FUTURES and OPTIONS are forward contracts. A forward contract is one where the actual delivery and payment obligations are met at a predetermined future date, irrespective of market conditions prevailing at the time of performance. Such forward contracts could be for any commodity including financial assets such as shares, securities, stocks, currency, etc. These commodities are termed as UNDERLYINGS in ordinary course of dealings.
The forward contracts are unique in terms and conditions and are binding only on the parties to such contracts. Therefore, there is an inherent risk of counter party default. Thus, if either party to a forward contract is unable to meet the obligation, the other party may suffer a huge loss.
FUTURES on the other hand are standard, exchange traded forward contracts. The terms as to UNDERLYINGS with respect to quantity, quality, delivery, prices, etc. are standard and normally they are Exchange floated and traded, where the trade is guaranteed by the clearing corporation of concerned exchange. For trade guarantee, the exchange monitors the exposures of individual member based on capital adequacy, collects various margins, devise and establish surveillance to check manipulations. Thus the counter party risk in FUTURES trading is eliminated.
OPTIONS are further refinement of FUTURES where, the buyer of the OPTION has right but not obligation to fulfill his commitment to the contract, but if the buyer exercises his right then the writer of the OPTION has to fulfill his commitment.
The OPTIONS may be CALL OPTION or a PUT OPTION.
A CALL OPTION is right to buy while the PUT OPTION is right to sell.
The person who buys a CALL OPTION is the holder of the OPTION and the person who sells the CALL OPTION is writer of the OPTION.
In case of CALL OPTION the holder has right but not obligation to buy from the writer.
Similarly the holder of PUT OPTION, has right to sell on due date and if he exercises his right the writer of the OPTION has to buy.
OPTIONS trading are subject to premium amount payable by holder to the writer. This premium is to be paid upfront on conclusion of the trade. The premiums are freely negotiated between parties and are again subject to the future price, money holding cost, current price and the general market movement expectations.
OPTIONS are classified as American Options and European Options.
American Options are exercisable on any day before maturity date while the European Options are exercisable only on maturity date.
At the Money: Spot price equals to strike price
In CALL OPTION
- If Strike Price is less than Spot Price than it is IN THE MONEY
- If Strike Price is higher then Spot Price it is OUT OF MONEY
In PUT OPTION
- If Strike Price is higher than Spot Price it is IN THE MONEY
- If Strike Price is less than Spot Price it is OUT OF MONEY