Investors are typically acquainted with the popular types of investments like stocks, bonds and mutual funds. However, there are other types of financial investments that provide their own unique risk and reward profiles. Futures, forwards and options are three types of financial contracts that provide access to a whole world of assets and risk/reward tradeoffs.
Understanding Financial Derivatives
A financial derivative is a contract between two or more counterparties that derives its value from one or more underlying assets such as stocks, bonds, currencies, market indices and commodities. Futures, forwards and options are three examples of financial derivatives. Options and futures are traded as standardized contracts on exchanges, whereas forward contracts are negotiated agreements between counterparties. Prices of derivatives vary directly or inversely with the prices of underlying assets, but they also can vary as a function of the time left until the contract expires.
Overview of Futures Contracts
A futures contract is a standardized contract that is:
- Used to buy or sell a standardized quantity and quality of a specified underlying asset that is delivered at a certain date in the future (the delivery date).
- Traded on a futures exchange in strict adherence to the exchange’s rules.
- Purchased using margin, meaning the trader pays only part of the purchase price up front and borrows the remainder from the trading account.
- Traded at prices determined by supply and demand throughout the trading day.
Settlement of Futures Contracts
Futures are cash-settled every trading day, meaning they are assigned a daily settlement price at the end of the exchange’s trading day. At the end of the day, the loss party – the buyer if prices declined or the seller if prices rose – must make a payment to the futures brokerage account of the gain party. This process is called marking to market and ensures that trading profits and losses are always promptly paid.
A physically settled financial futures contract obligates a buyer to take delivery of a specified quantity and quantity of an underlying financial asset from the contract seller at a future date (the delivery date) for a price set in advance. If you own the contract when it expires, you must take delivery. For example, if you buy a stock futures contract, you must take delivery of the underlying stock unless you sell the contract before expiration.
A financially settled financial futures contract does not involve delivery of assets but otherwise has the same potential for gain or loss as do physically settled contracts. This occurs until the final settlement date, which is either the expiration date or the date when a trader closes out a contract
Futures traders can close out their contracts at any time prior to expiration by offsetting their positions with opposite ones, meaning that buyers can sell identical contracts and sellers can buy identical ones.
Difference Between Futures and Forwards
A forward is similar to a futures contract in that it specifies the future delivery of an underlying asset at an agreed price. However, forwards differ from futures in several ways:
- Purpose: Forward contracts are almost always held until expiration and physically settled because the counterparties are interested in exchanging the underlying asset for cash. Physically settled future contracts might be held until expiration for traders who want to buy or sell the underlying. But most futures traders are speculating on the price of the underlying, hoping to make a profit from favorable price movements without taking or making delivery.
- Source of contract: A forward contract is a customized contract, privately traded directly between two identified counterparties. This is called over-the-counter trading and doesn’t involve a futures exchange. In contrast, futures contracts are only available on futures exchanges. You must set up a futures brokerage account to buy and sell these contracts. A futures trader does not directly transact with a counterparty; instead, a futures clearing house mediates all transactions – it acts as the buyer to sellers and the seller to buyers.
- Contract terms: A forward contract is completely customized according to the wishes of the buyer and seller. In addition, forward contracts have no built-in default protection, though a custom default-protection scheme can be negotiated and included. Futures contracts are highly standardized and guaranteed against default. Their expiration date, delivery date, delivery point, amount of underlying asset and settlement terms cannot be negotiated – the only decisions open to a trader are how much to bid or ask, when to close out the position and to select financial or physical settlement, the contract expiration month and the number of contracts.
- Settlement procedures: Forwards are settled at expiration and perhaps more frequently if both participants agree – there is no automatic daily cash settlement. Futures are cash-settled every trading day.
- Margin requirements: Forward contracts typically have few margin requirements, if any. Futures exchanges require traders to deposit into their brokerage accounts a minimum amount of cash per contract, as margin. The deposit is used to guarantee the daily mark to market payment. If the account balance falls below the minimum requirement, then the trader’s broker will issue a margin call – a directive to the trader to replenish the account. Failure to do so promptly will lead to a forced offset – the broker closes out the trader’s contracts and adds the cash proceeds to the brokerage account.
Overview of Option Contracts
Option contracts permit, but do not require, the option buyer to purchase or sell a specified amount of the underlying asset at a set price (the strike price) on or before the expiration date. The price of the option is called the premium, and it varies due to several factors including the price of the underlying asset relative to the strike price, the time left until expiration and the price volatility of the underlying asset.
Standardized options trade on exchanges that have strict specifications, much like those found on futures exchanges. In fact, you can trade options on futures in which the underlying asset is a futures contract.
Difference Between Options and Futures
The main differences between futures and option contracts include:
- Upfront cost: Buyers must pay a premium to purchase an option, and option sellers collect his premium. There are no upfront costs for futures trades, just margin requirements.
- Margin requirements: Option buyers do not have to post margin, but option sellers do, unless their options are “covered” by other assets. For example, if an option trader sells a call stock option while owning 100 shares of the underlying stock, the call is covered, and margin isn’t required. All futures trades require margin.
- Flexibility: The owner of an options contract does not have to execute it – that is, force the trade of the underlying asset for the strike price even if such a trade would be profitable. For physical delivery futures, buyers must take delivery of the underlying asset, and sellers must deliver the asset.
- Risk: Option buyers can lose no more than the premium they pay. Option sellers and futures traders have unlimited risk on their contracts.
- Mark to market: Most options, with a few exceptions, are not marked to market every day. An options trader can collect a gain by exercising a profitable option, closing out a profitable option position via offset or collecting profit at expiration. Futures contracts are always marked to market daily, which is the only way to experience gains and losses.
- Size: Options are generally less expensive than futures, and control a smaller amount of the underlying asset. This means that futures are riskier than options. Of course, option traders can increase their risks by trading multiple options.