Options Contract Explained

An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a preset price, referred to as the strike price, prior to the expiration date.

The two types of contracts are put and call options, both of which can be purchased to speculate on the direction of stocks or stock indices, or sold to generate income. For stock options, a single contract covers 100 shares of the underlying stock.

The Basics of an Options Contract

In general, call options can be purchased as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from price declines. The buyer of a call option has the right but not the obligation to buy the number of shares covered in the contract at the strike price.

Put buyers have the right but not the obligation to sell shares at the strike price in the contract. Option sellers, on the other hand, are obligated to transact their side of the trade if a buyer decides to execute a call option to buy the underlying security or execute a put option to sell.

Options are generally used for hedging purposes but can be used for speculation. That is, options generally cost a fraction of what the underlying shares would. Using options is a form of leverage, allowing an investor to make a bet on a stock without having to purchase or sell the shares outright.

Call Option Contracts

The terms of an option contract specify the underlying security, the price at which that security can be transacted (strike price) and the expiration date of the contract. A standard contract covers 100 shares, but the share amount may be adjusted for stock splits, special dividends or mergers.

In a call option transaction, a position is opened when a contract or contracts are purchased from the seller, also referred to as a writer. In the transaction, the seller is paid a premium to assume the obligation of selling shares at the strike price. If the seller holds the shares to be sold, the position is referred to as a covered call.

Put Options

Buyers of put options are speculating on price declines of the underlying stock or index and own the right to sell shares at the strike price of the contract. If the share price drops below the strike price prior to expiration, the buyer can either assign shares to the seller for purchase at the strike price or sell the contract if shares are not held in the portfolio.

Perpetual Future Contracts Explained

To understand the functions of a Perpetual Future Contract it is important to first fully understand the meaning of a future contract. A futures contract is an arrangement to buy or sell a commodity, currency, or another tool at a prearranged price at a definite time in the future.

Unlike an old-fashioned spot market, in a futures market, the trades are not ‘settled’ promptly. Instead, two counterparties will trade a contract, that defines the clearance at a future date. Also, a futures market doesn’t allow users to unswervingly purchase or sell the product or digital asset. Instead, they are trading a contract representation of those, and the actual trading of assets (or cash) will happen in the future – when the contract is exercised.

As a simple example, consider the case of a futures contract of a physical commodity, like wheat, or gold. In some traditional futures markets, these contracts are marked for delivery, meaning that there is a physical delivery of the commodity. As a consequence, gold or wheat has to be stored and transported, which creates additional costs (known as carrying costs). However, many futures markets now have a cash settlement, meaning that only the equivalent cash value is settled (there is no physical exchange of goods).

Additionally, the price for gold or wheat in a futures market may be different dependent on how far is the contract settlement date. The longer the time-gap, the higher the carrying costs, the larger the probable future price uncertainty, and the larger the potential price gap between the spot and futures market.

Perpetual Future Contract

A perpetual contract is a special type of futures contract, but unlike the traditional form of futures, it doesn’t have a termination date. So, one can hold a position for as long as they like. Other than that, the trading of continuous contracts is based on an underlying Index Price. The Index Price contains of the average price of an asset, according to major spot markets and their relative trading volume.

Thus, unlike conservative futures, perpetual contracts are often traded at a price that is equal or very similar to spot markets. Still, the principal difference between the traditional futures and perpetual contracts is the ‘settlement date’ of the former.

Forward Contracts Vs Future Contracts

In this article we will look into the key differences between Future and Forward contracts. If you would like to keep yourself informed on the same then please read on…

Forward Contract

The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract. These contracts are private agreements between two parties, so they do not trade on an exchange. Because of the nature of the contract, they are not as rigid in their terms and conditions.

Many hedgers use forward contracts to cut down on the volatility of an asset’s price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So, if two parties agree to the sale of 1000 ears of corn at $1 each for a total of $1,000, the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.

Futures Contracts

Like forward contracts, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract. First, futures contracts—also known as futures—are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of dates.

Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas. The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

These contracts are frequently used by speculators, who bet on the direction in which an asset’s price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.