Frequently Asked Questions 
14/09/2012 
 

Chapter 7 Products - Derivatives Market

7.1

Products Overview 

 

7.1.1    

What are futures?

A futures contract is a legally binding commitment between two parties to buy or sell a specific financial instrument at a given future date at a price set at the time of dealing. One of the main features of futures is the leverage they provide. With relatively little capital, usually just a small percentage of the contract's value, buyers and sellers are able to participate in the price movement of the full contract.  As a result, the leverage can lead to substantial returns on the original investment. However, it can also lead to substantial losses. The risks associated with futures can be significant and investors must fully understand the risks before buying or selling futures contracts.

Generally speaking, futures contracts can serve three objectives: pure trading, hedging and arbitrage.

Pure trading is mainly based on unidirectional investment strategies, where an investor buys or sells a specific quantity of futures contracts based on his own projection of the movement of an underlying stock or an index.  

The purpose of hedging is to offset the negative impact of market moves on a portfolio’s overall return.

Arbitrage refers to profiting from the difference between the prices of similar financial instruments in the futures and securities markets by buying low in one market and selling high in another. 

 

7.1.2

What is an option?

A stock option is a contract entered between the contracting parties, a buyer and a seller.  The buyer has the right, but not the obligation, to trade an underlying asset with the seller at a predetermined price, within a certain time.  The buyer is commonly referred to as the holder and the seller as the writer.  The position of a holder is referred to as a long position and that of a writer as a short position.

There are two types of options: a call and a put.  A call option gives the holder the right to buy the underlying asset.  A put option gives the holder the right to sell the underlying asset.  Therefore, an option holder really has an option to exercise either the right to buy or the right to sell.

While holders have no obligations to exercise their rights, writers are obliged to honour the contracts they have sold if the holders choose to exercise theirs however disadvantages this may be to the writers.  When writing options, the writers risk incurring a loss or forgoing a profit.  In turn, they receive a premium from the buyers.  The options buyers’ exposure (before exercising their rights) is limited to the premium paid for the options.