Derivatives: Futures, Forwards & Options

This is the first of two articles explaining various derivative contracts.

Futures contract

An agreement to buy/sell an asset at a specific price on specific date.

An exchange platform sets the deal terms (e.g. maturity date, size.)

Key terms

• Initial margin – you pay a small % of the total value up front to open the position (margin account.)

• Maintenance margin – there is a required minimum amount needed to be held in the account to keep the position open. It acts as a safeguard to the brokers that the investor can cover ongoing losses.

• Mark to market – Every day the futures position is revalued and the account balance is updated for P&L.

Example: Hedging

• A Bakery agrees to buy wheat at £500/tonne in 2 months time.

• If the wheat price moves to £550/tonne the bakery save money.

• They protected themselves from a price hike by locking in current rates.

• This is typically done by firms who require a specific asset.

Forward Contract

An agreement between 2 parties to buy/sell an asset at a specific price on a specific date.

It's a private deal (OTC over the counter.)

P&L is only determined on the final date (not daily e.g. mark to market.)

The deal has custom terms (you choose date, size etc.)

Uses

Hedging & speculation is the same principle as futures (locking in todays prices to protect/ make money from price movements.)

Arbitrage - Forward pricing is a technique used to exploit exchange differences and interest rates

Option Contract

These give the right(not obligation) to buy/sell asset at a set price before/at a future date.

There is a small fee per share.

Call option

Buying assets at a set price.

Let's say:

Apple shares are at £100 today

You buy a call option to buy at £105 in 1 month (costs £2)

If Apple rises to £115:

You exercise your option, buy at £105, sell at £115 = £10 profit

Minus the £2 you paid

£8 net profit

If Apple stays at £100:

You do nothing. Just lose the £2 fee.

Put option

Sell asset at set price.

Tesla shares = £200 today

You buy a put option to sell Tesla at £190 (costs £3)

The option expires in 1 month 

If Tesla falls to £170:

You can sell at £190 

Then buy back in the market at £170

Profit = £20

Minus the £3 you paid = £17 net profit

I hope this helped you understand derivative contracts more. I find them so interesting! For the rest of my work, click here.