1.1.1 Market Classification

A key feature of a futures contract is that it involves deferred delivery of the underlying asset (e.g. wheat, AT&T stocks), whereas spot (cash market) assets are for immediate delivery (although in practice, there is usually a delay of a few days). A primary use of derivative securities is to minimise price uncertainty. Therefore, where the underlying assets (e.g. currencies, stocks, oil, agricultural produce) are widely traded and yet their spot prices exhibit great volatility, there is likely to be a large active derivatives market.

Trading in derivative securities can be on a trading floor (or ‘pit’) or via an electronic network of traders, within a well-established organised market (e.g. with a clearing house, membership rules, etc.). However, many derivatives contracts – for example, all FX-forward contracts and swap contracts – are traded in OTC markets, where the contract details are not standardised but individually negotiated between clients and dealers. Options are traded widely on exchanges but the OTC market in options (particularly ‘complex’ or ‘exotic’ options) is also very large.

Today there are a large number of exchanges which deal in futures contracts. Most can be categorised as either agricultural futures contracts (where the underlying ‘asset’ is, for example, pork bellies, live hogs or wheat), energy futures (e.g. crude oil, natural gas, heating oil), metallurgical futures (e.g. silver, platinum) or financial futures contracts (where the underlying asset could be a portfolio of stocks represented by the S&P 500, currencies, T-bills, T-bonds, Eurodollar Deposits, etc.). Agricultural, energy and metallurgical futures are often generically referred to as ‘commodity futures’. There are some futures contracts that do not really fit into any of these definitions, such as weather futures – which we meet later.

Futures contracts in agricultural commodities have been traded (e.g. on the CBOT) for over 100 years. In 1972 the CME began to trade currency futures, the introduction of interest rate futures occurred in 1975 and in 1982 stock index futures (colloquially known as ‘pinstripe pork bellies’) were introduced. The CBOT introduced a clearing house in 1925, where each party to the contract had to place ‘cash deposits’ into a margin account. The latter provides insurance if one of the parties defaults on the futures contract.

Analytically, forwards and futures can be treated in a similar fashion. However, they differ in some practical details (see Table 1.2). Forward contracts (usually) involve no ‘up front’ payment and ‘cash’ only changes hands at the maturity of the contract. A forward contract is negotiated between two parties and (generally) is not marketable. In contrast, a futures contract is traded in the futures market (in Chicago)¹ and when initiated, traders have to provide a cash deposit known as the initial margin. However, the initial margin is merely a form of collateral to ensure both parties can fulfil the terms of the futures contract – it is not a payment for the futures contract itself and it is not the ‘futures price’. The margin usually earns a competitive interest rate so it is not a ‘cost’. As the futures price changes then ‘payments’ (i.e. debits and credits) are made into (or out of) the margin account. Hence a futures contract is a forward contract that is ‘marked-to-market’, daily.

Because the futures contract is marketable, the contracts have to be standardised – for example, by having a set of fixed delivery dates and a fixed ‘contract size’ (e.g. 1,000 barrels of oil for the oil futures contract or $100,000 for the US T-bond futures contract). In contrast, a forward contract can be ‘tailor made’ between the two parties, in terms of size and delivery date. Finally, forward contracts almost invariably involve actual delivery of the underlying asset (e.g. currency) whereas futures contracts can be (and usually are) ‘closed out’ prior to maturity which cancels any delivery obligations.

Forward contracts can be used for speculation. First, consider a speculator who on 1 April thinks the gold (spot) price will be high in September. On 1 April she therefore ‘buys’ (‘goes long’) a September-forward contract on gold, but does not pay any cash on 1 April. If the spot price of gold rises (falls), the speculator will make a gain (loss) on the forward contract at the time the contract matures in September.

