Options and Futures Quiz 1
Derivatives definition
A derivative is a financial contract whose value depends on, or is derived from, the value of another asset (also called an underlying asset).
The derivative itself is merely a contract between two parties. Fluctuations in the price of the underlying asset determine its value.
Types of Derivatives
Options
Futures
Forwards
Swaps
Vanilla Derivatives: tend to be simpler, with no special or unique characteristics, and are generally based upon the performance of one underlying asset.
Exotic Derivatives’: tend to have more complex payout structures and may combine several options or may be based upon the performance of two or more underlying assets.
Derivatives Market
Most derivatives are traded over-the-counter (OTC) on a bilateral basis between two counterparties, such as banks, asset managers, corporations and governments. These professional traders have signed documents in place with one another to ensure that everyone is in agreement on standard terms and conditions.
However, some of the contracts, including options and futures, are traded on specialized exchanges. The biggest derivative exchanges include the CME Group (Chicago Mercantile Exchange and Chicago Board of Trade), the National Stock Exchange of India, and Eurex.
Derivatives can be bought and sold on almost any capital market asset class, such as equities, fixed income, commodities, foreign exchange and even cryptocurrencies.
Participants in the Derivative Markets
Hedgers
Speculators
Arbitrageurs
Margin-Traders
Futures Contract Definition
Futures contracts are financial instruments that allow market participants to offset or assume the risk of an asset’s price change over time.
A futures contract is an agreement to buy or sell an asset at a certain time in the future at a predetermined price.
These “underlying” assets are usually commodities or financial instruments
A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month.
This transaction is facilitated through a futures exchange.
A Standardized Contract
An exchange-traded futures contract specifies the quality, quantity, physical delivery time and location for the given product.
The contract specifications are identical for all participants. This characteristic of futures contracts allows a buyer or seller to easily transfer contract ownership to another party through a trade.
Given the standardization of the contract specifications, the only contract variable is price. Price is discovered by bidding and offering, also known as quoting, until a match, or trade, occurs.
Futures contracts are products created by regulated exchanges. Therefore, the exchange is responsible for standardizing the specifications of each contract.
Exchange-Traded
The exchange also guarantees that the contract will be honored, eliminating counterparty risk. Every exchange-traded futures contract is centrally cleared.
This means that when a futures contract is bought or sold, the exchange becomes the buyer to every seller and the seller to every buyer. This dramatically reduces the credit risk associated with the default of a single buyer or seller.
The exchange thereby eliminates counterparty risk and provides anonymity to futures market participants, unlike a forward contract market.
Types of Underlying Assets
The most common underlying assets include stocks, bonds, commodities, currencies, cryptocurrencies interest rates and market indexes
The Difference Between Futures and Forward Contracts
Futures contracts and forward contracts are agreements to buy or sell an asset at a specific price at a specified date in the future.
The Difference Between Hedger, Speculator and Arbitrageur
Participants in the Derivatives Market
Hedgers: use financial markets instruments, such as derivatives, to reduce their existing risk or future exposure.
An example might be a farmer who sells cattle futures now in order to reduce price uncertainty when her herd is finally ready to be sold.
Another example might be a bond issuer that uses interest rate swaps to convert their future bond interest obligation to better match their expected future cashflows.
A derivative is a very popular hedging instrument since its performance is derived, or linked, to the performance of the underlying asset.
Buy-Side Hedgers: Protect against rising prices (e.g., companies needing raw materials like steel or fuel).
Sell-Side Hedgers: Protect against falling prices (e.g., producers like farmers or manufacturers).
Merchandisers: Buy and sell commodities. Their risk involves the spread (difference between purchase and selling prices) rather than price direction.
Speculators: a common, but risky, market activity for financial market participants of a financial market take part in.
Speculators take an educated gamble by either buying or selling an asset in the expectation of short-term gains.
It is risky because the trade can move against the speculator just as quickly, resulting in potentially significant losses.
As an example, a speculator can buy an option on the S&P 500 that replicates the performance of the index without having to come up with the cash to buy each and every stock in the entire basket. If that trade works in the speculators favor in the short term, she can quickly and easily close her position to realize a profit by selling that option since S&P 500 options are very frequently traded.
Arbitrageurs: a very common activity in financial markets that comes into effect by taking advantage of mispricings in assets, resulting in risk-free profits.
For example, let’s consider a situation where gold futures trade much higher than the spot price of gold. An arbitrageur may sell the gold future, purchase the gold now at spot, store it and deliver it into the futures contract to essentially lock-in riskless profit.
