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FORWARD CONTRACT

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to [1] buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized [2] assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to [clarification needed] better secure the party at gain.

Payoffs
The value of a forward position at maturity depends on the relationship between the delivery price (K) and the underlying price (ST) at that time.   For a long position this payoff is: fT = ST − K For a short position, it is: fT = K − ST 

How a forward contract works
Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.

Example of how forward prices should be agreed upon
Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered.

Spot - forward parity
Main article: Forward price See also: Cost of carry and convenience yield For liquid assets ("tradeables"), spot-forward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset:    pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as  an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities);  or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.)

Investment assets
For an asset that provides no income, the relationship between the current forward (F0) and spot (S0) prices is

F0 = S0erT
where r is the continuously compounded risk free rate of return, and T is the time to maturity. The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational pricing below. For an asset that pays known income, the relationship becomes:   Discrete: F0 = (S0 − I)e Continuous: F0 = S0e
rT

(r − q)T

where is the present value of the discrete income at time t1 < T, and q%p.a. is the continuous dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. Hence the income (I or q) must be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and example of an asset which pays a continuous yield might be a foreign currency or a stock index. For investment assets which are commodities, such as gold and silver, storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes:   Discrete: F0 = (S0 + U)e Continuous: F0 = S0e
rT

(r + u)T

is the convenience yield over the life of the contract.a. which means a [1] higher convenience yield. The opposite is true when high inventories exist. and are referred to as the convenience yield. this implies a greater chance of shortage. Hence. for example crude oil or iron ore. Relationship between the forward price and the expected future spot price Main articles: Normal backwardation and Contango . Thus. is the storage cost where it is proportional to the price of the commodity. c. for consumption assets. Thus. However. all of the costs and benefits above can be summarised as the cost of carry. The intuition here is that because storage costs make the final price higher. Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset.a. and is hence a 'negative yield'. These benefits include the ability to profit from temporary shortages and the [1] ability to keep a production process running. Cost of carry The relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that asset relative to holding the forward. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward. If users have low inventories of the commodity. it is important to note that the convenience yield is a non cash item. where c = r − q + u − y. the spot-forward relationship is:   Discrete storage costs: F0 = (S0 + U)e Continuous storage costs: F0 = S0e (r − y)T (r + u − y)T where y%p.where is the present value of the discrete storage cost at time . and u%p.   Discrete: F0 = (S0 + U − I)e cT (r − y)T Continuous: F0 = S0e . it can be modelled as a type of 'dividend yield'. but rather reflects the market's expectations concerning future availability of the commodity. we have to add them to the spot price. Consumption assets Consumption assets are typically raw material commodities which are used as a source of energy or in a production process.

if the speculators expect to profit. . Thus. where K is the delivery price at maturity Thus. it must be the case that the expected future spot price is greater than the forward price. In other words. the natural hedgers of [3][4] a commodity are those who wish to sell the commodity at a future point in time. hedgers will collectively hold a net short position in the forward market. There are a number of different hypotheses which try to explain the relationship between the current forward price. F0 and the expected future spot price. and thus will accept losing money on their forward contracts. Hedgers are interested in reducing risk.The market's opinion about what the spot price of an asset will be in the future is the expected future [1] spot price. a key question is whether or not the current forward price actually predicts the respective spot price in the future. the expected payoff to the speculator at maturity is: E(ST − K) = E(ST) − K. E(ST) − K > 0 E(ST) > K E(ST) > F0. The economists John Maynard Keynes and John Hicks argued that in general. Hence. are interested in making a profit. as K = F0 when they enter the contract This market situation. who must therefore hold a net long position. The other side of these contracts are held by speculators. where E(ST) > F0. E(ST). is referred to as normal backwardation. if speculators are holding a net long position. Speculators on the other hand. Since forward/futures prices converge with the spot price at maturity (see basis). and will hence only enter the contracts if they expect to make money. Thus.

A short forward contract means that the investor owes the counterparty the stock at time T. Then we have two possible cases. go to the bank and get a loan with amount St at the continuously compounded rate r. you will see that if there are finite stocks/inventory. is positive. with this money from the bank. Case 2: Suppose that Ft. This is called a cash and carry arbitrage because you "carry" the stock until maturity.. r(T − t) r(T − t) Extensions to the forward pricing formula Suppose that FVT(X) is the time value of cash flows X at the contract expiration time T. buy one unit of stock for St.T because the buyer receives ST from the investor. Specifically.T > Ste trades at time t: r(T − t) .T = Ste . Consequently. . Then an investor can do the reverse of what he has done above in case 1. At time T the investor can reverse the trades that were executed at time t. enter into one short forward contract costing 0. where E(ST) < F0. The sum of the inflows in 1. 2. It would depend on the elasticity of demand for forward contracts and such like. and 3. The inflow to the investor is − Ste r(T − t) . which by hypothesis. The opposite situation.T − Ste .' and 2. and r is the continuously compounded r(T − t) rate. The initial cost of the trades at the initial time sum to zero. This is an arbitrage profit. then the forward price at a future time T must satisfy Ft.normal backwardation implies that futures prices for a certain maturity are increasing over time. To prove this. the investor 1.T < Ste . suppose not. or costs of maintaining the asset. 2. contango implies that futures prices for a certain maturity are [5] falling over time.T. we have a contradiction. 3. and assuming that the nonarbitrage condition holds. But if you look at the convenience yield page. Then an investor can execute the following 1. ' repays the loan to the bank. is referred to ascontango. Rational pricing If St is the spot price of an asset at time t. The cash inflow to the investor is now Ft. Case 1: Suppose that Ft. the reverse cash and carry arbitrage is not always possible. 2. The forward price is then given by the formula: The cash flows can be in the form of dividends from the asset. and mirroring the trades 1. Likewise. ' settles the short forward contract by selling the stock for Ft.' equals Ft.

