30 Second Guide to: Futures & Options16:53
A futures contract is an agreement between two parties to exchange a certain quantity of a commodity, stock, or financial instrument at a specified point in the future for a pre-determined price. The buyer in the contract is referred to as the 'long' while the seller is known as the 'short.'
The main backbone of this entire contract is the aspect of time and the unpredictability of the future price of the underlying asset being traded. The buyer hopes that the price of the asset in question will increase while the seller can only hope that it will decrease.
For example, if a certain business requires sugar as a raw material, but anticipates that the price will rise 6 months from now, the business can buy sugar futures to cover its needs six months from now for a certain known price and thus reduce its exposure to a rise in the price of the raw material.
That is futures trading at its most basic; on the other hand, the underlying asset need not be a commodity--it can be a currency, security or financial instrument and intangible asset or referenced item such as a stock index or interest rate
Options are similar to futures, but differ in that the buyer has no obligation to actually complete the purchase--he is merely paying a premium for the option to complete a purchase at a date in the future. The seller, on the other hand, has to fulfill his end of the deal should the buyer choose to exercise his option.
There are many different kinds of options, including the call, which conveys the right to buy something and the put, which conveys the right to sell. Most importantly though, if an option is not realized by its expiration date, it becomes null and void immediately.
A simple example of an option is a movie production house paying an author an advance for the option to turn his book into a film. The producer is under no obligation to actually make the film, but should he choose to do so, he will exercise his option before a pre-determined expiration date, pay the writer an additional amount, and go ahead.
At their most complicated, options trades can involve a combination of several puts and calls--with optimum prices and permutations determined by computers running complex mathematical models to reduce risk and maximise gains.