For example, suppose on 1 April (t = 0) the quoted spot (‘cash-market’) price of gold is per oz and the gold forward price quoted in Chicago (for delivery in September, T) is per oz. Assume the speculator is correct and the spot (cash market) price for gold in September (T) turns out to be higher at per oz. The speculator holding the (‘long’) forward contract can take delivery of the ‘physical’ gold (in the forward contract, in Chicago) for which she pays in September. But she can now immediately sell the gold in the spot/cash market for , giving an overall profit of $190 per contract .

Now consider speculation using futures contracts, which can be closed out at any time before maturity. Most futures contracts are closed out prior to maturity and when they are, the clearing house (CH) in Chicago sends out a cash payment which reflects the change in the futures prices between the opening trade and closing out the contract (i.e. a buy followed by a sell, or vice versa). Therefore futures contracts can be used for speculation over very short time horizons. Remember that the futures price moves (approximately) dollar-for-dollar with changes in the price of the underlying spot (‘cash-market’) asset. If you think the futures price will rise (fall) then today a speculator will buy (sell) a futures contract.

Suppose on 15 June you purchased a September-futures contract on stock-XYZ at a price and one week later on 22 June you closed out the contract by selling it at its new price of .² Then the CH ‘effectively’ sends you a cheque for $10 – the difference between your buying price and selling price. Simplifying a little, the CH obtains this $10 from the person who initially sold the contract to you at $100 and is now buying it back at $110 – if you have gained $10 then the ‘other side of the contract’ must have lost $10. It also follows that a speculator would earn a $10 profit if she initially sold a contract at and later closed out the contract by buying it back at a lower price of (i.e. ‘sell high, buy low’). The different types of futures contracts that can be traded is almost limitless but only those which are useful for hedging and speculation will continue to be traded. The exchange will cease to trade any futures contracts where the trading volume is below a certain threshold.

1.2.1 Call Options

If today you buy a European call option and pay the call premium/price, then this gives you the right (but not an obligation):

• to purchase the underlying asset
• at a designated delivery point
• on a specified future date (known as the expiration or maturity date)
• for a fixed known price (the exercise or strike price)
• and in an amount (contract size) which is fixed in advance.

For the moment, think of a call option as a ‘piece of paper’ that contains the contract details (e.g. strike price, maturity date, amount, delivery point, type of underlying asset). You can purchase this contract today in the options market in Chicago if you pay the quoted call premium. There are always two sides to every trade – a buyer and a seller – but we will concentrate on your trade, as a buyer of the option. Note that all transactions in the option contract are undertaken in Chicago but the underlying asset, for example a stock, is traded on another exchange (e.g. NYSE).

Suppose the current price of stock-XYZ on the NYSE on 15 July is . On 15 July you can pay the call premium and buy (in Chicago) an October-European call option on the stock-XYZ. The strike price in the contract is ,⁴ and the expiry date T is in just over 3 months' time on 25 October. Because the maturity of the call is in October, and the strike is , it is known as the ‘October-80 call’ (Table 1.4). Assume each call option is for delivery of one stock of XYZ.

	Chicago (options market)	NYSE (cash market)
15 July	Call premium, Strike price,	Spot price,
25 October		Spot price,

1.2.2 Long Call: Speculation

How might a speculator use this call option contract? As we shall see, the speculator will buy the call option if she thinks stock prices will increase (sufficiently) in the future and end up above the strike price, K (on the option's maturity date). If stock prices do increase (sufficiently) then the speculator will make a profit when she exercises the call option (on 25 October, its maturity date).

For example, if the stock price on 25 October (on the NYSE) turns out to be , then the holder of the call option can ‘present’ (i.e. exercise) the option contract in Chicago on 25 October (the maturity date of the option), pay the strike price and receive one stock. This is exercising the option by taking delivery. She could then immediately sell the stock on the NYSE for , making a cash profit on 25 October equal to . Alternatively, the long call option can be ‘cash settled’ for which is paid via the clearing house in Chicago (and no stock is delivered). In either of these scenarios (i.e. delivery or cash settlement) the option's speculator has made $8 on an initial outlay of ‘own funds’ of C = $3, which is a percentage return of [(8 – 3)/3 × 100%] = 167% (over a 3-month period).

