Financial instruments are monetary contracts among parties. They can be created, modified, traded and settled. Today we take a look at equity financial instruments that you can invest in.
OPTIONS:
An option is nothing but a financial derivative in the form of a contract which is sold by one party, called the option writer, to another party, called the option holder. It is a form of contract which offers a right and not an obligation to either buy (call) or sell (put) a security or any other underlying financial asset at a predetermined price (strike price) either on a specific date (exercise date) or during a certain period.
A call is an option which provides a person an opportunity to buy at a given price. Therefore the buyer would want the stock price to go up.
Put is an option which provides a person an opportunity to sell at a certain price. Therefore the buyer would want the stock price to go down
Options are tremendously flexible securities which can be put to use in many different ways. The traders make use of options for speculation, which is a very risky practice; on the other hand, the hedgers make use of options so that they can reduce the risk of holding an asset.
The option buyers and writers have a contradictory outlook on how the underlying asset would perform during the scenario of speculation.
For example, since the option writer need to provide the underlying asset in case that the stock’s market price exceeds the strike, therefore, an option writer who sells a call option believes that the underlying security’s price will drop in relation to the option’s strike price during the life of the option, because that is how an individual would earn maximum profit.
Types of Options:
There are two types of options, viz, the Call Option and the Put Option.
A call is an option which offers the buyer the right and not the obligation to purchase the underlying stock at a specific time (the expiry date) and for a specific price, which is called the strike/exercise price. In the call option, the seller is under an obligation to deliver the underlying asset if the caller chooses to exercise.
If an investor believed that the price of the underlying security was going to increase, he would buy a call option in such a scenario. The profit potential for the buyer in case of the call option is enormous as because the price of the underlying security has the potential to rise indefinitely, whereas, the downside risk is limited to the price of the contract.
A put is an option which provides the buyer the right and not an obligation to sell the underlying stock to the seller of the option on or before a certain date for a specific price called the strike/exercise price.
If an investor believed that the price of underlying security would fall, he would buy a put option in such a scenario. The maximum which the holder of a put option would lose is the price that he has paid, and the maximum he can gain is the difference between the exercise price and the cost of the put. The put and the call options are usually consolidated with other option positions or the sale or purchase of the underlying asset.
FORWARD CONTRACT
A custom-made contract which allows the parties to either buy or sell an asset or underlying security at a particular price on a future date is called a forward contract. A forward contract can be put to use for two purposes- a) hedging or b) speculation. However, since a forward contract is of non-standardized nature, therefore, it is particularly used for hedging. In contrast to the futures contracts, a forward contract can be tailor-made with any commodity, amount, and the date of delivery. The settlement of a forward contract can be done on cash or delivery basis. The forward contracts are not traded on a centralized exchange market and are hence considered an over-the-counter (OTC) instrument. The OTC nature of the forward contracts makes them a lot riskier as the terms of the contract can be easily modified, and the lack of the centralized clearing and settlement house gives rise to a greater degree of default risk. Therefore, the forward contracts are not so easily available to the retail investor as the futures contracts are.
There is a huge market available for trading in the forwards contracts because many of the world’s biggest companies use it to hedge the risks associated with the volatile currency rates and the interest rates. Nevertheless, given that the particulars of forward contracts are constrained to the buyers and sellers only, and are not made accessible to the general public, therefore, it is very difficult to estimate the size of this market.
FUTURES
Futures are the financial contracts in which the buyer is under an obligation to purchase an asset which comprises of either a commodity or a financial instrument, at a date and price which is always predetermined. The futures contracts provide details of the quantity and quality of the underlying assets which are standardized to help them trade on the futures exchange. The delivery of the futures contract may either be in physical asset or cash. One specific character of the futures market is that it can use very high leverage, which is relative to stock markets. The purpose of the futures contract is either to hedge or to speculate the price movement of the assets underlying. To provide an example- a producer of wheat can use the futures contract to seal the deal at a certain price and thereby reduce the risk by using the hedging methodology.
The key difference between options and futures is that the holder of the options contract can sell or buy the underlying asset at the expiration of the contract date, while on the other hand, under the futures contract, the holder is under the obligation to fulfill the terms of his/her contract.
In reality, the actual rate of delivery of the underlying assets specified in the contract of futures is very low. This is because the hedging or speculating benefits of the futures contracts can be had mostly without holding the contract actually until expiry and until the delivery of the assets underlying.
DIFFERENCE BETWEEN FORWARDS AND FUTURES
Both forward and futures contracts have the same type of function: both the contracts permit the people to sell or buy a particular type of asset at a given specific time and a given specific price.
Both the contracts differ in their particular details. At first, futures contracts are the contracts which are traded on a centralized exchange and are therefore standardized. On the other hand, the forward contracts are traded Over The Counter (OTC) and are non-standardized private agreements among two parties and are not as rigid as the futures contracts concerning the terms and conditions stated therein. Since the forward contracts are non-standardized private agreements, there is a high risk of default by the party on their side of the contract. Futures contracts, on the other hand, have clearinghouses as the mediators that assure the fulfillment of the transactions, and thereby lower the risk of default to rarely.
Secondly, in the case of the futures contract, daily changes are settled day by day until the end of the contract. Therefore, settlement of a futures contract can take place over a range of date, whereas, the forward contracts possess only one settlement date.
Lastly, since speculators employ the futures contracts for betting purposes, therefore, they close out before maturity, and the actual delivery never happens. Conversely, since the forward contracts are used by hedgers to eliminate the volatility of an asset’s price, therefore, either the delivery of the asset or the cash settlement usually takes place.