Understanding the Mechanics of Derivatives

However, futures options trading has many more quirks than Forex trading and thus can pose a problem for those new to derivatives. Without a clear understanding of the mechanics of these two markets it is virtually impossible for a novice trader to make a profit.

What Is a Derivative?

Before we look at futures options trading, it is vital that you have a clear understanding of derivatives as a whole and how they are priced. A derivative is basically a financial instrument whose value depends on the price of the asset that is being traded. For example, a stock option is a derivative that is priced according to the rate of the stock.

What Are Futures Contracts?

A futures contract is an agreement between two parties to purchase or sell a certain asset at an agreed price some time in the future. Futures contracts are based on a variety of different commodities and financial assets from cattle, sugar, gold and tin to stock indices, currencies and Treasury bonds.

What Are Options?

Options are different from futures in that it gives the owner of the option a right to buy or sell but the holder is not obligated to exercise that right. Unlike with futures where a trader does not incur any costs other than the margin requirements, options require an up-front payment.

There are two basic types of options, namely call options and put options. A call option gives the owner the right to purchase an asset by a certain date at a certain price, where as a put option gives the holder the right to sell an asset. These options can be either American or European and this has nothing to do with the geographical location. American options give the holder the ability to exercise their right at any time up to the expiration date whereas European options can only be fulfilled on the expiration date itself.

How do Call and Put Options Work?

To be able to enter into futures options trading you need to understand how options work, because the price of the underlying asset will determine the price of the options you will be trading. However, it isn’t quite as clear cut as standard stock or currency trading where if you are bullish and the stock goes up you have made a profit.

Let’s look at a call option first. So, an investor decides to purchase a call option for 100 shares of a certain stock priced at $100, also referred to as the strike or exercise price, with a price of $3 per share. This means that the upfront payment will be $400. Let’s continue to presume that the current price of the stock is $95 per share. By purchasing the option, the investor is basically buying the right, but not the obligation, to purchase said stock at $95 at a certain date in the future.

Essentially, the investor is gambling, by purchasing a call option, that the price of the stock will increase by the expiry date of the option. Therefore, if the stock’s price has increased, say to $110, by the expiration date of the call option, the investor will exercise his right to purchase the stock at $95 and he will be able to sell it immediately for $110.

However, if the price of the stock remains the same or goes down, then the investor can choose not to exercise his right, but he will lose the initial investment of $400 which he paid for the call option. Put options function in much the same way except in reverse with the investor buying the right to go short on the underlying asset.

As you can probably tell, futures options are essentially options where the underlying asset is a futures contract. While futures options trading may seem like a good option, since your initial investment is minimal, it can be quite complicated and should not be considered until you have a good grasp of the mechanics. However, unlike the outright trading of stocks and commodities, the risk is lower, since you can choose not to exercise the option, as are the returns.

Related posts:

1. The Advantages of Futures Option Trading
2. Currency Option Trading
3. Currency Futures Trading
4. Understanding Futures Trading
5. Forex Binary Option
6. Binary Options
7. How to Succeed with Futures and Options Trading