Futures Contracts and Options: A Comprehensive Guide

Futures Contracts

Long Hedge:

Involves the purchase of a futures contract to guard against a price increase.

Short Hedge:

Involves the sale of a futures contract to protect against a price decline in commodities or financial securities.

Perfect Hedge:

Occurs when gain/loss on hedge transaction exactly offsets loss/gain on unhedged position.

Speculation: Buying a futures contract (today) is often referred to as 'going long,' or establishing a long position.

Recall: Each futures contract has an expiration date. A new futures price is established every day before expiration. If this new price is higher than the previous day's price, the holder of a long futures contract position profits from this futures price increase. If this new price is lower than the previous day's price, the holder of a long futures contract position loses from this futures price decrease.

Options

Definition:

An option is the right to either buy or sell something at a set price, within a set period of time. You can exercise an option if you wish, but you do not have to do so. The right to buy is a call option. The right to sell is a put option.

Goals:

Understand option terminology, be able to determine option payoffs and profits, understand the major determinants of option prices.

Terminology

Exercising the Option: The act of buying or selling the underlying asset.

Strike/Exercise Price: Fixed price in the option contract at which the holder can buy or sell the underlying asset.

Expiry/Expiration Date: The maturity date of the option.

Writer/Grantor: Institution that sells the option. Holder: Institution/investor that buys the option.