If these price relationships do not hold.T = (St − It)er(T − t) Where It is the time t value of all cash flows over the life of the contract. there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices.the relationship between forward and spot prices is driven by interest rates. . For perishable commodities. the forward price for nonperishable commodities. see forward price. securities or currency is no more a predictor of future price than the spot price is . For more details about pricing. arbitrage does not have this The above forward pricing formula can also be written as: Ft. As a result.

if it is a cash-settled futures contract. The contracts are traded on a futures exchange. the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short). is said to be "long". The difference in futures prices is then a profit or loss. Aristotle described the story of Thales. The terminology reflects the expectations of the parties -. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date. securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. Thus the exchange requires both parties to put up an initial amount of cash. However. as on the exchange. then a margin call is made and the account owner must replenish the margin account. is said to be "short".FUTURES CONTRACT In finance. the underlying asset to a futures contract may not be traditional commodities at all – that is. Thales used his skill in forecasting and predicted that . Unlike an option. To exit the commitment prior to the settlement date. The party agreeing to buy the underlying asset in the future. the margin. the delivery date. In many cases. both parties of a futures contract must fulfill the contract on the delivery date. or. Nor is the contract standardized. the "buyer" of the contract. which involves a principle of universal application". Thus on the delivery date. If the margin account goes below a certain value. then cash is transferred from the futures trader who sustained a loss to the one who made a profit.the buyer hopes or expects that the asset price is going to increase. the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. while the seller hopes or expects that it will decrease. the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. While the futures contract specifies a trade taking place in the future. and the party agreeing to sell the asset in the future. the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market). Additionally. the "seller" of the contract. a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date. for financial futures the underlying asset or item can becurrencies. a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. The seller delivers the underlying asset to the buyer. This process is known as marking to market. since the futures price will generally change daily. Note that the contract itself costs nothing to enter. The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. a poor philosopher from Miletus who developed a "financial device. A closely related contract is a forward contract. the difference in the prior agreed-upon price and the daily futures price is settled daily also.

In the case of bonds.   The type of settlement.[2] The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864.   The currency in which the futures contract is quoted. This can be the notional amount of bonds. the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world. and many presses were wanted concurrently and suddenly. Confident in his prediction. a fixed number of barrels of oil.[1] The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s. this specifies not only the quality of the underlying goods but also the manner and location of delivery. he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. units of foreign currency.    The delivery month.[3] By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex. When the harvest time came. The amount and units of the underlying asset per contract. etc. the notional amount of the deposit over which the short term interest rate is traded.[4] [edit]Standardization Futures contracts ensure their liquidity by being highly standardized. this specifies which bonds can be delivered. either cash settlement or physical settlement. and made a large quantity of money. to meet the needs of samurai who—being paid in rice. the minimum permissible price fluctuation. as well as the pricing point -. raw jute and jute goods and bullion. usually by specifying:  The underlying asset or instrument. he let them out at any rate he pleased. The last trading date. [edit]Margin . This could be anything from a barrel of crude oil to a short term interest rate. which were called futures contracts. Other details such as the commodity tick. The grade of the deliverable. and after a series of bad harvests—needed a stable conversion to coin. In the case of physical commodities. For example.the location where delivery must be made.the olive harvest would be exceptionally good the next autumn.

typically 5%-15% of the contract's value. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. The maximum exposure is not limited to the amount of the initial margin. This is a type of performance bond. trades executed on regulated futures exchanges are guaranteed by a clearing house. This enables traders to transact without performing due diligence on their counterparty. Futures Commission Merchants are responsible for overseeing customer margin accounts. Also referred to as performance bond margin. and the seller to each buyer. To minimize counterparty risk to traders. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. . The clearing house becomes the buyer to each seller. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial margin is the equity required to initiate a futures position.To minimize credit risk to the exchange. Initial margin is set by the exchange. however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. traders must post a margin or a performance bond. Customer margin Within the futures industry. so that in the event of a counterparty default the clearer assumes the risk of loss. Margins are determined on the basis of market risk and contract value.

