Fundamentals of Futures and Options

The futures market has its origins in the commodities industry. Farmers, oil and gas producers, miners, and others whose business it is to produce commodities wanted a way to manage the risk of having to accept an uncertain price for their future production. Futures contracts were the answer, and they met the needs of many market participants.

Under a futures contract, the contract seller agrees to sell a fixed amount of a certain commodity to the contract buyer on a particular day in the future. Most importantly, the price that the buyer will pay the seller is set based on the prevailing futures market price at the time the two parties enter into the contract.

Futures have a useful function in managing risk.

Options represent the right (but not the obligation) to take some sort of action by a predetermined date. That right is the buying or selling of shares of the underlying stock.

There are two types of options, calls and puts. And there are two sides to every option transaction – the party buying the option, and the party selling (also called writing) the option. Each side comes with its own risk/reward profile and may be entered into for different strategic reasons. The buyer of the option is said to have a long position, while the seller of the option (the writer) is said to have a short position.

Option Trades
Call Buyer (Long Position)
Call Seller (Short Position)
Put Buyer (Long Position)
Put Seller (Short Position)

Calls and puts, alone, or combined with each other, or even with positions in the underlying stock, can provide various levels of leverage or protection to a portfolio.