The point of this article is to explain very simply how futures and options work and how they are used. This is a very basic definition of their use, written with the intention of acting as an introduction to the theory of trading, rather than as a specific guide. The piece is written for the individual for clarification only— not to encourage inexperienced speculators!

You will find some more specific examples of how a company could use derivatives to protect against risk or to enhance profits.

HOW OPTIONS WORK

Taking as an example of options a share option; the purchase of an option is the right but not the obligation to buy or sell a specific number of shares within a fixed time period at a price that is stipulated when the option is bought. The sale offers the purchaser the right but not the obligation to exercise but commits the seller to fulfill those functions.

Example of Options in Practice

In August, you decide that shares in MF PLC will rise over the next month or so. The current price is 100p, and you hope that the shares will be at 150pby the end of October.

If you buy the shares, say 10 000 shares for £10 000 and you are correct in your expectations, your 10 000 shares will be worth £15 000 within three months, showing a profit to you of £5000, 50 per cent of your original outlay—less expenses. However, the drawbacks are that you need the original £10 000 to do this, and having done it and bought the shares, if MF PLC collapses in a heap and its share price drops, you have lost your cash.

As an alternative, you could buy an option on the share for, as an example, a 10p premium. This option would give you the right to buy a share in MF PLC for 100p at any time over the next three months. If MF’s share price remains at 100p, you have an option with no value and so you have lost the 10p premium per share that you paid, and that is the extent of your potential loss— £1000. But, if the share price does go up to 150p, then your option has value and is certainly worth exercising, because you have the right to buy something at 100p which is currently priced at 150p. If you had just bought the shares and the price had gone up to 150p, you would have made £5000. Having bought the option at a cost of £1000 and exercised it when the share price hit 150p, you still make £5000 but you have to allow for the cost of the option. So, you are only £4000 ahead, but on an outlay of £1000 this is a pretty hefty profit of 400 per cent.

On the other side of this arrangement, there was someone who disagreed with you on what the share price of MF PLC was going to do. He took the view that the share price was less volatile and so it was worth his while to receive an additional 10p of income (beyond the dividends) in his portfolio of shares— assuming he has one. In this case, he could have written an option at 10p per share, which is the option that you bought. If the shares fell below 100p, the option would not be exercised and he would keep the premium.

However, if the price rose to over 100p and the option was exercised, then he would be required to part with his shares in MF PLC at 100p, or buy them for onward delivery at the prevailing market price. (Exercising, rather than trading, an option in commodities, is uncommon, but useful for this example.) However, he would get the 10p premium as well, so he would really be getting 110p a share, and this 10p would limit the paper loss in his portfolio if the MF PLC share price falls.

Buyers of options always know exactly what sums of money are at risk because they simply pay for the option. It is important to remember that the potential losses for writers of options are infinite although in the case of writers of puts— the right to sell an option—losses are limited by the price differential between the strike price—the price at which the option is struck at the outset—and zero.

Possibly related posts: (automatically generated)
How Futures and Options Work Part 1

• Modern Managed Futures Portfolio Theory
• The Outlook for Managed Futures Funds
• Regulation of Managed Futures Funds in Europe Part 12
• Regulation of Managed Futures Funds in Europe Part 8
• Regulation of Managed Futures Funds in Europe Part 5
• How Futures and Options Work Part 2
• Brokerage Commissions Part 1
• The debt instruments with embedded options
• Regulation of Managed Futures Funds in Europe Part 7
• Regulation of Managed Futures Funds in Europe Part 4