Question

As in stated in financial instruments;

A. explain the derivative market.
B. What are the examples of option & future contracts trading?

Answer 1

What is a Derivative Market?

Derivatives can either be exchange-traded or traded over the counter (OTC).

Exchange refers to the formally established stock exchange wherein securities are traded and they have a defined set of rules for the participants.

Whereas OTC is a dealer oriented market of securities, which is an unorganized market where trading happens by way of phone, emails, etc.

Derivative traded on the exchange are standardized and regulated.

On the other hand, OTC derivative constitutes a greater proportion of derivatives contracts, but it carries higher counterpart risk and is unregulated.

These financial instruments help in making a profit by simply betting on the future value of the underlying asset.

Hence the name derivative as they derive the value from the underlying asset.

2.

What Is a Futures Contract?

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

FOR EXAMPLE -

An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.

What Is an Options Contract?

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.

Real World Example of an Options Contract

Company ABC's shares trade at $60, and a call writer is looking to sell calls at $65 with a one-month expiration. If the share price stays below $65 and the options expire, the call writer keeps the shares and can collect another premium by writing calls again.

If the share price appreciates to a price above $65, referred to as being in-the-money, the buyer calls the shares from the seller, purchasing them at $65. The call-buyer can also sell the options if purchasing the shares is not the desired outcome.