Options and futures contracts are considered derivative contracts in the sense that the contract derives its value from an underlying stock, commodity, currency or index which trades or value can be determined by agreement. The purpose of these derivative contracts is to accept or transfer risks from the other side of the transaction (e.g. buyer side and seller side). When there is uncertainty about the future prices there is risk in a position. Option and futures contracts can be used to hedge the risks associated with uncertainty of future prices. An investor can use options and futures contracts to speculate on future prices that is a risky strategy with the potential for significant gains or a complete loss. A more detailed discussion about derivative contracts can be reviewed in greater detail below:
- Equity Options Contracts
- Futures Contracts
Options and futures contracts can be used by a asset manager for a financial portfolio. A farmer can use futures contracts to “lock-in” the price for its crop. An airline can use futures contracts to “lock-in” the cost of fuel for operations. Options can be used to leverage risks of an investment portfolio or used to limit downside risk. Portfolios with unrealized gains or stock concentration can limit losses from declining share prices. If there is a tax or contractual restriction on the sale of a security or a contract to deliver a security in the future, options and futures contracts can meet these objectives.
Options and futures contracts can be structured and priced as a private transaction between two parties or traded on an organized exchange. Organized exchanges provide the following:
- Standardization of Contracts;
- Greater Liquidity;
- Disclosure and Surveillance; and
- Guaranteed Clearing.
A financial advisor can help determine the appropriate portion of your investment portfolio that should be invested in options and futures contracts based on your personalized investment policy statement designed to reach your True North.
