1. What are Derivatives?
Derivatives are financial contracts whose value is derived from an underlying asset, such as stocks, commodities, currencies, or indices. The two most common types of derivatives are options and futures.
2. Options
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (called the strike price) on or before a specific date (called the expiration date).
Key Terms in Options:
- Call Option: Gives the buyer the right to buy the underlying asset.
- Put Option: Gives the buyer the right to sell the underlying asset.
- Strike Price: The price at which the underlying asset can be bought or sold.
- Premium: The price paid by the buyer to the seller (writer) of the option.
- Expiration Date: The date on which the option contract expires.
- Underlying Asset: The asset (e.g., stock, commodity) on which the option is based.
Types of Options:
1. Call Option Example:
- You buy a call option for Stock XYZ with a strike price of $100 and an expiration date in 1 month.
- You pay a premium of $5 for this option.
- If the stock price rises above $100 (e.g., $120), you can exercise the option and buy the stock at $100, making a profit.
- If the stock price stays below $100, you let the option expire and only lose the premium ($5).
2. Put Option Example:
- You buy a put option for Stock XYZ with a strike price of $100 and an expiration date in 1 month.
- You pay a premium of $5 for this option.
- If the stock price falls below $100 (e.g., $80), you can exercise the option and sell the stock at $100, making a profit.
- If the stock price stays above $100, you let the option expire and only lose the premium ($5).
Options Payoff Examples:
1. Call Option Payoff:
- Strike Price: $100
- Premium Paid: $5
- If the stock price at expiration is $120:
- Profit = (Stock Price - Strike Price) - Premium = ($120 - $100) - $5 = $15
- If the stock price is $90:
- Loss = Premium = $5 (you don’t exercise the option).
2. Put Option Payoff:
- Strike Price: $100
- Premium Paid: $5
- If the stock price at expiration is $80:
- Profit = (Strike Price - Stock Price) - Premium = ($100 - $80) - $5 = $15
- If the stock price is $110:
- Loss = Premium = $5 (you don’t exercise the option).
3. Futures
A futures contract is an agreement to buy or sell an underlying asset at a predetermined price on a specific future date. Unlike options, futures are binding obligations—both parties must fulfill the contract.
Key Terms in Futures:
- Long Position: Agreement to buy the asset in the future.
- Short Position: Agreement to sell the asset in the future.
- Futures Price: The price agreed upon for the future transaction.
- Expiration Date: The date on which the contract is settled.
- Margin: A deposit required to enter into a futures contract.
Futures Example:
1. Agricultural Futures:
- A farmer agrees to sell 1,000 bushels of wheat at $5 per bushel in 3 months (futures contract).
- A bakery agrees to buy 1,000 bushels of wheat at $5 per bushel in 3 months.
- If the market price of wheat rises to $6, the farmer loses $1 per bushel but is obligated to sell at $5.
- If the market price falls to $4, the bakery loses $1 per bushel but is obligated to buy at $5.
2. Stock Index Futures:
- You buy a futures contract for the S&P 500 index at 4,000 points, expiring in 3 months.
- If the index rises to 4,200 at expiration, you make a profit of 200 points.
- If the index falls to 3,800, you incur a loss of 200 points.
Futures Payoff Example:
- Futures Price: $100
- If the market price at expiration is $120:
- Profit for the long position = $120 - $100 = $20
- Loss for the short position = $100 - $120 = -$20
- If the market price at expiration is $80:
- Loss for the long position = $80 - $100 = -$20
- Profit for the short position = $100 - $80 = $20
4. Long and Short Positions
A long position means you buy an asset with the expectation that its price will rise. A short position means you sell an asset with the expectation that its price will fall.
Long Position Example:
- You buy 100 shares of Company XYZ at $50 per share.
- Total cost = 100 shares × $50 = $5,000.
- If the stock price rises to $60:
- Profit = ($60 - $50) × 100 = $1,000.
- If the stock price falls to $40:
- Loss = ($40 - $50) × 100 = -$1,000.
Short Position Example:
- You borrow 100 shares of Company XYZ and sell them at $50 per share.
- Total proceeds = 100 shares × $50 = $5,000.
- If the stock price falls to $40:
- Profit = ($50 - $40) × 100 = $1,000.
- If the stock price rises to $60:
- Loss = ($50 - $60) × 100 = -$1,000.
5. PnL (Profit and Loss) Formulas
- For Long Positions: PnL = (Selling Price - Buying Price) × Quantity
- For Short Positions: PnL = (Buying Price - Selling Price) × Quantity
6. Key Differences Between Options and Futures
| Feature | Options | Futures |
|-----------------------|--------------------------------------|--------------------------------------|
| Obligation | Right, but not obligation | Binding obligation |
| Risk | Limited to premium paid | Unlimited risk |
| Profit Potential | Unlimited for calls, limited for puts| Unlimited for both long and short |
| Cost | Premium paid upfront | Margin required |
| Settlement | Can be exercised or expire | Must be settled on expiration |
7. Key Differences Between Long and Short Positions
| Feature | Long Position | Short Position |
|-----------------------|--------------------------------------|--------------------------------------|
| Action | Buy first, sell later | Sell first, buy later |
| Expectation | Price will rise | Price will fall |
| Risk | Limited to the initial investment | Unlimited (price can rise infinitely)|
| Reward | Unlimited (price can rise infinitely)| Limited to the price falling to zero |
8. Real-World Applications
- Options:
- Hedging: Protect against price fluctuations (e.g., buying a put option to hedge a stock portfolio).
- Speculation: Bet on price movements without owning the asset.
- Futures:
- Hedging: Lock in prices for commodities (e.g., farmers, airlines).
- Speculation: Profit from price movements in indices, currencies, or commodities.
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