Arbitrageurs are therefore, an important part of the derivative markets as they ensure that the relationships between certain assets are kept in check.
Closing Out a Futures Position
Offsetting or liquidating a position is the simplest and most common method of exiting a trade.
When offsetting a position, a trader is able to realize all profits or losses associated with that position without taking physical or cash delivery of the asset.
To offset a position, a trader must take out an opposite and equal transaction to neutralize the trade.
For example, a trader who is short two WTI Crude Oil contracts expiring in September will need to buy two WTI Crude Oil contracts expiring on the same date. The difference in price between his initial position and offset position will represent the profit or loss on the trade.
Rollover: when a trader moves his position from the front month contract to a another contract further in the future. Traders will determine when they need to move to the new contract by watching volume of both the expiring contract and next month contract/
A trader who is going to roll their positions may choose to switch to the next month contract when volume has reached a certain level in that contract.
When rolling forward, a trader will simultaneously offset his current position and establish a new position in the next contract month.
For example, a trader who is long four S&P 500 futures contracts expiring in September will simultaneously sell four Sept ES contracts and buy four Dec or further away ES contracts.
Difference Between Long and Short Positions
Long Position: If an investor has a long position, it means that the investor has bought and owns securities, such as shares of stocks.
For instance, an investor who owns 100 shares of Tesla stock in their portfolio is said to be long 100 shares.
Short Position: If the investor has a short position, it means that the investor sold shares of a stock (and thus, owes them to some other investor who buys them), but does not actually own them yet.
For instance, an investor who has sold 100 shares of Tesla without owning them is said to be short 100 shares.
Oftentimes, the short investor will borrow the shares from a brokerage firm through a margin account to make the delivery. The goal is for the stock price to fall. Then, the investor will buy the shares at a lower price than they sold at, to pay back the dealer who loaned them.
If the price doesn't fall but instead keeps rising, the short seller may be subject to a margin call from their broker.
A margin call occurs when the value of an account of an investor who borrows on margin falls below the broker's required minimum value.
Oftentimes, an investor may establish long and short positions simultaneously to leverage or produce income from a transaction. They can also use both positions to hedge against possible portfolio losses.
It is important to remember that short positions come with higher risks than long positions. They may be limited in IRAs and other cash accounts. Margin accounts are generally needed for most short positions, and your brokerage firm needs to agree that these more risky positions are suitable for you.
Practice Test
Multiple-Choice Questions
1. What is a derivative?
a. A stock that pays regular dividends
b. A financial contract whose value is derived from the value of another asset
c. A loan agreement between two parties
d. A form of physical commodity traded on the market
2. Which of the following is NOT a type of derivative?
a. Options
b. Futures
c. Swaps
d. Bonds
3. What is the primary difference between vanilla derivatives and exotic derivatives?
a. Vanilla derivatives are traded OTC, while exotic derivatives are exchange-traded
b. Vanilla derivatives are simple with one underlying asset, while exotic derivatives have complex payout structures
c. Vanilla derivatives have counterparty risk, while exotic derivatives do not
d. Vanilla derivatives are always based on equities, while exotic derivatives are based on commodities
4. Which of the following is an example of a standardized contract?
a. A forward contract privately negotiated between two parties
b. A futures contract traded on an exchange
c. A customized swap agreement between two banks
d. A margin loan
5. Who eliminates counterparty risk in exchange-traded futures contracts?
a. The buyer of the contract
b. The seller of the contract
c. The exchange clearinghouse
d. The government regulator
6. Which participant in the derivatives market seeks to profit from mispricing in assets?
a. Hedgers
b. Speculators
c. Arbitrageurs
d. Margin-traders
7. What does "rolling forward" mean in futures trading?
a. Closing a position without taking delivery
b. Simultaneously offsetting a current position and establishing a new position in a later contract month
c. Borrowing shares to cover a short position
d. Taking physical delivery of the underlying asset
True-or-False Questions
8. Futures contracts are privately negotiated agreements between two parties.
True / False
9. A short position means an investor has sold shares they do not own, expecting the price to fall.
True / False
10. Hedgers use derivatives to increase their risk exposure to potential price changes.
True / False
11. The main variable in a standardized futures contract is price.
True / False
12. Speculators aim to minimize their financial risks through derivatives.
True / False
13. An exchange-traded futures contract guarantees anonymity for participants.
True / False
14. Margin calls occur when an investor's account value falls below the broker's required minimum value.
True / False
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Answer Key
Multiple-Choice Questions
1. b
2. d
3. b
4. b
5. c
6. c
7. b
True-or-False Questions
8. False
9. True
10. False
11. True
12. False
13. True
14. True