Some U. that would be about 77% annualized. The low margin requirements of futures results in substantial leverage of the investment. in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U. Calls for margin are usually expected to be paid and received on the same day.S. but rather it is a security deposit. A futures account is marked to market daily. [edit]Settlement . However. can set it above that. Markets). however. The broker may set the requirement higher. After the position is closed-out the client is liable for any resulting deficit in the client’s account. The Initial Margin requirement is established by the Futures exchange. the exchanges require a minimum amount that varies depending on the contract and the trader. if he does not want to be subject to margin calls. a margin call will be issued to bring the account back up to the required level. exchanges also use the term ―maintenance margin‖. representing the amount of their trading capital that is being held as margin at any particular time. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. the broker will make a margin call in order to restore the amount of initial margin available. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. which in effect defines by how much the value of the initial margin can reduce before a margin call is made. most non-US brokers only use the term ―initial margin‖ and ―variation margin‖. margin called for this reason is usually done on a daily basis. A trader. of course.physical versus cash-settled futures . Margin-equity ratio is a term used by speculators.S. However. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. in times of high volatility a broker can make a margin call or calls intra-day. For example if a trader earns 10% on margin in two months. ROM may be calculated (realized return) / (initial margin). If not. Often referred to as ―variation margin‖.If a position involves an exchange-traded product. the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded. If the margin drops below the margin maintenance requirement established by the exchange listing the futures. the broker has the right to close sufficient positions to meet the amount called by way of margin. but may not set it lower. Margin in commodities is not a payment of equity or down payment on the commodity itself.

the March futures become the nearest contract. purchasing underlying components of those indexes to hedge against current index positions. then the price of a futures contract is determined via arbitrage arguments.a cash payment is made based on the underlying reference rate. as well as the final settlement price for that contract. Physical delivery is common with commodities and bonds. for most CME and CBOT contracts. or selling a contract to liquidate an earlier purchase (covering a long). could not be settled by delivery of the referenced item . such as a short term interest rate index such as Euribor. treasury bond futures. the increase in volume is caused by traders rolling over positions to the next contract or.[5] Cash settled futures are those that. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. The Nymex crude futures contract uses this method of settlement upon expiration  Cash settlement . in the case of equity index futures. Ice Brent futures use this method. and futures on physical commodities when they are in supply (e. This is typical for stock index futures. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. In practice. as a practical matter. This is an exciting time for arbitrage desks. Expiry (or Expiration in the U. At this moment also. For many equity index and interest rate futures contracts (as well as for most equity options).that is. agricultural crops after the harvest). and can be done in one of two ways.S. which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge.) is the time and the day that a particular delivery month of a futures contract stops trading.the futures price cannot be fixed by arbitrage. However. when the deliverable commodity is not in plentiful supply or when it does not yet exist . In . or the closing value of a stock market index. and by the exchange to the buyers of the contract. On this day the t+1 futures contract becomes the t futures contract. it occurs only on a minority of contracts.e. Most are cancelled out by purchasing a covering position . or may be freely created. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs.Settlement is the act of consummating the contract. as specified per type of futures contract:  Physical delivery . a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour. On the expiry date.for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) . at the expiration of the December contract.i. this happens on the third Friday of certain trading months. buying a contract to cancel out an earlier sale (covering a short). [edit]Pricing When the deliverable asset exists in plentiful supply.the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange. For example.g.

and convenience yields. in a shallow and illiquid market. Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures. differential borrowing and lending rates. the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down. for a simple. as expressed by supply and demand for the futures contract. Here. which is simple supply and demand for the asset in the future. In a deep and liquid market. as the arbitrage mechanism is not applicable. will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r. F(t).this scenario there is only one force setting the price. supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship. or may be freely created. or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known ascornering the market). in practice there are various market imperfections (transaction costs. restrictions on short selling) that prevent complete arbitrage. non-dividend paying asset. dividends. . the value of the future/forward. [edit]Arbitrage arguments Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply. dividend yields. Thus. the forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. the futures price in fact varies within arbitrage boundaries around the theoretical price. with continuous compounding This relationship may be modified for storage costs. [edit]Pricing via expectation When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied. By contrast. In a perfect market the relationship between futures and spot prices depends only on the above variables. Thus. . or.

follow the links. or where a far future delivery price is higher than a nearer future delivery. reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities. With this pricing rule. is known as contango. [edit]Contango and backwardation The situation where the price of a commodity for future delivery is higher than the spot price. For information on futures markets in specific underlying commodity markets. For a list of tradable commodities futures contracts. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. where the price of a commodity for future delivery is lower than the spot price. See also the futures exchange article. currencies or intangibles such as interest rates and indexes.[edit]Relationship between arbitrage arguments and expectation The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability. when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. a speculator is expected to break even when the futures market fairly prices the deliverable commodity. exchange trading has . see List of traded commodities. The reverse. Futures contracts and exchanges Contracts There are many different kinds of futures contracts. or where a far future delivery price is lower than a nearer future delivery. Trading in the US began in the mid 19th century.      Foreign exchange market Money market Bond market Equity market Soft Commodities market Trading on commodities began in Japan in the 18th century with the trading of rice and silk. meat and livestock. Although contract trading began with traditional commodities such as grains. securities (such as single-stock futures). and similarly in Holland with tulip bulbs. is known as backwardation.

