Understanding Futures & Options

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Understanding assignments

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Understanding assignments

It’s always been my understanding that buying (stock) options contracts to open is a risk-free proposition outside the (substiantial) risk of losing the cost of the contract itself. However, recently someone on this board mentioned in another post that there is a risk of assignment. I also noticed when filling out a new options agreement that there’s mention that they “allocate assignments randomly.”

From what I’m reading, assignment appears to be synonymous with exercising. And from my understanding, the only person who can be forced to exercise is the seller of the contract. I also assume you wouldn’t actually need the funds in your account to make the purchase and sale if a contract expires in the money–that you would just receive the net proceeds of the profitable exercise.

Is there something I’m missing or misunderstanding?

Info on futures options would be useful as well. I wonder if brokerage firms will let you force an immediate sale of the option before expiration or alternately an immediate buy/sell of the underlying future in order to avoid the requirement of holding a performance bond.

The Advantages of Trading Options vs. Futures

The Advantages of Trading Options vs. Futures

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Options and futures are two types of contracts known as derivatives, meaning they derive their values from their underlying assets. The price movements of these underlying assets – which include stocks, stock indexes, currencies, bonds and commodities – determine the ultimate profit or loss on these contracts. While sharing some similarities, the differences between futures and options significantly impact their risk/reward profiles. In general, futures are more efficient and control larger amounts of underlying assets, whereas options are more flexible and affordable.

Understanding Futures vs. Options

Option and future contracts involve speculation on the future value of the underlying asset. These contracts are typically used in three ways:

  1. To arrange for the delivery or receipt of the underlying asset
  2. To benefit from price movements of the underlying asset
  3. To hedge against losses on other positions in the underlying asset or similar assets

To appreciate the relative advantages of options and futures, it’s necessary to understand how they work.

A Word About Leverage

Leverage is the use of debt to purchase an investment. This impacts the percentage return on an investment. For example, compare the returns when a $100/share stock rises to $120. If you purchase the shares without leverage (i.e., all cash), your percentage return per share is (($120 – $100) / $100), or 20 percent. However, if you borrowed half of the purchase price ($50/share), your percentage return is (($120 – $100) / $50), or 40 percent.

Leverage introduces additional risk, as can be seen if the stock price had declined to $80. Options and futures provide leverage, but to different extents.

Primer on Options

An option gives you the right, but not obligation, to buy or sell a set amount of an underlying asset (e.g., such as 100 shares of stock) at a specified price on or before the option’s expiration date. To make sense of this concept, you must understand how the price of an option changes as the price of the underlying stock changes. Call options, which confer the right to buy the underlying asset, increase in value as the asset price increases. Put options give you the right to sell the asset at a set price, and they increase in value as the underlying asset’s price decreases.

Option Basic Terms

The set price at which you can buy or sell an asset via an option is called the strike price. The price you pay to buy an option is called the premium. You pay the premium to buy an option, or collect it if you sell (write), an option. A call can be out-of-the-money, at-the-money or in-the-money if the underlying asset price is below, equal to or above the option strike price, respectively. A put has the reverse relationships with the price of the underlying asset, i.e., a put is in-the-money if the asset price is below the strike price.

All options have an expiration date, which usually occurs weekly or on the third Friday of each month, although this varies with the type of underlying asset. Options can have lifetimes ranging from one week to more than a year.

Option Value Components

An option’s premium stems from two sources:

  1. The relationship between the option strike price and the current price of the underlying asset
  2. The time left until option expiration

For example, suppose you purchase one call option for $275 on XYZ Corp. stock with a strike price of $85 a share and one month left until expiration. The price of XYZ Corp. stock is $87 per share at the time of option purchase. The call’s money value per share is $87 minus $85, or $2. Since the option controls 100 shares, the money value is $200 for the in the money call.

The additional $75 of premium is due to the uncertainty regarding stock price changes until option expiration. This $75 is the time value of the option, which erodes to zero as the expiration date approaches. Time value is a positive for option buyers but a negative for sellers, because buyers want as much time as possible for the underlying asset’s price to move such that the option gains value.

Option Buyer’s Perspective

As the option buyer (known as the long position), you can experience three outcomes:

  1. The option expires. If it expires out-of-the-money, it is worthless. If it expires in-the-money, you take or make delivery of the underlying asset.
  2. You close out your option position any time before expiration for its current price.
  3. You exercise the option to purchase or sell the underlying asset at the strike price, depending on whether the option is a call or put, respectively.