Had the speculator bought the stock itself (with her ‘own funds’) for $80 and then sold at S_T = $88, she would have made a percentage return of 10% (i.e. $8 on an initial outlay of $80). The much larger percentage return when using the call option arises because you can purchase the option for the relatively small payment of $3, whereas the stock costs you $80. The higher percentage return from the option (relative to the percentage return from buying the stock with your ‘own funds’) is called leverage – here, a 10% increase in the stock price gives rise to a 167% return on the option strategy.

If the stock price on 25 October turns out to be which is less than the strike price then the option is not worth exercising – after all, why pay for delivery of stock-XYZ in Chicago, when XYZ is only worth on the NYSE. In this case the option on 25 October is worth zero and the speculator ‘throws it away’ (i.e. does not present/exercise the option in Chicago). Note, however, that no matter how low the stock price turns out to be on 25 October, the maximum amount the option's speculator can lose is known in advance and is equal to the call premium .

So a speculator who buys a call option has some rather nice advantages – she can benefit substantially from any upside in the stock market but can never lose more than the (rather small) option premium of $3 she initially paid, even if stock prices fall to zero. Contrast this with buying the stock on 15 July for on the NYSE – this might lead to a maximum loss of $80, if company-XYZ entered bankruptcy before 25 October.

1.2.3 Closing Out

When a speculator buys a call option she can make a profit if the stock price increases at any time before the maturity date of the option. She does this by selling (shorting) the call option to another options trader, after the stock price has increased – this is called ‘closing out’ (or ‘reversing’) her initial long position in the option. The speculator is able to make a profit because when stock-XYZ increases in price on the NYSE then this results in a rise in the call premium (on XYZ) in Chicago. For example, if stock-XYZ increases in price by $2 over one day then the price of the call option (quoted in Chicago) may increase from say $3 to , over one day. Hence the speculator who purchased the October-call for $3 on 15 July, can now sell the call in Chicago on 16 July (to another options trader) for $4. The speculator actually receives her $4 from closing out the contract, via the options clearing house in Chicago. She therefore makes a speculative profit of , the difference between the buying and selling price of the call – a return of over one day.

Conversely, after the speculator purchased the October-call for , on 15 July, if the stock price falls by $1 (say) on the NYSE, then the October-call premium will fall to $2.2 (say) and when she sells it to another trader (i.e. closes out) in Chicago, the options speculator will make a loss of $0.8 on the deal (but she will never lose more than the initial option premium of $3). Thus a naked (or open) position in a long call is risky.

1.2.4 Put Options

If you buy a European put option (in Chicago) this gives you the right to sell the underlying asset (in Chicago) at some time in the future, for a price which is fixed in the contract.

If today you buy a European put option and pay the put premium/price, then this gives you the right (but not an obligation):

• to sell the underlying asset at a
• specified future date (the expiration/maturity date) at a
• designated delivery point
• for a known fixed price (strike/exercise price)
• in an amount (contract size) which is fixed in advance.

1.2.5 Long Put: Speculation

A put option can be used for speculation. In contrast to speculation with a long call, a speculator will buy (‘go long’) a put option if she expects the stock price to fall in the future (and end up below the strike price). Suppose on 15 July the stock price for company-XYZ is on the NYSE and a speculator thinks the stock price will fall in the future. Assume the speculator is not going to gamble on the price fall by using stock-XYZ, itself. Instead, on 15 July the speculator buys (in Chicago) a European ‘October-put’ (expiry date is 25 October) with a strike price K = $70 for a put premium paid of P = $2.2.