lead. orange juice. Inactive market in Baltic Exchange shipping. Soybeans. gold. government interest rates and private interest rates.) . TOPIX Futures) Tokyo Commodity Exchange TOCOM Tokyo Financial Exchange . currency and currency indexes.(Euroyen Futures.)  IntercontinentalExchange (ICE Futures Europe) . CAC 40. (LIFFE had taken over London Commodities Exchange ("LCE") in 1996). FTSE 100. Milk). etc.energy and metals: crude oil. Index (Dow Jones Industrial Average).TFX .which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was merged. aluminum and palladium .softs: grains and meats. Cattle. This innovation led to the introduction of many new futures exchanges worldwide. Various Interest Rate derivatives (including US Bonds). AEX index. Soy Products. Metals (Gold. gasoline. energy. RNP Futures) London Metal Exchange . Index (NASDAQ.expanded to include metals. Agricultural (Corn.liffe). heating oil. tin and steel IntercontinentalExchange (ICE Futures U. Pork. propane. Butter. S&P. copper.metals: copper. coffee. Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Index futures include EURIBOR. nickel. cotton.S. heating oil.Currencies. sugar  New York Mercantile Exchange CME Group. silver. natural gas. zinc. SpotNext RepoRate Futures)    Osaka Securities Exchange OSE (Nikkei Futures. equities and equity indexes.SAFEX Sydney Futures Exchange Tokyo Stock Exchange TSE (JGB Futures. OverNight CallRate Futures.formerly New York Board of Trade softs: cocoa. Silver). natural gas and unleaded gas  NYSE Euronext .formerly the International Petroleum Exchange trades energy including crude oil. there are more than 90 futures and futures options exchanges worldwide trading to include: [6]  CME Group (formerly CBOT and CME) -.      South African Futures Exchange . platinum. coal. aluminium. such as the London International Financial Futures Exchange in 1982 (now Euronext. Exchanges Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. Today. Wheat.

November (X) 2010 (0) contract. In other words. Who trades futures? Futures traders are traditionally placed in one of two groups: hedgers.SGX . .KRX Singapore Exchange . who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes.   Dubai Mercantile Exchange Korea Exchange .into which merged Singapore International Monetary Exchange (SIMEX)  ROFEX . the third character identifies the month and the last character is the last digit of the year. The first two characters identify the contract type. who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper". while they have no practical use for or intent to actually take or make delivery of the underlying asset.Rosario (Argentina) Futures Exchange Codes Most Futures contracts codes are four characters. the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract. Third (month) futures contract codes are             January = F February = G March = H April = J May = K June = M July = N August = Q September = U October = V November = X December = Z Example: CLX0 is a Crude Oil (CL). and speculators.

for example. so that they can plan on a fixed cost for feed. and swing traders aim to buy or sell at the bottom or top of price swings. The social utility of futures markets is considered to be mainly in the transfer of risk. from a hedger to a speculator.Hedgers Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. This also preserves balanced diversification. the portfolio manager can close the contract and make purchases of each individual stock. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price. day traders. in traditional commodity markets.[7] With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil. In modern (financial) markets. [8] An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. livestock producers often purchase futures to cover their feed costs. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased). and swing traders (swing trading). maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. and experts are divided on the matter. day traders (or active traders) enter multiple trades during the day and will have exited all positions by market close. Similarly. "producers" of interest rate swaps or equity derivativeproducts will use financial futures or equity index futures to reduce or remove the risk on the swap. though many hybrid types and unique styles exist. making it easier for them to plan. and increased liquidity between traders with different risk and time preferences. Speculators Speculators typically fall into three categories: position traders. For example. In general position traders hold positions for the long term (months to years). Options on futures .

. Investors can either take on the role of option seller/option writer or the option buyer. COT-Report or simply COTR. and a call is the option to buy a futures contract. Option sellers are generally seen as taking on more risk because they are contractually obligated to take the opposite futures position if the options buyer exercises his or her right to the futures position specified in the option. the option strike price is the specified futures price at which the future is traded if the option is exercised. Futures are often used since they are delta one instruments. options are traded on futures. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. and under contract can fine companies for different things or extend the fine that the CFTC hands out. This type of report is referred to as the 'Commitments of Traders Report'. A put is the option to sell a futures contract. The price of an option is determined by supply and demand principles and consists of the option premium. We describe a futures contract with delivery of item J at the time T:  There exists in the market a quoted price F(t.  The price of entering a futures contract is equal to zero.T). Although by law the commission regulates all transactions. [9] Futures contract regulations All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC). These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. sometimes called simply "futures options".In many cases. Definition of futures contract Following Björk[10] we give a definition of a futures contract. or the price paid to the option seller for offering the option and taking on risk. which is known as the futures price at time t for delivery of J at time T. For both. The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. each exchange can have its own rule. an independent agency of the United States government. namely Black's formula for futures. Calls and options on futures may be priced similarly to those on traded assets by using an extension of the BlackScholes formula.