The option’s money value derives from the fact that you can exercise and then sell the resulting shares. If you own an XYZ Corp. $85 call when the stock is selling for $90, you will collect at least $5 a share, or $500, by either selling the option or exercising the option and selling the underlying shares. Your overall profit will be at least $500 minus $275 – your premium – or $225. If the option reaches expiration out-of-the-money, the option will expire without any value and your loss is the premium amount, $275. Notice that an option buyer can never lose more than the premium amount.

Option Seller’s Perspective

As an option seller (known as the short position), you collect the initial premium (in the example, $275) and then hope the option expires out-of-the-money. That’s because an in-the-money option can be exercised against you, which means, in the case of a call, you are obligated to deliver the underlying asset to the option buyer at the strike price.

In the example, suppose the option is exercised against you when the share price is $90. If you don’t already own the shares, you will have to spend $9,000 to acquire the 100 shares but will only receive $8,500 (the strike value, equal to the strike price times the number of shares) for them, giving you a net loss of $275 minus $500, or $225. Your potential loss on a call is unlimited, as there is theoretically no limit to the asset’s price increase, and therefore the strike value.

Had the option been a put, it would have expired out-of-the-money, and your profit would equal your initial premium of $275. Your only source of profit is the initial premium, which explains why time value is a negative to you, since the sooner the option expires, the less risk that the option will gain value. The maximum loss on a put is the premium minus the strike value, since the price of the asset cannot fall below zero. For example, if you sold a put on XYZ shares and they subsequently fall to zero, your loss is $275 – $8,500, or $8,225. That is, as a put writer, you will be assigned the shares for $8,500, but because they are worthless, you won’t be able to recoup any of your loss by selling them.

Primer on Futures

A futures contract that is physically settled obligates the buyer to take delivery (and the seller to make delivery) of a specified quantity and quality of the underlying asset at a specified location on a specified date (the delivery date). Some futures contract are financially settled and do not involve delivery of the underlying asset, but otherwise follow the same daily pricing rules used for physically settled futures. All futures are cash settled daily, meaning the futures exchange apportions gains and losses to the accounts of futures traders after daily trading ends.

Understanding Futures Contracts

Futures contracts trade on futures exchanges according to very strict standards that govern all aspects of the standard contract including the amount and quality of the underlying asset, the amount you must deposit to buy or write the futures contract, the rules for assigning daily profit and loss, and guarantees that the buyer and seller will fulfill their obligations under the contract.

The price of a futures contract has no additional premium – it simply is the value of the underlying asset. However, you must deposit a specified amount of money, called margin, when you buy or write a futures contract, and must continue to maintain margin in your trading account while you are in a long or short position, as specified in the futures contract.

Futures Contract Mark to Market

At the end of each trading day, the futures exchange moves money between accounts of long and short futures positions in a process called marking to market. If the contract gained value for the day, the amount of the gain moves from the loss accounts (the futures writers, or shorts) to the gain accounts (the futures buyers, or longs). This daily cash settlement continues until the futures contract expires or a futures trader closes out her position.

Traders close out a futures contract via offset: A long position sells an identical contract, and a short position buys an identical one. Contracts have terms from one month to more than one year.

Advantages of Options

Options have several advantages over futures:

  1. Less risk. Long option positions are less risky than futures and short option positions, because the potential loss (the premium) is known beforehand. Future contracts are valued by their underlying assets, which means there is no way to know for sure how much you will gain or lose.
  2. Less expensive. Generally, option premiums are smaller than futures margins. For example, you might be able to buy an out-of-the-money call for well under $50, whereas you must put up the initial margin on a futures contract, often thousands of dollars.
  3. More leverage. Option contracts for a given underlying are listed with many different strike prices and expiration dates, meaning that there is a large array of premiums available to options traders. In other words, you can control the amount of leverage you are willing to use. Futures contracts have no premiums, and leverage depends only on margin requirements.
  4. Flexibility. Long option positions are not obligated to exercise their options. Physically settled futures are always exercised at expiration.

Advantages of Futures

Advantages of futures contracts include:

  1. Efficiency. You don’t pay a premium to buy a futures contract, which saves you money when compared to the premiums you pay on options.
  2. Size. Futures contracts control more asset than the corresponding options. For example, a stock option controls 100 shares of the underlying stock, whereas a stock futures contract might control thousands of shares. For large traders, this is more efficient than buying multiple option contracts (and paying multiple premiums).
  3. Daily cash settlement. The futures exchanges slice your ultimate gain or loss into daily installments. For gainers, this means faster access to profits. For losers, it focuses the mind each day on whether to maintain or terminate the position, and whether you will need to add margin to your account.