Suppose the spot price of stock-XYZ on the NYSE on 25 October is (i.e. below ). Then on 25 October the speculator can purchase stock-XYZ on the NYSE for and then immediately ‘deliver’ stock-XYZ in Chicago along with the put contract and receive , given the terms in the put contract. The options speculator makes a profit of on 25 October. Alternatively, the speculator can simply ‘cash settle’ the long put contract, in which case the options clearing house makes a cash payment of when the long put is ‘cash settled’ on 25 October (and the holder of the long put does not have to deliver stock-XYZ).

In either of the above cases the speculator who is long the put, receives $5 on 25 October. The speculator's initial outlay was the put premium of paid on 15 July. The speculator by using the (long) put contract to speculate on a future stock price fall, has made a percentage return of , over a 3-month period. The fall in the stock price is . But the percentage return from investing in the long put (and exercising the put at maturity) is much larger at 127%. Hence, buying the put option for has provided a leveraged return for the speculator.

If the spot price of stock-XYZ on the NYSE on 25 October turns out to be higher than the strike price (e.g. , ) then the put option will not be exercised. Why would a speculator who holds the put, buy the stock for $73 on the NYSE on 25 October, if she could then only obtain by delivering the stock and exercising her put contract in Chicago? The put option is therefore worth zero on 25 October and the speculator ‘throws it away’ (i.e. does not exercise the option). But the most the speculator with a long put can lose is the put premium of . So a speculator who is long a put option can benefit from a sufficiently large fall in the price of stock-XYZ – but if she guesses wrong and the stock price rises, she can never lose more than the (rather small) put premium initially paid.

1.2.6 Long Put plus Stock: Insurance

Options can also be used to provide insurance. For example, suppose you run a pension fund and already own stocks whose current price on 15 July (on NYSE) is . But you are worried about a fall in price of the stocks between now and 25 October when your stocks will be sold to provide lump sum payments to pensioners. Well, you can ‘insure’ your stocks by buying an October-put option with a strike price of, say, (with maturity date 25 October). Note that in this example you hold two assets: the stock-XYZ and a put option (on stock-XYZ).

If stock prices in New York fall to on 25 October, then instead of selling your stocks in New York at , you can exercise your October-put option in Chicago, which means delivering your stock-XYZ in Chicago and you will receive for each stock (from the options clearing house). By buying the put option on 15 July, you have guaranteed a minimum price of on 25 October at which you can sell the stocks-XYZ, held by the pension fund. The cost of this ‘insurance’ is the put premium paid on 15 July. True, the pension fund has lost $2 per stock as the initial price of the stock was in July since the pension fund can only obtain when they deliver the stock and exercise the put option in Chicago – the $2 is the ‘deductible’ in the put insurance contract.⁵ Losing $2 per stock because you had the foresight to take out insurance by buying a put option (with ), is a lot better than if you had not purchased the put, since then your stocks-XYZ would have fallen in value by on the NYSE.

How does this ‘options insurance contract’ look if prices rise over the next 3 months? Suppose prices rise on the NYSE from in July to in October. Then your long put is worthless as the pension fund would not ‘deliver’ (sell) its stocks in Chicago for (using the stocks and the put) when it can sell its stocks in New York for . Indeed the pension fund will ‘throw away’ (i.e. not exercise) the put option in Chicago and will sell stocks-XYZ on the NYSE for $80 – so the pension fund (and the new pensioners) will be very happy.

The insurance policy provided by the ‘stock+put’ has allowed the pension fund to fix a minimum selling price of at which it can sell its stock holdings on 25 October, by exercising the October-put contract in Chicago. No matter how low the stock price on the NYSE on 25 October, the pension fund – by exercising the put option – can secure a minimum price of . But the ‘stock+put’ also allows the pension fund to benefit from any ‘upside’ if stock prices rise, because then the pension fund simply sells its stocks-XYZ on the NYSE at the high price. There are many types of situation that can be analysed using an options approach and some of these are discussed in Finance Blog 1.1.

