Understanding Futures and Options

Futures and Options are tools used by investors when trading in the stock market. Futures and Options represent the two of the most common form of derivatives.

Derivatives are financial instruments that derive their value from an underlying. The underlying can be a stock issued by company, index, currency, commodity etc. The derivative instrument can be traded independently of the underlying asset.

A ‘future’ is a contract to buy or sell the underlying asset for a specific price at a predetermined time. If you buy a futures contract it means that you promised to pay the price of the asset at a specified time.

If you sell a future you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time every future contract has the following features:

• Buyer
• Seller
• Price
• Expiry

Some of the most popular assets on which future contracts are available are equity stock, indices, commodities and currency. Buying and selling futures is essentially the same as buying or selling a number of units of a stock from the cash markets, but without taking immediate delivery.

The difference between the price of the underlying asset in the spot market and futures market is called ‘basis’. The basis is usually negative which means that the price of the assets in the futures market is more than the price in the spot market.

This is because of the interest cost, storage cost insurance premium etc. If you buy the asset in the spot market, you will be incurring all these expenses which are not needed if you buy a futures contract. This condition of basis being negative is called as ‘Contango’. A contango simply means that the forward price of a futures contract is above the expected future spot price.

If the price of the asset in the spot market is more than in the futures market the basis becomes positive this condition is called ‘backwardation’. In other words, the forward price of a futures contract is below the expected future spot price. Backwardation generally happens if the price of the asset is expected to fall.

Contango and backwardation are frequently seen in commodity markets where certain factors prompt the price discrepancy between expected future spot prices and the prices of futures contracts.

As the futures contract approaches maturity, the futures price and the spot price tend to close in the gap between them and the basis slowly becomes zero. (The author is a home maker who dabbles in stock market investments in her free time)