Options & Derivatives Trading
Understanding Options & Derivatives Trading
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Is options trading a derivative?
Yes, the simplest derivative investment allows individuals to buy or sell what is known as an option on a security. An option is a contract to buy or sell a specific financial product. Various derivative instruments besides options include swaps, futures, and forward contracts. The investor does not own the underlying asset, but they hope to profit by making bets on the direction of price movements spelled out in the contract.
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What are derivative ETF futures and options?
Simply put, ETF futures and options are derivative instruments tied to exchange traded funds. Futures represent an agreement to buy or sell shares of an underlying ETF at an agreed-upon price on or before a certain date in the future. Options, in contrast, give the holder the right, but not the obligation, to trade the underlying ETF shares at an agreed-upon price on or before a specified date in the future.
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How big is the derivatives market?
The actual size of the derivatives market depends on what a person considers part of the market and so estimates vary widely. The entire derivatives market is, simply put, huge, and top estimates can be more than $1 quadrillion on the high end, based on what is included as a derivative. The larger estimates come from adding up the notional value of all available derivatives contracts. For example, the overall derivatives markets include products including options, warrants, swaps, credit default swaps, futures contracts, and forward contracts, as just a handful of examples. Some analysts argue that such a calculation doesn't reflect reality, in that the notional value of a derivative contract's underlying assets does not represent the actual market value.
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What is a forward contract?
A forward contract is a derivatives instrument that is one of the oldest and most common types of derivative securities, in which counterparties agree to buy (receive) or sell (deliver) an asset at a specified price on a future date. They are used as a form of risk management, in that a forward contract can be used for hedging or speculation. They are quite common in foreign exchange markets as a way for investors to take advantage of arbitrage opportunities from various global currency markets.
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What are ETF futures?
ETF futures are a kind of financial derivatives product built on existing exchange traded funds. A futures contract is an agreement to buy or sell shares of an underlying ETF at an agreed-upon price on or before a specified date.
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Key Terms
- Federal Agricultural Mortgage Corporation (FAMC)
The Federal Agricultural Mortgage Corporation (FAMC) is commonly referred to as Farmer Mac, and was by an act of Congress in 1987 in response to the farm crisis in the United States, which led to thousands of farmers to default on their loans, lose their farms and led to the collapse of many agricultural banks that services the farming industry.
- Cboe Options Exchange
The Cboe Options Exchange is the world's largest options exchange that was founded in 1973. It was originally known as the Chicago Board Options Exchange (CBOE), and the exchange changed its name in 2017 as part of a rebranding effort by its holding company, CBOE Global Markets, which runs the exchange with contracts focusing on individual equities, indexes, and interest rates.
- Warrant Coverage
Warrants are similar to options, except that they are issued by a company and dilute overall equity ownership. Warrant coverage is an agreement between a company and shareholders in which the company issues a warrant that is worth some percentage of the dollar amount of their investment. Warrants, also like options, allow investors to acquire shares at an agreed-upon price.
- Warrant Premium
A warrant premium is the difference between the traded price of a warrant and its minimum value. A warrant's minimum value is the difference between its exercise price and the current traded price of its underlying stock.
- Weather Derivative
A weather derivative is a financial product that companies or investors can use to hedge risk against weather-related disasters, much like insurance. The seller of a weather derivative agrees to bear the risk of disasters in return for a premium for taking on that risk. If nothing happens before the agreed-upon contract, the seller will profit, but in the event of a weather phenomenon or disaster, the buyer of the derivatives contract will claim the set amount. Various industries such as agriculture or tourism and travel will use these financial products to offset any potential losses from unexpected weather disrupting business.
- Freight Derivatives
Freight derivatives are financial products that derive their value from various freight agreements and freight rates, such as dry bulk carrying rates, and is used primarily in the shipping and cargo industry to manage the risk of fluctuating levels of freight charges or oil tanker rates changing unexpectedly. The risk management tool has become more in focus as the shipping industry bears the burden of supply-chain shocks and delays as a result of the global pandemic.
- Transaction Risk
Transaction risk is the risk that an investor or company may take on when currency exchange rate fluctuations may change the value of a foreign transaction after a transaction has been completed but not yet settled, and can also be referred to as exchange rate, or currency risk. Transaction risk takes on greater risk when there is a longer time between when the transaction occurs and when it settles.
- Cashless Conversion
A cashless conversion is when the ownership of some kind of security or asset changes without cash payment by the owner. For example such a conversation may take place if convertible bonds or convertible preferred shares are part of a transaction in which there is a cashless conversion to common stock in the deal. A cashless conversion is typically spelled out in the contract when the deal occurs, and the transfer may happen by an agreed upon trigger event or specific date.
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