[Derivatives]: Options; Positions; Forwards & Futures

I’m always slightly confused about put option vs shorting; call vs long etc; hence I’ve decided to summarize them all into one single article in order to understand better and for future references!


 

A derivative (Options/forwards/futures etc) is a financial instrument or other contract with all three characteristics: characteristics:

(a) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, (sometimes called the ‘underlying’);

(b) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

(c) it is settled at a future date.

In general, firms transact in derivatives to:

• Manage market risks such as foreign exchange risk and interest rate risk;

• Reduce borrowing costs;

• Profit from trading or speculation



Options:

An Option is a contract that offers the buyer the right, but not the obligation, to buy (call option) or sell (put option) a specific amount (NOMINAL AMOUNT) of the underlying asset at an agreed-upon price (STRIKE/EXERCISE PRICE) during a certain period of time or on a specific date (EXERCISE DATE).

Call Option:

Call option

Basic concepts:

Buyer of call option: wants stock price to go UP, so that he can buy it at strike price at exercise date, which is CHEAPER, making a capital gain. THIS is also known as LONG CALL.

Writer/Seller of call option: wants stock price to go DOWN or stay the same, so that he/she earns the full premium as the option will not be exercised. Hence there is infinite risk in the sense that the price of the underlying stock can increase substantially. This is also known as SHORT CALL. Short call means you selling call option.

As buyer (long position), if stock price went UP:

Current market price of Underlying – (Strike Price + Premium paid) = Profit

If stock price went DOWN:

Loss = Premium paid

Put Option:

Image result for put option diagram with premium

Basic Concepts:

Buyer of put option: wants stock price to go DOWN, so that he can sell the shares at strike price at exercise date which is HIGHER than market price at exercise date, making a capital gain. THIS is also known as LONG PUT.

Writer/Seller of put option: wants stock price to go UP or stay the same, so that he/she earns the full premium as the option will not be exercised. Hence there is infinite risk in the sense that the price of the underlying stock can DECREASE substantially, yet he/she has to buy the shares at strike/agreed price if the buyer exercises the put option. This is also known as SHORT PUT. Short put means you selling put option.

As buyer (long position), if stock price went DOWN:

Strike Price – (Current market price + Premium paid). = Profit

If stock price went UP:

Loss = Premium paid

 




Trading Short/Long:

FOUND UNDER “Definitions” tab on this very website:

“Borrowing the stock first and selling them straight away, anticipate its price to drop, then “buy back” the same amount when price drop, then can earn the difference”

Short one lot of $50 stock, i.e. borrow 100 shares of $50 stock and sell straight, earning $5000 straight. But you still owe 100 shares, so must buy back. Hence the unlimited liability. If the stock goes to $40, then you earn 100 x 10, since you can now buy back and return the borrowed stock at $40 x 100 = $4000 (Closing the short sale).

If stock price go to $1000, then you need repay $1000 x 100 = $100 000, making a loss of $95000.

DIFFERENCE BETWEEN SHORT SELLING AND PUT OPTION:

Short selling and put options are essentially bearish strategies used to speculate on a potential decline in a security or index, or to hedge downside risk in a portfolio or specific stock.
Short selling is the sale of a security that is not owned by the seller or that the seller has borrowed.

Short selling involves the sale of a security that is not owned by the seller, but has been borrowed and then sold in the market. The seller now has a short position in the security (as opposed to a long position, in which the investor owns the security). If the stock declines as expected, the short seller would buy it back at a lower price in the market and pocket the difference, which is the profit on the short sale.

Put options offer an alternative route of taking a bearish position on a security or index. A put option purchase confers on the buyer the right to sell the underlying stock at the put strike price, on or before the put’s expiration. If the stock declines below the put strike price, the put will appreciate in price; conversely, if the stock stays above the strike price, the put will expire worthless.

Trading long (Long selling) = Buying of a security such as a stock, commodity or currency with the expectation that the asset will rise in value.



Forward Contract:

What is a forward contract?

• A forward contract is an agreement between 2 parties whereby one party  agrees to buy (long position) and the other party agrees to sell (short position)  a specified amount of an item at a fixed price (called forward price or forward rate) for delivery at a specified future date (called maturity date).
• The forward contract is a binding agreement between 2 parties. There is a  contractual obligation on the buyer (seller) to buy (sell)  the specified item  from (to) the seller (buyer) at maturity date

FORWARD CONTRACTS have no premiums, but are legally BINDING. i.e. at maturity date, the transaction between both parties HAVE to occur. Private agreement between 2 parties. Hence one party may have a chance to default.

FUTURES are just like Forwards, except the other party is with a legal body like a clearing house. In Singapore that’s the SEC. Standardized contract between 2 parties, no chance of a defaulting.

 

SOURCE: Combination of my own knowledge and Investopedia.com

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