When you trade in futures contracts, you rarely take possession of the commodity, currency or financial instruments being transacted. That’s because you are purchasing the right to buy or sell at a certain price on a certain date, not the item itself. With options this is not the case , you rent this right. Exchanges allow you to do this for very little money down, allowing the risk-adverse to hedge and risk takers to speculate.
Types
Future contracts and options are traded on barley, canola, cattle, corn, cocoa, coffee, cotton, flaxseed, hogs, lumber, milk, oats, orange juice, pork bellies, soybeans, soybean meal, soybean oil, rice, rye, sugar and wheat; on aluminum, copper, gold, palladium, platinum, and silver, rude oil, electricity, gas oil, gasoline, heating oil, natural gas, propane, the CRB index and even the weather.
Function
Futures contracts and options lock in a price months before the actual sale. They guarantee the seller a fixed income and the buyer a set supply. Doing so greatly reduces uncertainty. They do not, however, eliminate risk. . Options holders can avoid a loss by simply electing not to complete the full transaction. The seller still makes a small profit from the premium the option holder paid to reserve his or her right to buy. Since sellers must honor their deals, option holders profit at the sellers’ expense by exercising their option when the cash price is higher than the fixed one.
Procedures
To buy or sell futures contracts, an investor makes a “good faith” deposit in a futures exchange account. This small sum covers any losses incurred at the end of the trading day. When you enter into a futures contract you must deposit an initial margin of between five and 10 percent of the value of the contract.
Buyers or sellers can opt to close out their position anytime up to the contract’s expiration date. Once settled, the initial margin and the accrued gains or losses are credited or debited into the two parties’ accounts. These funds can then be used to help pay for the cash purchase of the underlying commodity.
Options lease out the ownership rights of futures contracts for a particular day at a particular price. A call option from a buyer is matched electronically or on the floor of an exchange by a broker with a matching put option from a seller. The full value of the contract is called the strike or exercise price. For rights to the option the buyer pays a fee called the premium. On the appointed date, the option is exercised or expires.