Business Times

Derivatives demystified – part two – “Futures” vs “Options”

By Upul Arunajith

Futures Options
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:
4delivery date

Margin Deposit:
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
4Interest rate
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:

Top to the page  |  E-mail  |  views[1]
SocialTwist Tell-a-Friend
Other Business Times Articles
IT stocks – Sri Lanka’s next big thing?
Lankem to expand in leisure, paints
Mega Rs 2.5 bln dairy project backed by “Tharunyata hetak”
Continental ups the stakes in 5-star comfort
Top SLT executive resigns over HR issues
Colombo stocks go berserk
Small is beautiful and cheap!
Comment - Of phones, IT and family firms
Feature - Human-elephant conflict: A viable solution through locally developed technology
Feature - Deteriorating salaries of university academics
International arbitration on SL oil hedging tomorrow
Sri Lanka still unknown as a destination in some tourism-generating countries
Pre-IPO roadshow of LankaBangla Securities on Monday
Sri Lanka on track to receive 600,000 tourists this year
Etisalat says minimum call rates good for the industry
Timeframe needed for large state enterprise turnaround: CCC chief
SIA celebrates 40 years in Sri Lanka by helping Lady Ridgeway Hospital
Concern over unfair practices in insurance sector
Japan manufacturer to pay US$3.3 million for software piracy
Derivatives demystified – part two – “Futures” vs “Options”
Crisis-struck Dankotuwa says floating private placement
Western, Southern province share of GDP drops in 2009
English for Life from JKH
Nearly 90% of Singapore youths want to make ‘responsible’ profit
Korea extends US$ 200 mln loan facility to Sri Lanka
Commercial Bank demos electronic ‘Paymaster’ facility
Coca Cola signs up another CBA (trade union related) pact with staff
Rubber plantations soon in the dry North
Sri Lanka must double credit flow to achieve target growth
HNB support to micro finance sector reaches Rs 7 bln in past 20 years
Dilith, Raynor to raise their stakes in Reefcomber
‘Laugh Tax’ campaign gets finalist certificate for Leo Burnett
Dockyard starts work on RDA passenger launch
Oman Air nominated for top industry award
Leo Burnett at Digital Boot Camp
SLT provides books to North-East students
Hemas, Rotary donate dental unit to Embilipitiya President’s College
US-based fund launches in SL, bullish on energy, leisure and construction
Shell Gas Netherlands team to visit for sale discussions
Pelawatte to go public by mid-August
Shippers lose sleep over port delays
Etisalat opens recycling facility in Lunama Ambalantota
Former Pramuka Bank completes initial payment of Rs.100, 000 each to earlier depositors
LMF unit runs into ‘juicy’ crisis with Customs
Major Ceylinco assets worth over Rs.42 billion to be sold to repay depositors
Credit card offers by Standard Chartered Bank
Belgium tour operator to start weekly charters to Colombo
Feature - Bread, wheat flour essential in today’s world


Reproduction of articles permitted when used without any alterations to contents and a link to the source page.
© Copyright 2010 | Wijeya Newspapers Ltd.Colombo. Sri Lanka. All Rights Reserved.| Site best viewed in IE ver 6.0 @ 1024 x 768 resolution