1.4.1 Hedgers

Examples of hedging using the forward market in foreign exchange are perhaps most common to the lay person. If a US exporter expects to receive £3,000 in 3 months, then the US exporter can buy dollars today in the forward market at the 3-month forward FX-rate, . The key feature is that today, the US company fixes the amount of USD it will receive at $4,500, in exchange for the £3,000 it provides, in 3 months' time.

Futures contracts if held to maturity, are like forward contracts – they fix the price that the hedger will pay or receive at maturity of the futures contract. However, it can be shown that even if the futures contract is closed out before maturity much of the risk can be hedged, but a small amount does remain (this is known as basis risk).

Options contracts provide ‘insurance’. Investors in options can protect themselves against adverse price movements in the future but they still retain the possibility of benefiting from any favourable price movements. To obtain this insurance, the option's purchaser (‘the long’) of either a call or a put has to pay the option premium, today.

For example, a US exporter to the UK can ‘insure’ (i.e. set a lower limit for) her future US dollar receipts in 3 months' time, if today she buys a put option on sterling at a strike price of K = 2 ($/£, USD/GBP), which matures in 3 months. Suppose the put option is for ‘delivery’ of £3,000. The put option implies she will receive a minimum of K = 2 USD/GBP by exercising her put in Chicago in 3 months' time – so the minimum she will receive from exercising the put is $6,000 (even if the quoted spot-FX rate in 3 months' time is S_T = 1.5 USD/GBP, say). But if in 3 months' time, the spot exchange rate is USD/GBP, she can ‘walk away’ from the put option contract (i.e. not exercise the put) and exchange her £3,000 at the higher spot rate (and receive $6,300 from the spot FX-dealer). For the privilege of having this ‘option’ to choose the best outcome in the future, she has to pay the put premium, at the outset.

1.4.2 Speculators and Leverage

We have seen that because the call option premium is small relative to the price of the underlying asset, then speculation with calls can provide a high percentage return on the ‘own capital’ used to purchase the option. In our above examples, buying a call option on stocks gave a return of 167%, whereas buying the stock itself only produced a return of 10% – options therefore provide leverage.

Leverage also applies to futures contracts because a speculator does not have to provide any of her own funds. Suppose on 25 January you ring up Chicago and buy a ‘June-futures’ contract (on stocks-ABC) at a price of . Assume the futures matures on 25 June. In January you do not pay any money – here we ignore (so-called) margin requirements which are small and earn a competitive interest rate, and therefore are not a cost. Suppose on 15 March, you close out your June-futures contract in Chicago by selling at the market price of . You make a cash profit of , on 15 March. Because the futures trade (buying then selling) does not require any ‘own funds’, the percentage return and hence leverage is infinite.

By using futures, speculators can make very large losses as well as very large gains. However, there is a difference between futures and options. In the case of futures the potential loss or gain can be very large. But when call or put options are purchased by speculators, the speculator's loss is limited to the option premium, yet the upside can be very large.

1.4.3 Arbitrageurs

Arbitrage involves ‘locking in’ a riskless profit by entering into transactions in two or more markets simultaneously. Usually ‘arbitrage’ implies that the investor does not use any of his own capital when making the trades. Arbitrage plays a very important role in the determination of both futures and options prices as we shall see in later chapters. Arbitrage is often loosely referred to as the ‘law of one price’ for financial assets. Simply expressed, this implies that identical assets must sell for the same price. We consider a very simple example of arbitrage in Finance Blog 1.2.

Larry Summers, a prominent US economist (and previous US Secretary of the Treasury) rather impishly characterised the difference between economists and traditional finance specialists with the following analogy. He said that economists are interested in why, for example, the price of a bottle of ketchup moves up and down (e.g. because of changes in incomes, relative prices, innovation in production processes, etc.), while finance specialists are only interested in whether a 16 oz bottle of ketchup sells for the same price as two 8 oz bottles. He's only half right.