forex, Forex trading

Derivative financial instruments – options

February 12, 2019

The development of financial markets has led to the widespread use of derivative financial instruments – derivatives . The following derivatives are distinguished: futures, forwards, spot and options . Each of the tools has specific characteristics and varieties.

The basis of any derivative instruments are underlying assets – securities, commodities, indices . The change in the price of derivatives is a result of a change in the price of the underlying asset .

Today, traders, banks and funds are actively using derivatives in speculative transactions . But the main initial purpose of derivatives is to reduce financial risks . This property is used by product manufacturers to hedge risks of changing market conditions.

Main types of derivatives

Futures contracts are widely developed in transactions between farmers and exchanges. The parties agreed on the terms of delivery – the quantity , quality , timing of the  next harvest. The meaning of the futures contract is that the contract will be executed in the designated future. Futures enshrines the mutual obligations of the parties. The seller undertakes to deliver the goods of a certain quality and quantity at the prices valid at the time of execution .

A similar type of transaction is a forward contract . Differs from futures in that it is an over-the-counter contract .

An option is a universal tool . It is used by traders and financial institutions in speculative transactions. By combining various types of contracts they create diverse and effective strategies for profit. Manufacturers use this tool for hedging. Increasing the market prices for raw materials and goods used in production leads to an increase in operating costs and a decrease in product competitiveness. Companies seek to control the risks of increasing the cost of raw materials and other costs or reducing the cost of their own products.

Specific Option Characteristics

  1. Options are different from other instruments in that the buyer has the right not to execute the transaction . The contract will be executed at the request of the buyer. This makes this tool as close as possible to the insurance . The seller has less rights, he will be obliged to execute the transaction if the buyer presents an option for execution.
  2. Award. Similar to buying an insurance policy, the option buyer pays a  premium . Seller receives a premium as a risk payment. The closer the expiration date, the higher the premium.
  3. Duration . An option contract has clearly defined time limits and ends on the set date – the expiration date (expiration date). In practice, two types of options are common – European and American . Their difference is that the European option is executed only on the day of expiration of the contract, and the American option gives the owner freedom of action, it can be exercised at any time before the expiration of the contract.
  4. Execution option . The contract that ends without execution expires – expire . The exercise option is exercise .

Put and Call Options

There are two types of options – Call and Put .

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Purchase Call provides the right to buy the underlying asset at a set price .

The question arises: “What is the advantage of this tool over the simple acquisition of an asset?”

For example, N shares worth $ 100 look attractive to traders at the moment. It is expected that the quotes will grow in the medium term. It is logical in this situation to buy stocks. And most traders just buy stocks. But the situation at any time may change, then the transaction becomes unprofitable. Having bought Call $ 100 (standard contract of 100 shares), the trader will execute the contract if the price of securities is higher or will not execute it if the price drops. For example, quotes rose to $ 130. It is profitable for the trader to exercise the option, the transaction will bring in the income of $ 3,000 per contract, minus the premium paid. The decline in the stock price is against the expectations of the trader, so he will not exercise the option, the loss will be limited to the amount of the premium.

Put gives the right to sell the underlying asset at a set price . What is the logic of using this tool?

Obviously, the trader expects that the price of the underlying asset tends to decrease. Buying Put, when stocks cost $ 100, the buyer can execute it – sell the paper for $ 100 if their price drops, for example, to $ 80. Profit will be $ 2,000, minus the premium.

Selling options is a reverse deal . Call sell, if the price of the underlying asset is expected to decline, Put is sold, if the asset price is expected to go up.

Brokers require increased margin support and limit the minimum deposit amount for option sellers. Deal with selling Call options involve risk,  virtually , unlimited loss –  the asset price can theoretically fly very high.

For the seller Put the risk of loss is limited – the asset can not cost less than 0 in terms of money .

Options “in the money”, “without money” and “with his”

The specificity of options is associated with the use of special terminology.

Operations in financial markets may be profit or loss . Options provide traders and investors with the opportunity to earn profits, but they also bear the risk of losing money. The duplicity of this tool is that, on the one hand, it can protect against losses and helps to keep the risk under strict control, but in other cases, losses can be simply crushing.

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In this context, three contract statuses are distinguished .

  1. In the case when the exercise price of the option and the market value of the asset are equal , the term “option with its own” – “at the money, atm” – is a transaction with zero yield if the contract is currently executed.
  2. If, with an immediate exercise of the option, it brings income , the term “option in money” is used – “in the money, itm” – this situation occurs when the quotes of the underlying asset rise above the strike price of Call or fall below the strike price of Rut.
  3. The term “out of money option” – “out the money, otm” , describes a potentially unprofitable situation . This happens when quotes rise above the Put execution price or are located below the Call execution price. This contract will not be executed by the buyer, since the implementation of such a transaction will bring a loss.

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