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Introduction Derivatives

Terminology

Futures Contract

An agreement between two parties (the buyer and the seller) over a commodity or index for settlement at a predetermined future date and price.

Hedge

Hedging is an investing strategy where the market movement effects from a stock or a portfolio are offset by some other financial instrument. As an example, a stock portfolio can be hedged buy purchasing a Put Option over the S&P 500 index.

Introduction to Derivatives - derivative contracts; picture of an animated contract with a pen signing the signature for an agreement between investors

Derivative

Contracts

These give the investor leverage or they can be used for hedging

A derivative contract is a financial product whose price is based upon or derived from the price of another financial product.

The most common derivatives that stock investors will come across are Options contracts and Futures contracts. These contracts can be over stocks, indices, commodities and currencies. The financial product that the options or futures contracts are over is known as the underlying.

An Options contract is an agreement where the option holder may buy or sell a financial product in the future at a price specified in the agreement. Options contracts are split into buy and sell contracts. A buy contract is referred to as a Call Option and a sell contract is referred to as a Put Option.

The option holder is not obliged to buy or sell in the future, but does have the option to do so. The option holder pays for this privilege. The price of the options contract is based on the price of the underlying but does not follow it directly. Option prices are actually derived from a complex mathematical formula. Basically, if the underlying price increases, the price of call options increase and the price of put options decrease.

A Futures contract is an agreement made between two parties, the buyer and the seller. The price of a futures contract follows the price of the underlying. If the price of the underlying goes up, the futures buyer receives the increased price difference as a cash payment and this is paid by the futures seller. Conversely, if the underlying price goes down, the futures buyer must pay the futures seller the amount that the contracts price decreased by. Thus, a futures contract is essentially an agreement between a buyer and a seller that one will pay the other the price difference.

Single Stock Futures are becoming more popular nowadays. These are future contracts over stocks rather than the traditional futures contracts which are over commodities (such as oil) or over Indices or over Currencies. Single Stock Futures also have contacts over some of the popular index tracking ETFs (Exchange Traded Funds).

Table 1. below shows a sample of some of the popular Single Stock Futures for stocks and index ETFs

Table 1. Popular Single Stock Futures

Derivative Contracts Table 1. Popular Single Stock Futures for investors to use when trading or hedging

There are some basic differences with using Options compared to Single Stock Futures. These are best explained using the following examples.

Example: A stock investor wants to buy a stock in the future but wants to pay the current price of $20 (or at least close to it), the investor can either buy a Call Option for say $2 or enter into a Single Stock Futures contract. Let's suppose that in the future the stock's price has increased to $25.

  • The Call Option allows the investor to buy the stock for $20 even though the price is actually now $25, but the investor did have to pay $2 for this privilege. So the stock actually cost the investor $22.
  • The Single Stock Futures contract requires the seller to pay the investor the price increase of $5, but the investor has to pay the seller $25 for the stock to take delivery of the stock. The net result is that the stock still cost the investor around $20 (which is the $25 paid for the stock less the $5 received from the seller).

But what happens if the stock's price instead of increasing actually decreased to $15.

Example: The stock price decreased to $15

  • The Call Option is just that, an option to buy. If the investor still wants to buy the stock, then the investor can simply buy the stock from the stock market for $15. The total cost for the stock then becomes $17 (the $15 stock price plus the $2 paid for the option).
  • The Single Stock Futures contract requires the investor to pay the seller $5, but the investor now only needs to pay the seller $15 to buy the stock. The net result is that the stock still cost the investor around $20 (which is the $15 paid for the stock plus the additional $5 paid to the seller).

Thus, an options contract costs the investor money to buy the contract, but this does give the investor the option of whether to buy from the option contract or to buy direct from the stock market.

With the Single Stock Futures contact, the investor effectively locks in the current price today (or close to it) and can take settlement of the stock at a future date. Also there are no additional costs with futures contract. However in reality, Single Stock Futures contracts tend to be priced slightly higher than the current stock price. This takes into account the interest rate over the time period until the contracts expiry date.

Both Options and Single Stock Futures contracts have a termination date after which the contract ceases to exist and both Options and Single Stock Futures contracts can be sold at any time prior to their termination date. Also most Options and Single Stock Futures contracts are for 100 shares of the underlying stock. This means the investor has to deal with lots of 100 shares. The investor cannot buy an Options or Single Stock Futures contract for say 133 shares.

Care needs to be taken with derivatives

since they have an expiry date

The price to buy an Options contract can be a small portion of the underlying price. A Single Stock Futures contract involves an upfront payment known as a deposit margin, which is generally also small (in the order of 20% of the underlying price).

Options and Single Stock Futures contracts typically provide a significant amount of leverage. This means that these contracts can be entered into with only a small upfront payment and because of this a lot of short-term speculators and traders actively use derivatives. The derivatives are commonly used to profit directly from the derivative by short-term buying and selling, rather than using the derivative as a means of acquiring the underlying.

Derivatives are also extensively used for hedging purposes. Buying Put Options and selling Single Stock Futures contracts are popular hedging strategies which offset the price decline of the underlying.

For example, a stock investor who is concerned about the short-term price decline of a stock they own can buy a Put Option. If the stock's price drops, the value of the Put Option actually increases which helps offset the stock's loss. The investor also has the option of selling the stock on the Options contract for the price specified in the contract.

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