Difference Between Futures and Options

Last updated on May 19, 2020 by Surbhi S

The term ‘financial derivative’ implies futures, forward, options, swaps or any other hybrid asset, that has no independent value, i.e. its value is based on the underlying securities, commodities, currency etc. In this context, futures and options are often misconstrued, by many people. Futures may be understood as the legally binding contract to trade the underlying financial asset of standardized quality and quantity, at an agreed price, at a future specified date.

Conversely, options contract is described as a choice in the hands of the investor, i.e. the right to execute the contract of buying or selling a particular financial product at a pre-specified price, before the expiry of the stipulated time. Take a glance at the article provided to your, to have a clear understanding of the difference between futures and options.

Content: Futures Vs Options

Comparison Chart

Basis for Comparison Futures Options
Meaning Futures contract is a binding agreement, for buying and selling of a financial instrument at a predetermined price at a future specified date. Options are the contract in which the investor gets the right to buy or sell the financial instrument at a set price, on or before a certain date, however the investor is not obligated to do so.
Obligation of buyer Yes, to execute the contract. No, there is no obligation.
Execution of contract On the agreed date. Anytime before the expiry of the agreed date.
Risk High Limited
Advance payment No advance payment Paid in the form of premiums.
Degree of profit/loss Unlimited Unlimited profit and limited loss.

Definition of Future Contract

Future is defined as a contract, between two parties, buyer and seller where both the parties promise to each other of buying or selling of the financial asset at an agreed date in the future and at a set price. As the contract is legally binding, the parties to it must perform it by transferring stock/cash respectively.

The futures contract is a standardized and transferable contract that revolves around, its four key elements, i.e. transaction date, price, buyer, and seller. The items which are traded on the stock exchange like NYSE or NASDAQ, BSE or NSE in a future contract include currencies, commodities, stocks and other similar financial assets. In such contracts the buyer expects the asset price to rise while the seller expects it to fall.

Definition of Option Contract

An exchange traded derivative where the holder of the financial asset has the right to buy or sell securities at a certain price, on or before a stipulated date is regarded as an option. The predetermined price on which the trading is concluded is known as the strike price. The option can be purchased by paying an upfront cost, which is non-refundable in nature, known as premium.

The option to buy the underlying asset is call option while the option to sell the asset is put option. In both the cases, the right of exercising the option lies with the buyer only, but he is not obligated to do so.

Key Differences Between Futures and Options

The significant differences between future and options are mentioned below:

  1. A binding agreement, for buying and selling of a financial instrument at a predetermined price at a future specified date, is known as Futures Contract. The contract in which the investor gets the right to buy or sell the financial instrument at a set price, on or before a certain date, however, the investor is not obligated to do so, is known as Options Contract.
  2. Futures contract puts an obligation on the buyer to honour the contract on the stated date, so he is locked into the contract. Conversely, in the options contract, there is an option, not the obligation of buying or selling the security.
  3. In futures, the performance of the contract is done only at the future specified date, but in the case of options, the performance of the contract can be done at any time before the expiry of the agreed date.
  4. Futures are riskier than the options.
  5. Apart from the commission paid, futures do not require advance payment, but options require the payment of premium.
  6. In futures, a person can earn/incur an unlimited amount of profit or loss, whereas in options the profits are unlimited, but the losses are up to a certain level.

Similarities

Futures and Options both are exchange traded derivative contracts that are traded on stock exchanges like Bombay Stock Exchange (BSE) or National Stock Exchange (NSE) which are subject to daily settlement. The underlying asset covered by these contracts is the financial products such as commodities, currencies, bonds, stocks and so on. Moreover, both the contracts require a margin account.

Conclusion

So, after the detailed discussion on the two investment topics, it can be said that there is nothing to be confused between the two. As the name suggests options come with an option (choice) while futures does not have any options but their performance and execution are certain.

Options Risks

An option is the right to purchase or sell an underlying financial instrument on or before a specific date in the future. The fact that an option is a derivative of an underlying instrument means that there are a number of components that make up the option that generate risk for both the option buyer and seller. Although many options traders will look at the risks they have as option owners as the erosion of time value of their premium, there are other risks that should concern an investor which can assist in the process of optimizing their profitability.