The trend is for the CBOT to continue to restrict those entities that can actually participate in settling commodities contracts to those that can ship or receive large quantities of railroad cars and multiple barges at a few selected sites. the failure of futures contracts and the value of the physical commodities they represent to reach the same value on 'contract settlement' day at the designated delivery points. while forwards are customized and face a non-exchange counterparty. Please improve it by verifying the claims made and adding references. while forwards are traded over-the-counter. the ability of the markets to discern the appropriate value of a commodity reflecting current conditions.T). An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures.s]. It follows that the function of 'price discovery'. Nonconvergence This section may contain original research.T) and is entitled to receive J. has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market. they are different in two main respects:  Futures are exchange-traded. is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent. the holder pays F(T. (this reflects  At time T. which has oversight of the futures market in the United States.00 difference between settlement days. (April 2008) Some exchanges tolerate 'nonconvergence'.T) should be the spot price of J at time T. while forwards are not.  Futures are margined. TheCommodity Futures Trading Commission. During any time interval [t. Thus futures are standardized and face an exchange. Statements consisting only of original research may be removed.[11] Futures versus forwards While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price. More details may be available on the talk page.T) instantaneous marking to market) − F(t. Note that F(T. SRW futures have settled more than 20¢ apart on settlement day and as much as $1. Therefore. . the holder receives the amount F(s. it's impossible for almost any individual producer to 'hedge' efficiently when relying on the final settlement of a futures contract for SRW. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to settle futures contracts.

Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs. Margining For more details on Margin.assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery. The fact that forwards are not margined daily means that. for example.Thus futures have significantly less credit risk. More typical would be for the parties to agree to true up. The counterparty for delivery on a futures contract is chosen by the clearing house. the spread in exchange rates is not trued up regularly but. this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. or can simply be a signed contract between two parties. the time the contract is closed prior to expiration) . Exchange versus OTC Futures are always traded on an exchange. being over-the-counter. They may transact only on the settlement date. and have different funding. so if the buyer of the contract incurs a drop in value.  In the case of physical delivery. due to movements in the price of the underlying asset. Again. Forwards do not have a standard. rather. an unrealized gain (loss) can build up. whereas forwards can be unique. the forward contract specifies to whom to make the delivery. This true-ing up occurs by the "loss" party providing additional collateral. see Margin (finance). The result is that forwards have higher credit risk than futures. being exchange-traded. In a forward though. a large differential can build up between the forward's delivery price and the settlement price. the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring . In most cases involving institutional investors. and in any event. the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. Thus:  Futures are highly standardized. every quarter. and that funding is charged differently. it builds up as unrealized gain (loss) depending on which side of the trade being discussed. whereas forwards always trade over-the-counter.

rather than an individual party. Thus. the risk of a forward contract is that the supplier will be unable to deliver the referenced asset. while the forward's spot price converges to the settlement price. This means that the "mark-to-market" calculation would requires the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). potentially building up a large balance. strictly speaking. while for a forward contract the gain or loss remains unrealized until expiry. On day 51. where no daily true-up takes place in turn creates credit risk for forwards. a European-style derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry. to the holder of the other side of the future. not the gain or loss over the life of the contract. that futures contract costs $90. except for tiny effects of convexity bias (due to earning or paying interest on margin). Simply put. Example: Consider a futures contract with a $100 price: Let's say that on day 50. the daily futures-settlement failure risk is borne by an exchange. further limiting credit risk in futures. a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes.000. however. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss. due to the path dependence of funding. for both assets the gain or loss accrues over the holding period. the loss party wires cash to the other party. via margin accounts. The threshold amount for daily futures variation margin for institutional investors is often $1. That is. this may be reflected in the mark by an allowance for credit risk. may pay nothing until settlement on the final day. In addition. This difference is generally quite small though. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. while under mark to market accounting. The situation for forwards. a futures contract is not. So. . but also on the path of prices on the way. however. Note that.back and forth small sums of cash. for a futures this gain or loss is realized daily. but not so much for futures. or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. This money goes. futures and forwards with equal delivery prices result in the same total loss or gain. A forward-holder.

