difference between options and futures

The main fundamental difference between options and futures lies in the obligations they put on their buyers and sellers. An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract. A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to expiration.

Another key difference between options and futures is the size of the underlying position. Generally, the underlying position is much larger for futures contracts, and the obligation to buy or sell this certain amount at a given price makes futures more risky for the inexperienced investor.

Future

A Future is an exchange-traded derivative which is similar to a forward. Both futures and forwards represent agreements to buy/sell some underlying asset in the future for a specified price. Both can be for physical settlement or cash settlement. Both offer a convenient tool for hedging or speculation. For little or no initial cash outlay, both instruments provide price exposure without a need to immediately pay for, hold or warehouse the underlying asset. In this sense, both instruments are leveraged. Futures and forwards trade on a variety of underlies: wheat, oil, live beef, Eurodollar deposits, gold, foreign exchange, the S&P 500 stock index, etc.

The fundamental difference between futures and forwards is the fact that futures are traded on exchanges. Forwards trade over the counter. This has three practical implications.

forward contract

 A forward contract—or forward—is an OTC derivative. In its simplest form, it is a trade that is agreed to at one point in time but will take place at some later time. For example, two parties might agree today to exchange 500,000 barrels of crude oil for USD 42.08 a barrel three months from today.

A forward contract is specified with four variables:

the underlier,

the notional amount n,

the delivery price k, and

the settlement date on which the underlier and payment will be exchanged.

 

In Above example, oil is the underlier. The notional amount is 500,000 barrels. The delivery price is USD 42 per barrel. The settlement date is the actual date three months from now when the oil will be delivered in exchange for a total payment of USD 21.04MM.

The party who receives the underlier is said to be long the forward. The other party is short.

REPO And Reverse Repo

A repurchase agreement (or repo) is an agreement between two parties whereby one party sells the other a security at a specified price with a commitment to buy the security back at a later date for another specified price

Most repos are overnight transactions, with the sale taking place one day and being reversed the next day. Long-term repos—called term repos—can extend for a month or more. Usually, repos are for a fixed period of time, but open-ended deals are also possible.

 Reverse repo is a term used to describe the opposite side of a repo transaction. The party who sells and later repurchases a security is said to perform a repo. The other party—who purchases and later resells the security—is said to perform a reverse repo.

derivative

A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable. For example, a stock option is a derivative because it derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from one or more interest rate indices. The value(s) from which a derivative derives its value is called its underlier(s).

By contrast, we might speak of primary instruments, although the term cash instruments is more common. A cash instrument is an instrument whose value is determined directly by markets. Stocks, commodities, currencies and bonds are all cash instruments. The distinction between cash and derivative instruments is not always precise, but it is a useful informal distinction.

SWAP

A swap is an agreement between two counterparties to exchange two streams of cash flows—the parties "swap" the cash flow streams. Those cash flow streams can be defined in almost any manner. All that matters is that their present values be equal. Their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability.

 When a swap is first entered into, it has zero market value. This is because both cash flow streams have identical, offsetting market values. As time goes by, the swap is likely to take on a positive or negative market value. This may happen for one or two reasons:

Market variables that affect the market values of one or both cash flow streams will fluctuate, causing the values of the cash flow streams to change.

One cash flow stream may have more accelerated payments than the other, so the swap takes on a positive market value for the party making the more accelerated payments. An extreme case of this is some customized swaps that require one party to make a substantial payment right at the outset.

A swap is a cash-settled OTC derivative under which two counterparties exchange two streams of cash flows. It is called an interest rate swap if both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations.

The most popular interest rate swaps are fixed-for-floating swaps under which cash flows of a fixed rate loan are exchanged for those of a floating rate loan.

OPTION

An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. The owner of a property might sell another party an option to purchase the property any time during the next three months at a specified price.

Option contracts are a form of derivative instrument. Stand-alone options trade on exchanges or OTC.

Options take many forms. The two most common are:

call options, which provide the holder the right to purchase an underlier at a specified price;

put options, which provide the holder the right to sell an underlier at a specified price.

The strike price of a call (put) option is the contractual price at which the underlier will be purchased (sold) in the event that the option is exercised. The last date on which an option can be exercised is called the expiration date. Options may allow for one of two forms of exercise:

With American exercise, the option can be exercised at any time up to the expiration date.

With European exercise, the option can be exercised only on the expiration date.

 

A third form of exercise, which is occasionally used with OTC options, is Bermudan exercise. A Bermuda option can be exercised on a few specific dates prior to expiration. Yes, the name was chosen because Bermuda is half way between America and Europe.