New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: Futures vs Forwards vs Options: Differences Explained. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
4.1 Futures & Forwards — Locking In a Price
The idea in plain words
A forward or futures contract fixes today the price of something that will be traded later. Its fair price is not a forecast. It comes from arbitrage: start with today’s price, add the cost of financing and storing it, and subtract any income it pays. Futures add a safety feature. Gains and losses are settled every day through a central counterparty, so neither side can owe more than one day’s move.
Key points
■One-year gold at $3,000 and 4% has a fair futures price of $3,120; a $3,200 quote locks in $8,000 per 100-ounce contract by cash-and-carry.
■Daily variation margin can demand cash even on a trade that ends profitable: a long gold contract up $1,500 needed $6,000 of top-ups along the way.
■Contango and backwardation describe the curve’s shape; the basis converges to zero at expiry.
A closer look
A forward contract is a private agreement between two parties to buy or sell an asset at a specified price on a specified future date. A futures contract is functionally the same idea, standardized and traded on an exchange, with a clearing house (Volume I’s Part 11) stepping in as counterparty to both sides and requiring daily margin — a good-faith cash deposit, adjusted daily as the contract’s value moves — to guarantee performance.
Decision rule
If a futures quote differs from S × (1 + r)ᵗ + storage − income by more than your round-trip costs (commissions, both bid-ask spreads, your borrowing spread), the gap is tradable; otherwise it is noise. To hedge, use futures when a listed contract matches your asset and you can fund daily margin; use a forward when you need an exact amount or date or cannot absorb interim cash calls, and control its credit risk with collateral.
The costliest mistake
Hedging with futures without funding the margin. In 1993 Metallgesellschaft’s US unit had sold fixed-price oil products for up to ten years and hedged with short-dated futures it rolled forward. When oil fell, the futures demanded cash at once while the customer contracts gained value only over years; losses exceeded $1 billion when the parent unwound the hedge (whether the hedge or the exit was the error is still debated). A $1 billion futures hedge hit by a 15% price drop needs 0.15 × $1,000,000,000 = $150 million of cash immediately.
4.2 Options — Rights, Not Obligations
The idea in plain words
An option is a right, not a duty. A call gives the buyer the right to buy at a fixed price, called the strike, and a put gives the right to sell at that price. You pay an upfront premium for the right, like paying a deposit to hold a price. The buyer can lose only the premium, but the seller can lose many times what they collected. Put-call parity links the prices of calls and puts so they cannot drift apart.
Key points
■For a $100-strike, one-year option worth $9.93 (call) and $6.00 (put), break-evens are $109.93 and $94.00.
■Put-call parity, C + K × e^(−rT) = P + S, holds at $106.00 on both sides in the example; a $1 mispricing is an arbitrage.
■In, at and out of the money describe moneyness; American options can be exercised early, European only at expiry.
Decision rule
Buy an option to cap a loss on a position you hold, or when you expect a bigger move than is priced in: the call above profits only above $109.93, a 9.9% rise. Sell one only if you can carry the worst plausible case: size it so a three-standard-deviation move, S × σ × √T × 3 (100 × 0.20 × 1 × 3 = $60 per share here), stays within your loss limit. Premium tells you the most you can make, not the most you can lose.
The costliest mistake
Treating option writing as steady income. Selling the one-year at-the-money call collects $9.93 per share, $993 per contract. If the company receives a takeover bid and the stock gaps to $150 overnight, the short call loses (150 − 100 − 9.93) × 100 = $4,007 per contract, about four times the premium, and no stop-loss order can act inside a gap. Many small gains and rare large losses make a good track record meaningless. Cap the tail with a higher-strike call bought against the one sold (a call spread), and size by the loss, not the premium.
What the full article covers
In the full article I take you through these sections:
■4.1 Futures & Forwards — Locking In a Price
■4.2 Options — Rights, Not Obligations
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Futures vs Forwards vs Options: Differences Explained, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
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