NB: The following article provides more information about the different types of risks associated with owning options. You can read a more advanced article on how to hedge different types of risks here.

Options are comprised of a number of sub-components that make up the bulk of the risks associated with owning or writing options. Options generate outright directional risk, risk related to volatility, risks related to interest rates, and risk related to time decay. Each of these risks can be hedged to mitigate an investor’s exposure.

The Delta

When an investor purchases a call option, they are purchasing the right to buy the underlying security. As the security rises in price, the value of the option also generally rises. There are a number of components within an option that creates this dynamic. One of these components is the idea that the investors owns a theoretical number of shares of the underlying instrument which allows the value of the option to increase as the price of the underlying security increases. This theoretical value is called the delta of the option.

When an investor purchases 1 share of a stock option they control 100 shares of the underlying security. The theoretical number of shares will change with the underlying stock prices as well as time to maturity. The time to maturity is the number of days prior to the expiration date. When the underlying price of a security is above the strike price of a call option the option is considered in the money. When the underlying price of a security is below the strike price of a call option it is considered out of the money. When the underlying price of a security is equal to the strike price of a call option it is considered at the money. Generally, at the money call options have a delta of 50%. This means that one option contract on XYZ stock will have a theoretical value of 50 shares. If the price of the underlying stock rises $1 dollar, with all other inputs into the option remaining the same, the value of the option will increase by $50 dollars (50 shares * $1).

Vega

The value of an option is determined by many factors, which include the perception of how much a specific security will move over a certain period of time. Market participants value this by determining the implied volatility of a security. The implied volatility is a forward looking concept, which is the amount a security will move in percentage terms over a specific period on an annualized basis. Implied volatility is different from historical volatility as it’s the markets perception of how much a security will move in the future, compared to how much the market has actually moved in the past. Historically implied volatility is the historical valuation of how much market participants priced in to an option.

The exposure and options trader has to implied-volatility is referred to as Vega. A long Vega position means that a trader benefits as implied volatility rises. A short Vega positions benefits when implied volatility of a security falls. Generally owners of calls and puts are long Vega as their option values decline if implied volatility drops.

Gamma

Gamma is defined as the rate of change of the delta with respect to the underlying asset’s price. In a delta hedge strategy, gamma is sought to be reduced in order to maintain a hedge over a wider price range.

All individual option trades have inherent gamma risk associated with the position. The close the strike price of an option is to the current underlying market, the higher the gamma. The closer an option is to expiration the higher the theoretical gamma.

Gamma is dynamic risk, meaning the risk changes as other option inputs change. Gamma is a function of the underlying price of the asset, along with time to maturity, interest rates, and implied volatility. The underlying price plays the largest roll toward determining the gamma associated with an individual option.

Gamma is generally reflected as a percentage, which can be used to determine the change in your theoretical delta based on a specific market movement. This process will allow a trader to simulate different movements in the market and delta hedge their position based on the gamma of an option.

For example, let’s assume a trader owns 1 contract of Apple options that expire in 30 days. The strike of the option is “at the money” when Apple’s stock price is $600. The gamma on the stock is .5%. This means that for every increase of $2 increase in the stock price (from $600 to $602) the theoretical delta of the option position will increase by 1 share. If a trader had a delta of .50 or 50 shares (1 contract equals 100 shares), a $2 increase in the price would generate a delta of 51 shares.

Positive gamma is associated with long positions in options. When an investor purchases an option they pay a premium to the seller, and their inherent risk is time decay, gamma, vega, and delta. The seller of the option has a negative gamma positive, and receives a premium to compensate for this type of risk.

Theta

The theta of an option refers to its exposure to time. The value of an option erodes as the time to maturity declines. An investor can measure the theoretical cost per day of an option which describes the daily theta.

When an option is out of the money, the entire option is described as only having time value. This is also referred to as the extrinsic value of an option. When the price of an underlying security moves above the strike price of a call option, the difference between the underlying security price and the strike price is called the intrinsic value and the balance of the value is referred to as the time value or extrinsic value.

Rho

Rho is the sensitivity of an option to changes in interest rates. Rho generally is more influential on options that have long tenors. This Greek calculation mainly focuses on the present value of the option those changes as the discount value of the security changes.

Rho can be hedged buy using interest rate products such as futures or swaps. An investor who trades leap options, which are long dated options, could consider hedging their Rho exposure.

More About Adam

Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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