar trading products that provide investors with the chance to make money and hedge current investments. An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract.

A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date unless the holder's position is closed prior to expiration.

The Mechanics of Options

Options are based on the value of underlying security such as a stock. As noted above, an options contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific price while the contract is still in effect. Investors don't have to buy or sell the asset if they decide not to do so.

Options are a derivative form of investment. They may be offers to buy or to sell shares but don't represent actual ownership of the underlying investments until the agreement is finalized.

Buyers typically pay a premium for options contracts, which reflect 100 shares of the underlying asset. Premiums generally represent the asset's strike price—the rate to buy or sell it until the contract's expiration date. This date indicates the day by which the contract must be used. MBA Bangalore

Types of Options: Call and Put Options

There are only two kinds of options: Call options and put options. A call option is an offer to buy a stock at the strike price before the agreement expires. A put option is an offer to sell a stock at a specific price.

Let's look at an example of each—first of a call option. An investor opens a call option to buy stock XYZ at Rs. 50 strike price sometime within the next three months. The stock is currently trading at Rs. 49. If the stock jumps to Rs. 60, the call buyer can exercise the right to buy the stock at Rs. 50. That buyer can then immediately sell the stock for Rs. 60 for an Rs. 10 profit per share.

Other Possibilities

Alternatively, the option buyer can simply sell the call and pocket the profit, since the call option is worth Rs. 10 per share. If the option is trading below Rs. 50 at the time the contract expires, the option is worthless. The call buyer loses the upfront payment for the option, called the premium.

Meanwhile, if an investor owns a put option to sell XYZ at Rs. 100, and XYZ’s price falls to Rs. 80 before the option expires, the investor will gain Rs. 20 per share, minus the cost of the premium. If the price of XYZ is above Rs. 100 at expiration, the option is worthless and the investor loses the premium paid upfront. Either the put buyer or the writer can close out their option position to lock in a profit or loss at any time before its expiration. This is done by buying the option, in the case of the writer, or selling the option, in the case of the buyer. The put buyer may also choose to exercise the right to sell at the strike price.

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