and options can in principle be created for any type of valuable asset.g. the premium. called writing the option. In return for assuming the obligation. a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. 100 shares of XYZ Co. An option can usually be sold by its original buyer to another party. while the seller incurs the corresponding obligation to fulfill the transaction. at minimum. An option which conveys the right to buy something at a specific price is called a call. however. If the option is not exercised by the expiration date. they usually contain [4] the following specifications:       whether the option holder has the right to buy (a call option) or the right to sell (a put option) the quantity and class of the underlying asset(s) (e. if the option is exercised. which is the price at which the underlying transaction will occur upon exercise the expiration date. from the buyer. it becomes void and [1] worthless. B stock) the strike price. an option which conveys the right to sell something at a specific price is called aput. Other types of options exist. but not the obligation. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock. or expiry. an option is a derivative financial instrument that specifies a contract between two parties for [1] a future transaction on an asset at a reference price. a bond. The process of activating an option and thereby trading the underlying at the agreed-upon price is referred to as exercising it. Contract specifications Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. for instance whether the writer must deliver the actual asset on exercise. while other over-the-counter options are customized ad hoc to the desires of the buyer.. The buyer of the option gains the right. which is the last date the option can be exercised the settlement terms. the originator of the option collects a payment. The reference price at which the underlying asset may be traded is called the strike price or exercise price. Many options are created in standardized form and traded on an anonymous options exchange among the general public. to engage in that transaction. also known as the exercise price. Most options have an expiration date. Option contracts may be quite complicated.OPTION In finance. usually by [2][3] an investment bank. or may simply tender the equivalent cash amount the terms by which the option is quoted in the market to convert the quoted price into the actual premium – the total amount paid by the holder to the writer . The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent.

bond options and other interest rate options stock market index options or. also called "dealer options") are traded between two private parties. and are not listed on an exchange.. currency cross rate options.Types The Options can be classified into following types: Exchange-traded options  Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives. particularly in the U. However. and are settled through a clearing housewith fulfillment guaranteed by the credit of the exchange. Option types commonly traded over the counter include: 1. Exchange-traded options include:       stock options. Bermudan option – an option that may be exercised only on specified dates on or before expiration. . options on swaps or swaptions. and 3. Since the contracts are standardized. which are awarded by a company to their employees as a form of incentive compensation. commodity options. many of the valuation and risk management principles apply across all financial options. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. and prepayment options are usually included in mortgage loans. Other option types Another important class of options. at least one of the counterparties to an OTC option is a well-capitalized institution. Option styles Main article: Option style Naming conventions are used to help identify properties common to many different types of options. for example real estate options are often used to assemble large parcels of land. In general.S. are employee stock options. simply. These include:    European option – an option that may only be exercised on expiration. Exchange traded options have standardized contracts. interest rate options 2. Other types of options exist in many financial contracts. American option – an option that may be exercised on any trading day on or before expiry. accurate [5][6] pricing models are often available. index options and options on futures contracts callable bull/bear contract Over-the-counter  Over-the-counter options (OTC options.

   Barrier option – any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. particularly in relation to the current market price of the underlying (in the money vs. and an estimate of the future volatility of the underlying security's price over the life of the option. These models are implemented using a [8] variety of numerical techniques. out of the money).k. Thorp. the application of the model in actual options trading is clumsy because of the assumptions of continuous (or no) dividend payment. In general. and a constant interest rate. Nevertheless. More sophisticated models are used to model the volatility smile. the Black-Scholes model is still one of the most important methods [11] and foundations for the existing financial market in which the result is within the reasonable range. constant volatility. The most basic model is the Black-Scholesmodel.. varying both for time and for the price level of the underlying security. Black-Scholes Main article: Black–Scholes Following early work by Louis Bachelier and later work by Edward O. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option. The following are some of the principal valuation techniques used in practice to evaluate option contracts. it has been observed that market implied volatility for options of lower strike prices are typically higher than for higher strike prices. suggesting that volatility is stochastic. the cost of holding a position in the underlying security. the model generates hedge parameters necessary for effective risk management of option holdings. More advanced models can require additional factors. Stochastic volatility models Main article: Heston model Since the market crash of 1987. While the ideas behind the Black-Scholes model were ground-breaking and eventually led to Scholes and Merton receiving the Swedish Central Bank's associated Prize for Achievement in [10] Economics (a.a. the Nobel Prize in Economics). standard option valuation models depend on the following factors:      The current market price of the underlying security. [7] Valuation models Main article: Valuation of options The value of an option can be estimated using a variety of quantitative techniques based on the concept of risk neutral pricing and using stochastic calculus. Black and Scholes produced a [9] closed-form solution for a European option's theoretical price. such as an estimate of how volatility changes over time and for various underlying price levels. At the same time. Exotic option – any of a broad category of options that may include complex financial structures. the strike price of the option. the time to expiration together with any restrictions on when exercise may occur. Stochastic volatility models have . including interest and dividends. Vanilla option – any option that is not exotic. or the dynamics of stochastic interest rates. Fischer Black and Myron Scholes made a major breakthrough by deriving a differential equation that must be satisfied by the price of any derivative dependent on a non-dividend-paying stock.

