Learning About Futures & Options
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Welcome to SharpDeal’s Education Center. Whether you are just beginning to trade or you are a seasoned investor looking for new trading strategies, this Centre provides a wealth of information on the most relevant topics.

What is a Futures Contract?

A futures contract is a legally binding agreement to deliver or receive a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future.

Where are Futures Contracts Traded?

All Futures are traded on an exchange in a controlled, regulated environment where the underlying specifications related to the trades, called the Contract Specifications, are set. For a list of ‘Contract Specifications’, please refer to the relevant exchanges where the futures contract trades.

Types of Products Traded

A futures contract can be any physical commodity, such as corn, wheat or meat products. It can also be a financial instrument, such as government bonds, equity indices and currencies. There are also futures contracts based on energy commodities, such as oil, natural gas and heating oil.

Elements of a Futures Contract

The extent and number of futures contracts tradable globally is significant so understanding the nature of a futures contract is important when entering the arena.

Settlement

The date when the trade month expires is called the delivery date or final settlement date for a futures contract. The official price of the futures contract at the end of a day’s trading session on the exchange is called the settlement price for that day of business on the exchange. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Both parties of a contract must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

Who Trades Futures?

There are two types of futures investors, the speculator and the hedger.
The speculator looks to take advantage of directional price movements in the market. The speculative investor is typically risk-willing, taking positions in which there is a potential for large gains relative to the capital outlay. They in turn also carry the risk of large losses.
The hedger trades futures to neutralize the risk associated with other investments, and takes positions to reduce or avoid market exposure and vulnerability to future price movements in the underlying assets. The aim of a Hedger can be to lock in a current price for a future delivery; such as a farmer.

Why Trade Futures

For the investor looking to diversify his/her portfolio, futures offer an exciting option, giving the opportunity-seeking investor access to a variety of alternative markets.
Futures are highly liquid financial instruments, meaning that you can trade on tight spreads. The transaction costs for trading futures are generally low, the pricing is very transparent due the level of specificity found in the futures contract and the regulations imposed by the various exchanges.
Online trading of futures offers swift order and trade execution and low counterparty risk as all transactions are handled through the exchange and the clearinghouses have a daily responsibility to ensure that all transactions and margins are conducted in an orderly manner.

What is an Option?

An Option gives the purchaser the right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time.

In the case of a security that cannot be delivered such as an index, the contract is settled in cash. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. For the buyer, the upside is unlimited. Options are therefore said to have an asymmetrical payoff pattern.

For the writer, the potential loss is unlimited unless the contract is covered, meaning, in the case of a written covered call option, that the writer already owns the security underlying the option. Options are used most frequently as either leverage or protection. As leverage, options allow the holder to control equity in a limited capacity for a fraction of what the shares would cost. The difference can be invested elsewhere until the option is exercised. As protection, options can guard against price fluctuations because they provide the right to acquire the underlying stock at a fixed price for a limited time. Risk is limited to the option premium (except when writing options for a security that is not already owned). However, the costs of trading options (including both commissions and the bid/ask spread) is higher on a percentage basis than trading the underlying stock. In addition, options are very complex and require a great deal of observation and maintenance.

Basic Strategies in Options:

Long Puts

For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock).

Naked Call

Selling naked calls is a very risky strategy which should be utilized with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk.

Put Back Spread

For aggressive investors who expect big downward moves in already volatile stocks, backspreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price.

Bear Call Spread

For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call.

Bear Put Spread

For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases.

Butterfly

Is a low risk, low reward options strategy designed to take advantage of a range bound stock or market. It can be created using either call options or put options. An example of a Butterfly spread would be: Buying 1 in the money Call option, selling 2 at the money call options and buying 1 out of the money call option.

Condor

Is a limited risk, non directional options trading strategy (similar to the Butterfly spread) comprising 4 options with the only difference being the 2 at the money options in the Butterfly spread have strikes of in the money and out of the money (one of each) in the Condor structure.

Straddle

Holding a position in both a call and put with the same strike price and expiration. The position is profitable (to the buyer) if the underlying stock changes value in a significant way, either higher or lower. If the options have been bought, the holder has a long straddle. If the options were sold, the holder has a short straddle.

Strangle

The simultaneous buying or selling of out-of-the-money put and an out-of-the-money call, with the same expirations. Similar to the straddle, but with different strike prices.

Greeks

Options are known as Derivatives of their underlying reference asset (stock index etc). As such, the change in a number of underlying parameters can cause a change in the value of an option. These sensitivities are termed The Greeks.

The Greeks are calculated from the price of the stock, the strike price of the option, the estimate of volatility of the stock, the time to expiration of the option, the current interest rate and any dividends payable on the stock before the expiration date of the option.

The Delta of an option measures the rate of change in the option value with respect to changes in the underlying asset’s price. The Delta of a long call is positive; the delta of a long put is negative. The delta is reversed for short calls and puts. This can be understood by knowing that, all things being equal, a long call makes money if the stock price goes up, and a long put makes money if the stock price goes down.

The Gamma of an option measures the rate of change in the Delta with respect to changes in the underlying price of the reference asset. If you look at delta as the “speed” of your option position, gamma is the “acceleration”. The gamma of long options, calls or puts, is always positive; of short options, always negative. Gamma is highest for the ATM strike, and slopes off toward the ITM and OTM strikes. One good way of interpreting gamma is that long gamma “manufactures” deltas in the direction the stock is moving. That is, positive gamma is why long calls get more positive delta when the stock price rises, and why long puts get more negative deltas when the stock price falls. With a small gamma, your position delta probably won’t change much. The more gamma your position has, your position delta can change a great deal and needs close monitoring.

But if you think the price of a stock is going to move a great deal very quickly, you want to buy an option with relatively high gamma. The high positive gamma will get you more deltas if the stock price moves the way you want it to, and reduce your deltas if the stock price moves against you.

The Theta of an option or “Time Decay” measures the sensitivity of the value of the option to the passage of time. Long calls and puts have negative theta and, all other things being equal, lose “Time Value” as time passes. Short calls and puts have positive theta and, all other things being equal, make “Time Value” as time passes.

The theta of options is indirectly proportional to gamma. When gamma is big and positive, theta tends to be big and negative. That’s the trade-off. A position that has a lot of gamma (good for fast changing stocks) also has lots of theta that is continuously eroding its value.

Theta is highest for the ATM strike, and slopes off to the ITM and OTM options, and responds to the passage of time and changes in volatility the same way that gamma does.

The Vega of an option measures the sensitivity of the options value to changes in the volatility of the value of the underlying reference asset. Long calls and puts both have positive Vega and, all things being equal, increase in value when volatility rises. Short calls and puts both have negative Vega and, all things being equal, increase in value when volatility falls. Volatilities move up and down, sometimes by significant amounts.

The Rho of an option measures sensitivity of the option value to movements in interest rates. The value of an option is usually (except in extreme circumstances) the least sensitive to changes in interest rates compared to its sensitivity to the other primary Greek measures.

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Disclaimer

Trading foreign exchange and futures on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange or futures you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange- and futures trading, and seek advice from an independent financial advisor if you have any doubts.

Any SharpDeal advice is general advice only.