[Corporate Finance] Foundation of Finance Topics (9): Options and Futures

While diversification can’t eliminate systematic risk, investors use other strategies to manage it, such as hedging. Hedging might involve using financial instruments like options or futures to protect against market-wide losses.
- [Corporate Finance] Foundation of Finance Topics (4): Portfolio Theory

 

Options and futures trading can offer significant benefits, such as hedging and speculative opportunities: Options Trading is about having the choice to buy or sell something at a set price. Futures Trading is making a firm commitment to buy or sell something at a set price in the future. However, they come with high risks. They are typically more suitable for experienced investors who understand the markets and are capable of managing the potential for substantial losses. 

Options

Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) before a specified expiration date.

Key Concepts in Options

• Call Options: Give the holder the right to buy the underlying asset.
• Put Options: Give the holder the right to sell the underlying asset.
• Premium: The price paid to buy an option.
• Strike Price: The set price at which the option can be exercised.
• Expiration Date: The date by which the option must be exercised.
• American vs. European Options: American options can be exercised at any time up to the expiration date, while European options can only be exercised on the expiration date.
• Intrinsic Value and Time Value: The intrinsic value is the difference between the current price of the underlying and the strike price. The time value is the additional amount paid for the option, reflecting its probability of moving in-the-money before expiration.
• Moneyness: Options can be in-the-money (profitable to exercise), at-the-money (the underlying price equals the strike price), or out-of-the-money (not profitable to exercise).

Uses of Options

• Hedging Risk: Investors use options to protect against price movements in the underlying asset.
• Speculation: Traders use options to profit from anticipated price movements.
• Income Generation: Selling options can generate income through the premiums received.

Options in layman's terms

Think of an option like a ticket to a concert. When you buy a concert ticket, you have the right, but not the obligation, to attend the concert. Similarly, in finance: Options give you the right to buy or sell something in the future, but you don't have to if you don't want to.

• Call Option: Like having a ticket to buy a specific item (like stocks) at a set price.
• Put Option: Like having a ticket to sell a specific item at a set price.
• Example 1: You have an option (or 'ticket') to buy a toy for $10 any time in the next month. If the toy's price goes up to $15 in the store, your option is valuable because you can still buy it for $10. But if the toy's price drops to $5, you wouldn't use your option, because you can buy it cheaper in the store.
• Example 2: Imagine you're interested in buying a new phone that's coming out soon, but you're not sure if you'll have the money to buy it when it's released. So, you make a deal with the store: you pay them a small fee now, and in return, they give you the right (but not the obligation) to buy the phone at a fixed price within the next two months.
  
  

Futures

Futures are standardized contracts to buy or sell an asset at a predetermined price at a specified time in the future. Unlike options, futures carry an obligation to buy or sell the asset when the contract expires.

Key Concepts in Futures

• Standardized Contracts: Futures are standardized in terms of quantity, quality (in the case of commodities), delivery time, and place.
• Margin and Leverage: Futures are traded on margin, allowing for significant leverage but also increasing risk.
• Marking to Market: Futures contracts are "marked to market" daily, with gains and losses tallied daily.
• Settlement: Futures can be settled by physical delivery of the asset or by cash settlement.
• Hedging and Speculation: Like options, futures are used for hedging risk and for speculation.

Understanding Futures

• Price Determination: Futures prices are influenced by the current price of the underlying asset, the cost of carry (or storage), and the time to expiration.
• Futures vs. Forwards: Futures are similar to forward contracts but are standardized and traded on exchanges, whereas forwards are private agreements customized between parties.

Futures in layman's terms

Futures are like making a promise or an agreement to buy or sell something at a set price on a future date, no matter what the market price is on that day. Unlike options, with futures, you are obligated to go through with the buy or sell.

• Imagine you're a farmer who grows apples. You agree today to sell 100 apples at $1 each to a store next month (this is your future contract). If the price of apples goes up to $2 next month, you still have to sell them at $1 each as per your agreement. But if the price drops to $0.50, you benefit because you’re still selling at $1.
• Now imagine you're a farmer and you will harvest your crop in three months. You're worried that the prices might drop by the time you harvest. So, you enter into a contract with a buyer to sell your crop at a fixed price in three months. This is useful for managing risk. If you're the farmer, you're protected if prices fall, but if they rise, you might miss out on higher earnings.