Monte Carlo models Main article: Monte Carlo methods for option pricing For many classes of options. and American options can be modeled as well as European ones.g. Binomial models are widely used by professional option traders. the binomial model is considered more accurate than Black-Scholes because it is more flexible. The resulting solutions are readily computable. This value can approximate the theoretical value produced by Black Scholes. The average of these payoffs can be discounted to yield [15] an expectation value for the option. Note though. discrete future dividend payments can be modeled correctly at the proper forward time steps. each of which results in a payoff for the option. particularly when fewer time-steps are modelled. Analytic techniques In some cases.been developed including one developed by S. down or stable path. Rather than attempt to solve the differential equations of motion that describe the option's value in relation to the underlying security's price. allowing for an up. e. See also: SABR Volatility Model [12] Model implementation Further information: Valuation of options Once a valuation model has been chosen. as are their "Greeks". Stephen Ross and Mark [13] [14] Rubinstein developed the original version of the binomial options pricing model. traditional valuation techniques are intractable because of the complexity of the instrument. to the desired degree of precision.L.. The model starts with a binomial tree of discrete future possible underlying stock prices. Once expressed in this form. a finite difference model can be derived. a Monte Carlo model uses simulation to generate random price paths of the underlying asset. while other stochastic volatility models require complex numerical [12] methods. Binomial tree pricing model Main article: Binomial options pricing model Closely following the derivation of Black and Scholes. Heston. In these cases. it is less commonly used as its implementation is more complex. One principal advantage of the Heston model is that it can be solved in closed-form. TheTrinomial tree is a similar model. a Monte Carlo approach may often be useful. using simulation for American styled options is somewhat more complex than for lattice based models. there are a number of different techniques used to take the mathematical models to implement the models. although considered more accurate. John Cox. Finite difference models Main article: Finite difference methods for option pricing The equations used to model the option are often expressed as partial differential equations (see for example Black–Scholes PDE). It models the dynamics of the option's theoretical value for discrete time intervals over the option's life. that despite its flexibility. However. one can take the mathematical model and using analytical methods develop closed form solutions such as Black-Scholes and the Black model. and . By constructing a riskless portfolio of an option and stock (as in the Black-Scholes model) a simple formula can be used to find the option price at each node in the tree.

A trinomial tree option pricing model can be shown to be a simplified application of the explicit finite difference method. Γ.5 and volatility falls to 23. For instance. with XYZ currently trading at $48. Other models Other numerical implementations which have been used to value options include finite element methods. or some combination of these – that are not tractable in closed form. This technique can be used effectively to understand and manage the risks associated with standard options. the risks associated with holding options are more complicated to understand and predict. various short rate models have been developed for the valuation of interest rate derivatives. Although the finite difference approach is mathematically sophisticated. bond options and swaptions. 0. XYZ stock rises to $48.022).5%. Γ. implicit finite difference and the Crank-Nicholson method.439. or volatility. Additionally. lattice-based. one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs. at any point in time. The corresponding price sensitivity formula for this portfolio Π is: Example A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50.0631. allow for closed-form. 9. We can calculate the estimated value of the call option by applying the hedge parameters to the new model inputs as: .the valuation obtained. The hedge parameters Δ. and −0. the change in the value of an option can be derived from Ito's lemma as: where the Greeks Δ. unlike traditional securities. dσ and dt. These. However. κ and θ are the standard hedge parameters calculated from an option valuation model. Thus. the theoretical value of the option is $1. A number of implementations of finite difference methods exist for option valuation. the return from holding an option varies non-linearly with the value of the underlying and other factors. respectively. risk free rate. With future realized volatility over the life of the option estimated at 25%. κ. In general. and dS. by offsetting a holding in an option with the quantity − Δ of shares in the underlying. Risks As with all securities. and simulation-based modelling. dσ and dt are unit changes in the underlying's price. such as Black-Scholes. it is particularly useful where changes are assumed over time in model inputs – for example dividend yield. dS. with corresponding advantages and considerations. the underlying's volatility and time. θ are (0. respectively.6.89. a trader can form a delta neutral portfolio that is hedged from loss for small changes in the underlying's price. similarly. trading options entails the risk of the option's value changing over time. Therefore. including: explicit finite difference. Assume that on the following day. provided the changes in these values are small.

which typically has the highest rating (AAA). enforcement of market regulation to ensure fairness and transparency. The risk can be minimized by using a financially strong intermediary able to make good on the trade. Listings and prices are tracked and can be looked up byticker symbol. As an intermediary to both sides of the transaction. regardless of their best efforts to avoid such a residual. the value of the option increases by $0. the benefits the exchange provides to the transaction include:     fulfillment of the contract is backed by the credit of the exchange. and maintenance of orderly markets. Counterparty risk A further.14. Ordinarily. but instead between two independent parties. However. By publishing continuous. Trading The most common way to trade options is via standardized options contracts that are listed [16] by various futures and options exchanges. users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. . the net loss under the same scenario would be ($15. Pin risk Main article: Pin risk A special situation called pin risk can arise when the underlying closes at or very close to the option's strike value on the last day the option is traded prior to expiration. In addition.86). an exchange enables independent parties to engage in price discovery and execute transactions. often ignored. where by the trader had also sold 44 shares of XYZ stock as a hedge. In an option contract this risk is that the seller won't sell or buy the underlying asset as agreed. unwanted residual position in the underlying when the markets open on the next trading day after expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. and conform to each others clearing and settlement procedures. Therefore. at least one of the counterparties is a well-capitalized institution.9514. especially during fast trading conditions. realizing a profit of $6. OTC counterparties must establish credit lines with each other.0614 to $1. By avoiding an exchange. but in a major panic or crash the number of defaults can overwhelm even the strongest intermediaries.Under this scenario. the option writer may end up with a large. risk in derivatives such as options is counterparty risk. Note that for a delta neutral portfolio. counterparties remain anonymous. Over-the-counter options contracts are not traded on exchanges. live markets for option prices.

