Margin Deposit Yes NoTerm / Expiration Yes/Yes
Premium Payment No YesPrice guarantee Yes YesParticipate in market downturn No/Yes
Daily Settlement Yes/No
Structure of a Futures Contract:
A Futures contract is a structured Forward contract in terms of:
Futures contract trades in an organized exchange and guaranteed by the clearinghouse corporation. To guarantee the performance of the contract both parties to the contract (“buyer” and “seller”) are required to place margin deposits (= a deposit of good faith).
Two types of margin deposits: “Initial margin” “Maintenance margin”.
If the market moves adversely against the investor, the broker makes a “Margin Call” asking the investor to place more collateral in the maintenance margin account as additional security. Failure to do comply with a margin call will lead the clearing house to cash the security held in the margin account and closing the Futures trading account. Unless cash flows are strong, market spikes can lead to whiplashes and reason why Futures trading is not in the realm of the retail investor.
Pricing a Futures Contract:
Futures contracts are priced based on Cost of Carry (COC) model. Basically what it involves is the:
4cost of funds
4cash-flow during the term until the trade is consummated.
Futures contracts lock in the futures delivery price as these contracts are guaranteed by the clearing house and the mark to market is settled daily.
Futures price locks in the final delivery price and the parties to the contract cannot move away from the Futures contract obligation.
Structure of an Option Contract:
Option contract gives the Option holder the right but not the obligation to sell / buy the underlying product (i.e Gold, Equity) at the strike price during the term of the Option contracts. To have this privilege the Option buyer must pay an Option premium (=cost of Option contract) upfront to the Option seller (writer).
Option seller (writer) has the obligation to sell / buy the under product at the strike price if and when the Option buyer (holder) decides to exercise the Option via the broker.
Pricing an Option Contract:
Price of and Option is referred to as an “Option Premium”
Option Premium is driven by:
4Volatility of the price of the underlying product
4Duration of the contract
4Strike Price = / exercise price
In its most rudimentary form, the Option Premium can be seen as an Auto Insurance premium. Higher the coverage, higher the premium payment.
Option contract caps the (purchase / sale) price of the underlying. The Option holder gets the flexibility to walk away from the Option contract and participate in the spot market in the event the market price moves in favour of the Option holder. Premium paid will be an expense and will add to the cost of the purchase / sale of the underlying. Salient difference between the Futures and Options is this flexibility associated with the settlement of Option.
Futures do not offer the flexibility to participate if the cash market (spot market) moves in favour of the investor as the Futures Contract locks in the future delivery price. This flexibility makes Options contracts more retail investor friendly.
Next week: Options - Fallacies vs Facts.
(The writer can be reached at: firstname.lastname@example.org).