The Risk Management Process: Futures, Options
Depending on the selection of buying or selling the numerator or denominator of a currency pair, the derivative contracts are known as futures and options.
There are various ways to earn a profit from futures and options, but the contract-holder is always obliged to certain rules when they go into a contract.
There are some basic differences between futures and options and these differences are the ways through which investors can make a profit or a loss.
Long and Short Currency Trading
Currency futures and options are derivative contracts. These contracts derive their own values from utilization of the underlying assets, which, in this case, are currency pairs. Currencies are always traded in pairs.
For example, the Euro and U.S. Dollar pair is expressed as EUR/USD. When someone buys this pair, they are said to be going long (buying) with the numerator, or the base, currency, which is the Euro; and thereby selling the denominator (quote) currency, which is the Dollar. When someone sells the pair, it is selling the Euro and buying the Dollar. When the long currency appreciates against the short currency, people make money.
Foreign Currency Futures
Currency futures make the buyer of the contract to buy the long currency (numerator) by paying with the short currency (denominator) for it. The seller of a contract has the reverse obligation. The obligation of the contact is usually due on the expiration date of the future.
The ratio of currencies, bought and sold, is settled in advance between the parties involved. People make a profit or loss depending on the gap between the settled price and the real, effective price on the date of expiration.
Margins are deposited for the futures trades – cash is the important part that serves as the performance bond to make sure that both parties are obliged to fulfil their obligations.
Options on Currency Pairs
The party that purchases a currency pair call option may also decide to settle for an execution or to sell out the option on or before the date of expiration. There is a strike price of the option that shows a particular exchange ratio for the given pair of currencies.
When the actual price of the currency pair is more than the strike price, the call holder earns a profit. It is said to execute the option by buying the base and selling the quote at a profitable term. A put buyer always bets on the denominator or quote currency appreciating against the numerator or the base currency.
Options on Currency Futures
Instead of having to buy and sell currency pairs, options in a currency future offers the contract-holders the right, but not an obligation, to purchase a futures contract on the particular currency pair.
The strategy in such a case is that the option buyer can profit from the futures market without having to put down any margin in the contract. When the futures contract appreciate, the call or contract holder can just sell the call for a profit. The call holder does not need to buy the underlying futures contract. A put buyer can easily earn a profit if the futures contract loses value.
Difference between Options and Futures
The basic and most prominent difference between options and futures is related with the obligations they create on part of the buyers and sellers.
- An option offers the buyer the basic right, but not an obligation, to buy (or sell) a certain kind of asset at a decided or settled price, which is specific at any time while the contract is alive.
- On the other hand, a futures contract offers the buyer the obligation to buy a specific asset, and the seller the obligation to sell and deliver that asset on a specific future date, provided the holder does not close the position prior to expiration.
- An investor can go in into a futures contract with no upfront cost apart from commissions, whereas purchasing an options position does not need to pay a premium. While comparing the absence of any upfront cost of futures, the premium of the option can be considered as the fee for not being obligated to purchase the underlying asset in the case of an adverse movement in prices. The premium paid on the option is the maximum value a purchaser can lose.
- Another important difference between futures and options is the size of the given or underlying position. Usually, the underlying position is considerably bigger in case of futures contracts. Moreover, the obligation to purchase or sell this given amount at a settled price turns the futures a bit riskier for an inexperienced investor.
- The final and one of the prominent differences between futures and options is the way the gains or earnings are obtained by the parties. In case of an option, the gains can be realized in the following three ways −
- Exercising the option when it is deep in the money,
- Going to the market and taking the opposite position, or
- Waiting until expiry and gaining the gap between the asset and the strike prices.
On the other hand, gains on the futures positions are naturally ‘marked to market’ every day. This means that the change in the price of the positions is assigned to the futures accounts of the parties at the end of every trading day. However, a futures call-holder can also realize gains by going to the market and opting for the opposite position.