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Futures exchange :A futures exchange, is a corporation or organization which provides a marketplace in which to trade derivatives such as futures contracts and options. Known also as Commodities exchanges, contracts transact daily in a variety of standardized products such as grains, softs, currency, short-term interest rates and bonds.
-Nature of contracts :Exchange traded contracts are not issued like securities, but they are "created" when one party buys (goes long) a contract from another party (who goes short). In the beginning there are no contracts, so the number of contracts that clients are long must equal the number of contracts that clients are short.
This always goes through the exchange, which means that the exchange is the counterpart for all trades. However, the exchange does not take any net positions. In this way clients do not know who they have ultimately traded with. Compare this with securities, in which an issuer issues the security.
After that, it is a legal entity that is traded independently of the issuer. Even if the issuer buys back some securities, they still exist. Only if they are legally cancelled can they disappear.
-Call option : A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for (a) the premium (paid immediately) plus (b) retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlying instrument is moving up, making the price of the underlying instrument closer to the strike price. When the price of the underlying instrument surpasses the strike price, the option is said to be "in the money."
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.
Exact specifications may differ depending on option style. A European call option allows the holder to exercise the option (i.e., to buy) only on the option expiration date. An American call option allows exercise at any time during the life of the option.
Call options can be purchased on many financial instruments other than stock in a corporation -
options can be purchased on futures on interest rates, for example (see interest rate cap) - as well as on commodities such as gold or crude oil. A call option should not be confused with either Incentive stock options or with a warrant..
An incentive stock option, the option to buy stock in a particular company, is a right granted by a corporation to a particular person (typically executives) to purchase treasury stock. When an incentive stock option is exercised, new shares are issued. Incentive stock options are not traded on the open market. In contrast, when a call option is exercised, the underlying asset is
transferred from one owner to another.
Example of a call option on a stock
An investor buys a call on Microsoft Corporation stock with a strike price of $50 and an option
expiration date of June 16, 2006, and pays a premium of $5 for this call option. The current price is $40. Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e., buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5.
The investor has thus doubled his money, having paid $5, and ending up with $10. If however the share price never rises to $50 (that is, it stays below the strike price) up through the
exercise date, then the option would expire as worthless. The investor loses the premium of $5. Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited (consider if the share price rose to $100). From the viewpoint of the seller, if the seller thinks the stock is a good one, he/she is $5 better (in this case) by selling the call option, should the stock in fact rise. However, the strike price (in this case, $50) limits the seller's profit. In this case, the seller does realize the profit up to the strike price (that is, the $10 rise in price, from $40 to $50, belongs entirely to the seller of the call option), but the increase in the stock price thereafter goes entirely to the buyer of the call option.
-Put option: A put option (sometimes simply called a "put") is a financial contract between two parties, the buyer and the writer of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer of the option for a certain time for a certain price (the strike price). The writer has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.
Note that the writer of the option is agreeing to buy the underlying asset if the put holder exercises the option. In exchange for having this option, the buyer pays the writer a fee (the premium).
(Note: Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus, taking a short position in the option, they are not the only sellers. An option holder can also sell his long position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas, the option holder is merely selling his long position, and is not contractually obligated by the sold option.)
Exact specifications may differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration. An American put option allows exercise at any time during the life of the option.
The most widely-known put option is for stock in a particular company. However, options are traded on many other assets: financial - such as interest rates (see interest rate floor) - and physical, such as gold or crude oil.
The buyer of the put either expects the price of the underlying asset to fall or to protect a long position in the asset. The advantage of buying a put over shorting the asset is that the risk is limited to the premium. The put writer does not expect the price of the underlying to fall, and so writes the put to collect the premium. Puts can also be used to limit portfolio risk, and may be part of an option spread.
Example of a put option on a stock
I purchase a put contract to sell 100 shares of XYZ Corp. for $50. The current price is $55, and I pay a premium of $5. If the price of XYZ stock falls to $40 per share right before expiration, then I can exercise my put by buying 100 shares for $4,000, then selling it to a put writer for $5,000.
My total profit would equal $500 ($5,000 from put writer - $4,000 for buying the stock - $500 for buying the put contract of 100 shares at $5 per share, excluding commissions). If, however, the share price never drops below the strike price (in this case, $50), then I would not
exercise the option. (Why sell a stock to someone at $50, the strike price, if it would cost me more than that to buy it?) My option would be worthless and I would have lost my whole investment, the fee (premium) for the option contract, $500 ($5 per share, 100 shares per contract). My total loss is limited to the cost of the put premium plus the sales commission to buy it.
