Forwards and Options

Derivatives contracts come in two basic types: forwards, and options. More complex derivatives contracts build on these basic types.

FORWARDS

A forward contract is an agreement between two parties to trade a specified volume of a specified asset, at a specified price, at a specified future date. It's a binding, legal agreement.

Terms

The asset being traded is called the underlying asset. These can be commodities, shares, indexes, etc. The expiration date is when the contract has been settled. The spot price is the current market price.  The term long is used to refer to the buyer, and short to the seller. 

Payoff on a Forward Contract

Generally, the long party benefits when the (spot) price of the asset goes up (relative to the contract price), and the short party benefits if the price of the asset goes down.

For example, let's say the contract was to purchase a unit of stock index at $1,000 at the end of December. If at the end of December, the spot price for that stock index is $1,500, then:

Long position to the contract makes: $1,500 - $1,000 = $500, because they are able to buy the asset at $1,000 instead of the current market price of $1,500.

Short position to the contact loses: $1,000 - $1,500 = ($500), because they are obligated to sell the asset at $1,000 instead of the current market prices of $1,500.

FUTURES

Futures are forward contracts that can be traded at futures exchanges. Some futures exchanges are the CME (Chicago Mercantile Exchange), ICE (Intercontinental Exchange), LIFFE (London International Financial Futures Exchange), Eurex, SGX (Singapore Exchange), OSE (Osaka Tokyo Exchange), and the HKEx (Hong Kong Exchange and Clearing).

A party may buy a futures contract and become the new party.  The party that sold the contract removes themselves from the trade.

OPTIONS

An options contract gives the buyer of the contract the right (but not the obligation) to trade an asset at the contract price. There are two kinds. The call option gives the buyer of the contract the right to purchase an asset.  The put options gives the buyer the right to sell an asset.

Options Terminology

The strike price is the price the buyer pays for an asset, also called the exercise price. The act of acting on their right is called exercise.  Options contracts indicate the style of exercise allowed:

• American style allows the buyer to exercise their right only at the expiration date.
• European style allows the buyer to exercise their right  at anytime before and on the expiration date.
• Bermuda style allows the buyer to exercise their right during a defined period before and on the expiration date 

Call Options

A call option  that gives the buyer the option to not buy the asset if the contract price is higher than the spot price; ie, if they will lose money.  The seller's obligation remains the same: sell the asset at the contract price.  In a call option, the seller can only lose money, so the payoff comes in the form of a premium.  The seller needs to be paid upfront to put themselves in this exposure.

References

McDonald, Robert Lynch. Derivatives Markets. Boston: Pearson, 2013.