Readings: Fundamentals of Futrues And Options Markets
Chapter 1: Introduction
1.1 Futures Contracts
Futures contract: an agreement to buy or sell an asset at a certain time and certain price in the future.
- Each contract will have a buyer who will pay and receive the asset on the delivery date and a seller who will deliver the product on the date.
- Long future position: buying the asset at a certain time and price in the future
- Short future position: selling the asset at a certain time and price in the future
- Futures price: the price that is being executed at
- Spot price: the price right now (immediate delivery)
1.3 Over-The-Counter Market
- OTC: trades are done over phone between buyer and seller instead of an exchange
- Market Makers: always prepared to quote both a bid price and an offer price
1.5 Options Contract
Options: gives the holder the right (but not obligation) to buy or sell an asset for a certain price (strike price) by a certain date (maturity)
- Call option: right to buy
- Only makes money if the spot price is above the strike price -> buy cheaper
- The price of the contract goes up as the strike price decreases - chances of the spot being lower than strike price (lose money) is low
- Put option: right to sell
- Only make money if the spot price is below the strike price -> sell higher
- The price of the contract goes up as the strike price increase - chances of the spot being higher than strike price (lose money) is low
- Types:
- American: exercise the option any time
- European: exercise the option only at maturity
- Option vs futures:
- Futures require no cost to enter a contract (only pay on maturity)
- Option will pay a premium for the contract
- Parties:
- Buyers of calls
- Sellers of calls
- Buyers of puts
- Sellers of puts
Hedgers
Hedge Funds: accepts from financially savvy individuals and are susceptible to lesser regulations
Mutual Funds: accept money from anyone and face more regulations (cannot short sell)
Hedging using forward (OTC futures) contracts:
- If an importer from the USA is importing goods from a company in the UK and the goods are paid in GBP
- Importer is can buy forward contracts for GBP -> buy GBP with USD at a fixed price in the future
- The FX rate on the delivery date will not affect anything
Hedging using Options:
- If you hold 1000 shares of MSTF and would like to hedge your risk against the stock going down
- Purchase puts at a strike price that is slightly lower than the current price
- This means that if the the price of the stock goes below the strike price, it will not affect you and you can still sell at the strike price
- Hedging with options will incur an option premium and will reduce the gains
Futures vs Option:
- Future: designed to neutralize risk - any price movement will not affect the outcome of it
- Options: designed to be insurance
- if you are long MSFT and hold stocks, you can buy puts to hedge against the stock going down
- but if the stock goes up you will still be able to experience the gains - only cost is the option premium
Speculators
Speculating with futures:
- If the spot price is higher than the future price, you can this means you can buy the product at a cheapr price in a later date
- If the spot is lower than you will buy the spot instead of the future
- At maturity holding spot will give you less gains than futures as the entry price of the future is lower
Speculating with Options:
- The option premium is much lower than the spot price -> you are able to buy much more option contracts than the underlying contract
- If the asset goes up in price a lot, the option gain is
(SPOT_PRICE - STRIKE_PRICE)*QTY - PREMIUM - If the price goes in the opposite direction and the option is out of the money, the option will become worthless and the spot will still be worth the low price