Risks in Options and Futures Trading

Both options and futures trading involve significant risks and are generally considered more advanced and complex than trading stocks. 

 

Risk in Options Trading

• Leverage: Options provide leverage, meaning you can control a large amount of the underlying asset with a relatively small investment (the premium paid for the option). While leverage can amplify profits, it also magnifies losses.
  
  • Example: Imagine a stock is trading at $100 per share.
  • Buying Stock Outright: If you buy 100 shares, it costs you $10,000.
  • Buying Call Options: Instead, you decide to buy call options (giving the right to buy the stock at $100). Suppose the option premium is $5 per share. For 100 shares, the cost is only $500.
  • Scenario 1 (Stock Price Rises to $120): If the stock price rises to $120, and you exercise your options, you effectively buy the stock at $100 and can sell it at $120, making a $20 profit per share. Your total profit is $2,000 (100 shares x $20), minus the $500 paid for the options, netting $1,500.
  • Return on Investment: Your initial investment was $500, but you made a $1,500 profit, which is a 300% return, far greater than the 20% increase in the stock price.
  • Scenario 2 (Stock Price Falls): If the stock price falls below $100, your option might expire worthless, and you lose the entire $500 investment, a 100% loss, even if the stock only falls by, say, 10%.
• Premium Loss: If the market doesn't move in the direction you anticipated, you may lose the entire premium paid for the option.
• Complexity: Understanding options requires knowledge of various factors like strike price, expiration date, intrinsic value, time value, and volatility, making them more complex than traditional stock trading.
• Time Decay: Options have an expiration date. As the expiration date approaches, the time value of the option decreases, which can lead to losses if the market doesn't move as expected.
• Example: Imagine you're planning to buy a limited-edition sneaker that's going to be released next month. You're not sure if its price will go up after the release. So, you pay a small fee to the store now for a 'reservation ticket' that gives you the right to buy the sneaker at today's price for the next 30 days.
  • Scenario 1 (Loss): You buy the 'reservation ticket' (like an options premium), but after the release, the sneaker's price drops lower than today's price. Your ticket becomes worthless because you can buy the sneaker cheaper directly from the store. You lose the fee (premium) you paid for the ticket.
  • Scenario 2 (Profit): The sneaker's price goes up after the release. Your 'reservation ticket' lets you buy it at the lower price, so you make a profit. This is like exercising a call option profitably.
• Options Trading Risk: The risk is usually the premium you pay. If the market doesn't move as you expect, you lose the premium, but that's the maximum loss.

Risk in Futures Trading

• Obligation to Fulfill Contract: Unlike options (which give a right but not an obligation), futures contracts involve an obligation to buy or sell the asset at the specified price on the settlement date, regardless of the market price.
• High Leverage: Futures also involve high leverage. A small margin deposit controls a much larger contract value, leading to significant gains or losses.
  
  • Example: Suppose you want to enter into a futures contract for oil, where each contract is for 1,000 barrels. If the price of oil is $60 per barrel, the total contract value is $60,000.
  • Margin Requirement: The exchange might require a margin of 10%, so you only need $6,000 to control a contract worth $60,000.
    
