Understanding derivatives: Futures, Forwards and Options

In finance, derivatives are an integral part of investments. Derivatives are a category of financial security with a value that is derived from an underlying asset or group of assets. It’s a category which has several types under it. The three main types of derivative securities are futures, forwards and options. 

Before investing in them, you should understand the crucial differences between these derivative securities. Let’s take you through them:

FUTURES

Future contracts is a standardized legal agreement between two parties upon the sale of an asset at a predetermined price at a specific date in the future. Futures are mainly used by two kinds of market participants: hedgers and speculators. If the current market scenario is bad, you can use future contracts to hedge against risk. Investing in futures is basically like placing a bet – you agree to purchase/sell a commodity at a price that seems right in the moment, but may either be profitable or a loss to you in the future. The most popular futures contracts sold on the exchange are live cattle futures, gold futures, and currency futures.

FORWARDS

Forwards contracts are an important type of security, similar to futures. Both contracts allow you to buy/sell an asset at an agreed upon price at a specific time. The main difference between to the two, however, is that futures are traded on an exchange, while forwards contracts are traded Over-The-Counter (OTC). Forwards are non-standardized and are used to most for hedging. Forwards are private agreements between the two parties, and thus poses high counterparty risk.

OPTIONS

Options contracts give you the right to purchase or sell an asset at a specific time on a specific price. But you are not obligated to make the potential transaction – you can let the option go by the expiration date, after which the contract has no worth. However, you do lose the amount you pay for the option premium. Options contracts are great tools to add flexibility to your portfolio. They can be used for hedging and speculation purposes.