A derivative is a financial instrument derived from something else. A derivative is therefore a financial instrument whose price is based on the price of an underlying asset. This underlying asset can be a financial asset or a commodity. Examples include bonds, stocks, stock market indices and interest rates. Goods include oil, silver or wheat. Futures and options are commonly used derivative instruments.
Derivatives are used both for hedging and for speculation and for more favorable market binding, especially when a market security transaction is illiquid. Derivatives can be used as part of a risk management technique, but have been used in recent decades as a way to speculate and generate profits. However, some companies have used them solely for speculation outside of their line of business and made spectacular losses.
A furure is an agreement between a buyer and a seller.
The buyer agrees to pay a specified amount for the delivery of a specified quantity of an asset at a future date.
The seller agrees to deliver the asset at the later date in exchange for the specified amount of money based on the price agreed between them.
A futures contract is a legally binding commitment between the two parties.
A buyer could agree with a seller to pay $56 a barrel for 1,000 barrels of Brent crude in three months. The buyer could be a power generation company that wants to fix the price it has to pay for the oil to use in its oil-fired power plants, and the seller could be an oil company that wants to fix the selling price of some of its future oil production.
Long - the alternative way of describing the buyer of the futures. The long is obligated to buy the underlying asset at the specified future price on the specified future date.
Short - the alternative way of describing the seller of the futures. The short is obligated to deliver the underlying against the pre-agreed price on the specified future date.
Open - the first trade. A market participant opens a trade when entering a future for the first time. You could buy a future - open a long position or sell a future - open a short position.
Underlying - The underlying determines the value of the futures contract and is usually referred to as the underlying or cash value.
Basis - Basis quantifies the difference between the cash price of the underlying asset and the futures price.
Delivery Date - This is the day when the agreed transaction takes place and thus represents the end of the future life.
Close - The buyer of a future can either hold the future until expiration and accept the underlying asset, or sell the future before the expiry date. The latter is known as closing out the position. An investor who bought a future would be long and would sell the future when it closed; An investor with an open short position would do the opposite and buy the future to close it out.
An option gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed strike price, called the strike price, on or before a specified future date or between two specified dates. The seller grants the option to the buyer in exchange for paying a premium.
The term "premium" is most commonly used in options. These are the costs to the buyer (holder) of the option and the fee paid to the seller (writer) of the option. However, it can sometimes be referred to more loosely in other derivative contracts such as futures.
In exchange-traded contracts, both buyers and sellers enter into contracts through the exchange and its clearinghouse, not with each other.
There are two types of options:
A call option gives the buyer the right to buy the asset at the strike price if they choose. The seller is obliged to deliver if the buyer makes use of the option.
A put option gives the buyer the right to sell the underlying asset at the strike price. The seller of the put option is obligated to take delivery and pay the exercise price if the buyer exercises the option.
Suppose Umba AG shares are trading at €3.24 and an investor buys a €3.50 call for three months. The investor Frank has the right to buy Umba shares from the writer of the option at €3.50 if he wants to, at any point in the next three months.
Should the Umba share fall below €3.50 in three months, Frank will relinquish the option.
For example, if they rise to €6.00, Frank will either exercise the option (buy the shares at €3.50 and keep them or sell them at €6.00), sell the option before it expires to give him around €6.00 - 3 €.50 = €2.50 profit.
If Frank pays a premium of €0.42 - what is Frank's maximum loss and how high does Umba AG have to be for Frank to make a profit?
The maximum amount Frank can lose is €0.42, the premium he paid. If the Umba AG share rises above €3.50 + €0.42 or €3.92, then he makes a profit. On the other hand, if the shares only go up to €3.51, Frank would exercise his right to buy – rather earn a cent and reduce his losses to €0.41 than lose the whole €0.42.
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