Derivatives are an important part of the world's financial markets. Three examples of derivatives are futures contracts, forward contracts and option contracts. All of these derivatives reference an underlying security with an eye toward possible future changes in its value. However, there are important distinctions in the details of how these contracts are managed.
Options contracts, appropriately, imbue the holder of the contract with the right to purchase or sell the designated asset at a specified price. This specified price is called the strike price. The holder of the contract incurs no obligation -- he may decide not to exercise the option for any reason. However, the issuer of the option, called the writer, must buy or sell the asset if the holder does exercise the option. Options are temporary instruments that expire at a predetermined date. Options allowing the holder to purchase an asset are referred to as call options. Options allowing the holder to sell an asset are put options. In all cases, the writer of the option receives a commission, called a premium.
A futures contract is a formal commitment to purchase a specified sum of a specific commodity on a designated date. Futures contracts have historically been favored by industries using said commodities as inputs. For example, a large food processor may purchase futures in corn or other grain. Industrial concerns may acquire futures contracts in oil, copper, natural gas or other materials. In these cases, the purpose of the futures contract is to protect the firm from an increase in price of the raw materials it uses. However, many participants in the futures markets are simply hoping to profit from changes in price of such commodities. If a futures contract is purchased and the commodity’s market price significantly increases, the holder of that contract may then sell it at a profit.
Forward contracts are similar in many respects to futures contracts. Like futures, there are frequently used to sell commodities not immediately available for use. Unlike futures contracts, forward contracts involve two parties. Futures contracts are traded on an exchange, rather than being an agreement between two parties. Another key difference is that forward contracts often are made with no intermediaries. On the other hand, futures contracts are facilitated by brokers. While options and futures contracts frequently are used by speculators, forward contracts generally are used to reduce risk for the producers and consumers of a product, rather than as an investment.
- ferlistockphoto/iStock/Getty Images