    • Margin in trading, especially in futures and options, is a bit like a security deposit. It's money that you need to deposit with your broker to open and maintain a trading position. There are two main types of margin:
    • Initial Margin: This is the amount you need to deposit to open a position. It's like a down payment to ensure you can cover the potential losses on the trade.
    • Maintenance Margin: This is a lower amount than the initial margin. It's the minimum amount of equity you must maintain in your trading account. If your account balance falls below this due to trading losses, you'll receive a margin call, requiring you to deposit more funds to bring the account back to the initial margin level.
    • The margin can be returned to you, but there are conditions to this:
    • Closing the Position: When you close a futures or options position, the margin you posted is released back to you. If you've made a profit on the trade, this profit is added to your margin. If you've made a loss, the loss is deducted from your margin.
    • Margin Call: If you receive a margin call because the value of your account has fallen below the maintenance margin, you need to deposit additional funds. If you don't meet the margin call, the broker may close your position at a loss, and this loss is deducted from your margin.
  • Scenario 1 (Price Increase): If the price of oil increases to $65 per barrel, the value of the contract is now $65,000. You sell the contract and make a profit of $5,000. This is a high return compared to your initial $6,000 margin.
  • Scenario 2 (Price Decrease): However, if the price drops to $55 per barrel, the value of the contract is now $55,000. If you close the contract, you face a loss of $5,000, which is a significant portion of your initial margin.
  • Magnified Losses: Just as leverage can magnify profits, it can also magnify losses. A small percentage decrease in the underlying asset's price can result in a substantial percentage loss of the initial margin.
• Market Volatility: Futures prices can be highly volatile, and rapid price movements can lead to large gains or losses.
• Liquidity Risk: While most futures contracts are liquid, some less-traded contracts might have lower liquidity, leading to difficulty in exiting positions.
• Example: Think of a wedding planner who has to organize a big wedding in six months. To control costs, they sign a contract with a flower supplier to buy roses at a fixed price in six months, predicting that flower prices will rise.
  • Scenario 1 (Loss): If the market price for roses unexpectedly drops due to, say, a bumper crop, the planner still has to buy at the higher contract price. They could have gotten the roses cheaper without the contract. This is like being on the losing side of a futures contract.
  • Scenario 2 (Profit): If the price of roses increases as predicted, the planner benefits by getting them at the lower, contracted price, saving money compared to the market price. This is a profitable futures contract scenario.
• Futures Trading Risk: The risk can be much higher compared to options trading. You're obligated to buy or sell at the contract price, regardless of the market price. If the market moves against your position, the loss can be substantial.

Mitigating Risks

• Education: Understanding how these instruments work is crucial. Traders should educate themselves thoroughly before engaging in options or futures trading.
• Risk Management Strategies: Employing risk management strategies, such as setting stop-loss orders and only investing money that you can afford to lose, is essential.
• Diversification: Avoid putting all your capital into options or futures; diversifying your investment portfolio can help manage risk.

 

Floor and Ceiling of Options Trading Gain/Loss

For Option Buyers

1. Call Options (Right to Buy):
   • Ceiling on Gains: Theoretically unlimited. As the price of the underlying asset rises, the value of the call option can increase indefinitely.
   • Floor on Losses: The maximum loss is limited to the premium paid for the option. If the option expires worthless (the stock price is below the strike price), the loss is confined to what you paid for the option.
2. Put Options (Right to Sell):
   • Ceiling on Gains: Limited but can be substantial. The maximum gain on a put option occurs if the underlying asset goes to zero. The gain is the strike price minus the premium paid.
   • Floor on Losses: As with call options, the maximum loss for put option buyers is the premium paid.

For Option Sellers (Writers)

1. Selling Call Options:
   • Ceiling on Gains: Limited to the premium received for selling the option.
   • Floor on Losses: Potentially unlimited. If the price of the underlying asset rises significantly, the seller of the call option could face substantial losses.
2. Selling Put Options:
   • Ceiling on Gains: Limited to the premium received for selling the option.
   • Floor on Losses: Substantial but not unlimited. The maximum loss occurs if the underlying asset's price falls to zero. The loss would be the strike price minus the premium received.

Key Points

• Option Buyers: Have limited risk (the premium paid) and potentially unlimited gains for call options or substantial gains for put options.
• Option Sellers: Face limited gains (the premium received) and potentially unlimited losses for call options or substantial losses for put options.

Strategy Implications

Understanding these limits is crucial for developing an options trading strategy. Buyers of options risk only the premium paid and have the potential for significant gains, making it an attractive proposition for those with lower risk tolerance. However, the premium paid can add up over time, especially if many options expire worthless.

Option sellers, on the other hand, face the opposite risk-reward profile. While they receive an immediate premium, they could be exposed to large losses, making option writing a riskier strategy that requires careful risk management.

In summary, options trading comes with inherent floors and ceilings on gains and losses, which vary based on the position (buying or selling) and the type of option (call or put). This structure of risk and reward is a key aspect of options trading strategy.