but has the right to do so until the expiration date. he can control (leverage) a much larger number of shares. A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just purchase the stock itself. If the stock price at expiration is lower than the exercise price. If the stock price at expiration is above the exercise price by more than the premium (price) paid. He will be under no obligation to sell the stock. and only lose the amount of the premium. he will profit. Long put Payoff from buying a put. If the stock price at expiration is above the exercise price. [edit]Short call . [17] The basic trades of traded stock options (American style) These trades are described from the point of view of a speculator. These must either be exercised by the original grantee or allowed to expire worthless. there are no secondary markets for employee stock options.With few exceptions. He would have no obligation to buy the stock. If the stock price at expiration is below the exercise price by more than the premium paid. because for the same amount of money. only the right to do so until the expiration date. he will let the call contract expire worthless. If they are combined with other positions. Long call Payoff from buying a call. he will profit. he will let the put contract expire worthless and only lose the premium paid. they can also be used in hedging. An option contract in US markets usually [18] represents 100 shares of the underlying security. A trader might buy the option instead of shares. A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option).

Payoff from writing a call. with the potential loss unlimited. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. the short put position will make a profit in the amount of the premium. or "write. If the stock price increases over the exercise price by more than the amount of the premium. A trader who believes that a stock price will increase can buy the stock or instead sell. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. with the potential loss being up to the full value of the stock. A benchmark index for the performance of a cash-secured short put option position is the CBOE S&P 500 PutWrite Index (ticker PUT). a put. Option strategies Main article: Option strategies . If the stock price at expiration is above the exercise price. If the stock price decreases. If the stock price at expiration is below the exercise price by more than the amount of the premium. A trader who believes that a stock price will decrease can sell the stock short or instead sell. Short put Payoff from writing a put. the trader will lose money." a call. the short call position will make a profit in the amount of the premium. the short will lose money. or "write".

Payoffs from a covered call. but also reducing the risk of loss in the trade. Strategies are often used to engineer a particular risk profile to movements in the underlying security. Similar to the straddle is the strangle which is also constructed by a call and a put. in which a trader buys a stock (or holds a previously-purchased long stock position). If the stock price rises above the exercise price. but with different strikes for the short options – offering a larger likelihood of profit but with a lower net credit compared to the butterfly spread. Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price. while more complicated strategies can combine several. and sells a call.Payoffs from buying a butterfly spread. buying a butterfly spread (long one X1 call. and does not expose the trader to a large loss. An Iron condor is a strategy that is similar to a butterfly spread. but might result in a large loss. For example. short two X2 calls. If the stock price . Payoffs from selling a straddle. but whose strikes are different. X2. the call will be exercised and the trader will get a fixed profit. Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades. reducing the net debit of the trade. One well-known strategy is the covered call. and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price.

Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought. or may be called (bought back) at specified prices at the issuer's option. In the real estate market. the payoffs match the payoffs from selling a put.falls. e.g. Privileges were options sold over the counter in nineteenth century America. or embedded options. On a certain occasion. . and any loss incurred to the trader will be partially offset by the premium received from selling the call. which corresponds to a callable bond option. In London. and the expiry date was generally three months after purchase. Many choices. have traditionally been included in bond contracts. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out [20][21] at much higher price than he paid for his 'option'. call options have long been used to assemble large parcels of land from separate owners. and during the off-season he acquired the right to use a number of olive presses the following spring. Lines of credit give the potential borrower the right — but not the obligation — to borrow within a specified time period. but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. puts and "refusals" (calls) first became well-known trading instruments in the [19] 1690s during the reign of William and Mary. A benchmark index for the performance of a buy-write strategy is the CBOE S&P 500 BuyWrite Index (ticker symbol BXM). a developer pays for the right to buy several adjacent plots. the call will not be exercised. Historical uses of options Contracts similar to options are believed to have been used since ancient times. For example many bonds are convertible into common stock at the buyer's option. Mortgage borrowers have long had the option to repay the loan early. Overall. This relationship is known as put-call parity and offers insights for financial theory. with both puts and calls on shares offered by specialized dealers. Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. They were not traded in secondary markets. it was predicted that the season's olive harvest would be larger than usual. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific book or script..

Privileges were options sold over the counter in nineteenth century America. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought.[20][21] . When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price than he paid for his 'option'. with both puts and calls on shares offered by specialized dealers. On a certain occasion. They were not traded in secondary markets. and during the off-season he acquired the right to use a number of olive presses the following spring. Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. and the expiry date was generally three months after purchase. it was predicted that the season's olive harvest would be larger than usual.