Options Contracts

Options contracts are financial derivatives that provide the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) on or before a specified future date (expiration date). There are two types of options: call options and put options.

Call Options

A call option gives the holder the right to buy the underlying asset at the strike price. If the market price of the asset rises above the strike price, the call option becomes valuable, as the holder can buy the asset at a lower price than the current market value.

Example: Suppose an investor holds a call option on a stock with a strike price of $50. If the stock’s market price rises to $60 before the option’s expiration, the investor can exercise the option and buy the stock at $50, selling it immediately in the market at $60, thus making a profit of $10 per share.

Put Options

A put option gives the holder the right to sell the underlying asset at the strike price. If the market price of the asset falls below the strike price, the put option becomes valuable, as the holder can sell the asset at a higher price than the current market value.

Example: An investor holds a put option on a commodity with a strike price of $100. If the commodity’s market price falls to $80 before the option’s expiration, the investor can exercise the option and sell the commodity at $100, even though it is currently worth less in the market, thus limiting their loss to $20 per unit.

Forwards Contracts

Forwards contracts are agreements between two parties to buy or sell an asset at a specified price on a future date. Unlike options, forwards involve an obligation to fulfill the contract. These contracts are typically traded over-the-counter (OTC) and are customized according to the specific needs of the parties involved.

Example: An exporter enters into a forward contract to sell 1,000 barrels of oil at $70 per barrel in three months. Regardless of the market price at the contract’s maturity, the exporter is obligated to sell the oil at the agreed price.

Futures Contracts

Futures contracts are similar to forwards contracts, but they are standardized and traded on organized exchanges. They are highly liquid and can be easily bought or sold before expiration. Futures contracts also involve an obligation to buy or sell the underlying asset at a predetermined price and date.

Example: An investor buys a futures contract for 100 shares of a company’s stock at $120 per share with an expiration date of one month. If the stock price rises to $140 at expiration, the investor can sell the futures contract, realizing a profit of $20 per share.

Key Differences between Options, Forwards, and Futures

Obligation vs. Right

Options provide the holder with the right, but not the obligation, to buy or sell the underlying asset. Forwards and futures, on the other hand, involve an obligation to fulfill the contract.

Standardization

Options contracts are standardized with respect to the strike price and expiration date. Forwards are customized agreements, while futures contracts are standardized like options but without the choice aspect.

Exchange vs. OTC

Options and futures are traded on organized exchanges, while forwards are typically traded over-the-counter.