Understanding Derivatives, Puts, Calls, and Futures Contracts

When navigating the world of financial markets, it's important to comprehend the different types of financial instruments such as derivatives, puts, calls, and futures contracts. Each serves a specific purpose and carries distinct characteristics. This article aims to clarify these concepts, providing a comprehensive understanding for both novice and seasoned investors.

Derivatives: Introduction and Overview

Derivatives are financial contracts whose value is derived from some underlying asset or security. Examples of underlying assets include stocks, commodities, currencies, interest rates, or even the performance of an index. The value and payoff of a derivative depend on the performance of the underlying asset. There are numerous types of derivatives, including options and futures contracts, which we'll explore in more detail below.

Puts and Calls: Understanding Options

Options are a type of derivative that gives the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specified price (strike price) within a specific time frame.

Put Option

A put option is a contract that grants the holder the right to sell the underlying asset at a predetermined price (strike price) before or on a specific date (expiration date). For instance, at the moment of writing, CSCO (cisco systems) stock is approximately $51 per share. An October-21, 50 Put option could cost around $3.50 per share.

Here is what a purchase of this option entails:

You can buy the option to sell 100 shares of CSCO stock for $50 per share any time between now and October 21, 2023. It's important to note that you are not obligated to sell the shares, but you have the option to do so. The purchase of the option costs approximately $350, and you can sell it to someone else at any time before the expiration date. If CSCO stock suddenly drops to $40 per share, you can buy CSCO at $40 per share, exercise your put option to sell it at $50 per share, and make a net profit of $6.50 per share and subtracting the $3.50 option cost, you get a net profit of $3.00 per share.

Another benefit is that you can sell your put option to someone else at a profit or loss before the expiration date. However, after October 21, 2023, your option will expire and you might automatically have it exercised by your broker to collect its value.

Call Option

A call option is similar to a put but gives the holder the right to buy the underlying asset at a specified price before or on a specific date. Using the same example, if the underlying asset is CSCO stock, a call option may give you the right to buy CSCO stock for $50 per share.

Futures Contracts: An Obligation to Trade

Futures contracts are financial instruments that obligate the buyer to purchase (go long) or the seller to sell (go short) the underlying asset or security at a predetermined future date and price. These contracts are commonly used for commodities like wheat, cocoa, or gold, but any underlying asset can be used.

For example, if you buy a September 2022 wheat futures contract, at the expiration date, you become the owner of 5000 bushels of wheat. If you're a major bakery chain, you might arrange to have that wheat delivered to your location. If you're an individual investor, you probably don't want to hold the wheat and incur storage fees, so you'd sell the futures contract before the expiration date.

Futures contracts can also be bought "long" (going long, lower risk, paying the option cost if unexercised) or "short" (going short, higher risk, unlimited if the stock price increases).

Buying and Selling Long and Short

When buying options or futures contracts, you become long. When selling options or futures contracts, you become short.

Going Long

When you go long on an option, your maximum risk is limited to what you paid for the option, as you are not obligated to exercise it. If you go long on a futures contract, your maximum risk is also limited, as you can sell the contract before the expiration date to avoid the obligation.

Going Short

Going short on an option or a futures contract involves a higher risk. For instance, if you go short on a put option (selling the right to buy), your risk is limited to the total value of the contract minus the price you sold the option for. However, if you go short on a call option (selling the right to sell), the potential loss is theoretically unlimited if the stock price increases.

Examples and Real-World Scenarios

Let's consider a naive real-world scenario. A large farm operation that expects to harvest lots of wheat in September might 'sell short' a Sep 2022 wheat contract to lock in a price now, expecting to deliver actual wheat. Conversely, an investor betting that wheat prices will fall might 'sell short' a Sep 2022 wheat contract, hoping to buy back the contract at a lower price before the expiration date.

If the investor fails to do so, they would be obligated to come up with 5000 bushels of wheat. However, as a retail investor, your broker would likely prevent you from this situation by force closing the position before the expiration date.

Derivatives: A Broader Term

Different derivatives, such as put options, call options, and futures contracts, fall under the broader category of derivatives. Other examples of derivatives include credit default swaps, which are agreements between parties to pay or receive payments based on the credit quality of an underlying asset.

Note that these concepts are applicable in the US markets, but the specifics can differ in other markets. For example, in many European markets, put and call options can only be exercised on the expiration date, unlike in the US where they can be exercised at any time before or on the expiration date.

Conclusion

Understanding derivatives, puts, calls, and futures contracts is essential for navigating the financial markets successfully. Each instrument serves a unique purpose and carries distinct risks and rewards. Whether you are a seasoned investor or a newcomer, taking the time to learn about these financial tools can significantly enhance your investment strategies.