By Sunil K Parameswaran
Futures and forward contracts are known as commitment contracts. This is because once a party has entered into such a contract, it has an obligation to perform, regardless of whether it has made a profit or incurred a loss. By contrast, options contracts are known as contingent contracts since the performance of the holder is contingent upon the occurrence of an event.
In the case of calls, the holder will only exercise if the spot price of the underlying asset is greater than the contract exercise price. Likewise, holders will exercise to sell if and only if the spot price is lower than the strike price of the contract.
Futures and options
Both futures and options are agreements that are negotiated today regarding future performance. By the time the future date arrives, one of the parties will have a profit, which clearly means that the counterparty will incur a loss. In the case of a long futures position, if the price of the final asset is greater than the price of the initial futures contract, the purchase will make a profit and the short selling will be the loss. On the other hand, if the price of the final asset is lower than the price of the initial futures contract, the sale will make a profit and it will be a long loss.
It is quite clear that the price of the final asset must be either higher or lower than the price of the initial futures contract. Thus, one of the parties is bound to incur a loss. Thus futures contracts require both parties to initially record a performance security or margin. This is adjusted on a daily basis for gains and losses, which is referred to as market ticking. Thus, by the time the contract ends, the loss incurred by one of the parties is transferred to the party making a profit. Thus, the specter of default is gone.
In options contracts, there is no possibility of default on the part of buyers. They will exercise if it is profitable, and they do not need to do otherwise. However, in principle, short performances may lag. That is, if the spot price of the payment terminal is greater than the exercise price, it may refuse to sell in the case of call options. Similarly, in the case of put options, the sell may refuse to accept delivery, if the final spot price is less than the exercise price. Thus, all options sellers or writers must deposit margins.
The need for margin can be viewed by options writers as follows. Once the options contract is entered into, buying will get positive or none cash flow, while selling will get negative or none cash flow. Since the holder cannot have a subsequent negative cash flow, but the counterparty can, the option buyer has to pay a non-refundable upfront price or premium to the option writer.
This is true for all options, whether calls or puts, European or American. In contrast, due to the fact that either party may have to accept a subsequent negative cash flow, futures and forward contracts do not necessitate the payment of a premium by either party. Because of the two-way risk factor, market labeling applies to both parties to a futures contract. However, in the case of options, it only applies to book or shorts because the risk is one-way.
The writer is CEO of Tarheel Consultancy Services