A derivative is a financial instrument that does not have an independent value. It derives its value from an underlying asset. The underlying asset may be a currency, a stock issued by a company, rate of interest, indices, and gold, besides others.
Two common forms of derivatives are futures and options.
A future contract is an agreement to buy or sell the underlying asset at a pre-determined time in the future for a specific price. Futures are primarily used by traders for arbitrage. Traders may buy at a low price in the stock market and sell at a higher price in the futures market. The price difference between the two markets for the same stock helps them earn a profit. Here, the buyer and the seller both have the obligation to execute the contract at a fixed time in the future.
In futures trading, the buyer and the seller may not know the identity of one another. It is important to know that every futures contract is honored by the cleaning house or the cleaning corporation of the stock exchange. Futures trading may be done on various assets, such as currency pairs, indices, stocks, and commodities, besides many others.
There are numerous advantages of futures trading. It allows hedgers to transfer risks to speculators. Besides, traders get a fair idea of the future price of a stock or value of an index. Based on this information, traders may also determine the future demand and supply of the asset.
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An options contract gives the holder of the instrument the right to buy or sell at a pre-determined price. As opposed to futures trading, options trading gives the buyer the right and not the obligation to buy. The seller of the contract, however, has an obligation to abide by the contract. Since the seller has the obligation, he is entitled to receive a premium, which is the price paid for buying an options contract.
There are two types of options, namely put option and call option. The right to sell the security is known as a put option, whereas the right to buy the security is known as the call option.
The major advantage of an options contract is the benefit of leverage. Traders may profit from changes in the share prices, and may get control of the shares without purchasing them outright. Options may also be used as a hedging instrument, which helps receive protection from fluctuations in share prices.
Choosing between options contract and futures contract
Based on the investment goals and risk appetite, an investor may make the right choice between futures and options. Options contract is less risky due to the lack of obligation. Those with a low-risk appetite may choose to trade in options. It is imperative to have a thorough knowledge on both the common types of derivatives before making an investment.