Investors who trade in futures and options are dealing in a different world of investing, removed from stocks, bonds or unit trusts. It is a specialised market where the pace is much faster and the risk, higher. While with stocks, an investor can still afford to sit back and see which direction his shares are heading, in futures he has to stay on top of price all the time for he can lose a fortune or make a fortune in minutes.

It is important to understand fully the risks and financial liabilities involved in trading futures and options before you even begin to consider venturing into these investments. The complexity of these instruments cannot be fully explained here, so a simplified explanation of what they are is offered here.

Futures and options are basic derivative instruments whose values are dependent on the value of an underlying asset such as common stocks, bonds, indices, currencies or commodities e.g. crude palm oil, rubber, cocoa and tin. They are often used for risk management or hedging by investors to safeguard their investments in anticipation of future market directions. Speculators also trade in the market, trying to achieve a profit by buying futures at a low price and selling at a high price. Speculators are important participants who give liquidity to the market and opportunities for continuous trading.

Forward Contract

When an agreement to buy or sell an asset at an agreed price and specified date is privately made between two parties, it is termed as a forward contract. For example, a crude palm oil refiner requires 1,000 tonnes of crude palm oil in six months time. He finds a palm oil producer who agrees to sell him the 1,000 tonnes at a specified date and price, six months down the road. Such an agreement between the two parties is a forward contract.

Forward contracts are therefore not standardised, meaning that as long as the price and date set is agreeable between the two parties, they can create their own forward contract on any commodity. Such a form of privately arranged trading is done over-the-counter (OTC) as opposed to buying and selling futures contracts at the exchanges.

Futures Contract

Futures contracts are like forward contracts in that they represent an agreement between a buyer and a seller to exchange a specified amount of cash for an asset at a future date. But unlike forward contracts, futures contracts are traded on an exchange (the Malaysia Derivatives Exchange) and the agreements are standardised with contract specifications stating exactly the amount and quality of goods to be bought or sold at a fixed price at a fixed future date. The contracts are not privately arranged but made known publicly so that anyone can participate in the trading.

Each futures contract has an expiry date, which is the last day of trading in the particular contract month. On that day, any futures position that is open (i.e. has not been closed out - meaning offset - by an opposite transaction) will be called upon for physical delivery or cash settlement. After the expiry date, the futures contract ceases to exist.

Hence when you buy a futures contract, it requires you to take delivery of the goods - or to make delivery if you sell the contract - unless your position is closed. However most of the time, the delivery exchange doesn't take place and positions are closed out or resold before the expiry date. This is because the main purpose of futures trading is not to buy or sell the physical goods or financial instruments but to manage the risk of price changes for hedgers; and for speculators, to profit from the changes.

As the market price of the futures goods fluctuates during the contract period, a difference arises between the contract price and the market price and so the futures contract shows a gain or loss in value. Most traders, both the hedgers and speculators, will close out their contracts by taking an opposite position, when they feel the contract value has risen or fallen in their favour. If a trader has bought a futures contract, he will sell it to close out when the price has gone up. On the other hand, if a trader has sold a futures contract, he will buy it back to close out when the price goes down. The futures market acts as a risk-shifting mechanism, enabling those exposed to these risks to shift them to someone else.

The allure of futures trading is that you don't need a lot of money to start. You are obligated to put up a percentage of the contract value i.e. you trade on margin. If the price swings in your favour, you stand to gain the amount of profit that is calculated from the entire contract value. Of course, if the price swings the other way, your loss is also calculated from the whole contract value. Thus, because futures allows you to control a larger amount of a product without paying a lot of money upfront, it is high stakes investing. For a small sum, you could win - or lose - a fortune within minutes.

Options

Options give the buyer/holder of the option the right, but not the obligation, to buy or sell a specified asset at a specified price (strike price), at or before a specified date from the seller, for which the buyer pays a premium. (This limits the buyer's potential loss in the options market to the amount of his premium.) Options that give the buyer the right to buy are known as calls. Options that give the buyer the right to sell are known as puts. The seller of the option has a contingent liability or an obligation, which is activated if the buyer exercises his right.
To understand how options work, we create examples which are not to be construed as investment advice to trade in options, but are for illustration purposes only.

First, call options. Let's assume that you buy a call option for RM2 premium a share with a strike price of RM30 a share for 1,000 shares of XXX Company. Your option therefore costs you RM2,000 (RM2 x 1,000 shares). This means you have bought the right to buy 1,000 XXX shares for RM30 a share until the expiry date.

Now, because you own a call option, you want the XXX share price to go higher than RM30 so that you will make a profit. Let's assume that it does go higher, to RM40. Your option price could then soar from RM2 to RM10. When this happens, your option is in-the-money, because the share price of RM40 is higher than your strike price of RM30.

There are two ways to realise your gain. One, you can exercise your option, that is, you cash in your right to buy 1,000 XXX shares from the seller of your option and pay RM30,000. Then you sell the 1,000 shares at the market price of RM40 and realise your profit which is RM40,000 minus RM30,000 less your premium of RM2,000 equals RM8,000.

Or two, you don't exercise your option but instead sell your right to buy 1,000 XXX shares. You can sell your option for RM10 a share and receive RM10,000. Your profit will equal RM10,000 minus your premium RM2,000 equals RM8,000.
Either way, the end result is the same (a profit of RM8,000), but selling your option is less cumbersome. It is up to you which way to go, although most of the time, investors don't exercise their options to buy the security.

If the XXX share price does not rise above your strike price (of RM30), then your option will be considered out-of-money and when the expiry date arrives, your option expires worthless and you lose all your investment money, which is your premium of RM2,000.

Put Options. Investors buy put options to protect their investment portfolios from downside risk, or to profit from expectations that the market of the underlying security will tumble.

For example, let's say you had bought 1,000 shares of YYY Company at RM10 a share some time ago. The price is now riding at RM15 but you anticipate that the share price will drop sharply over the next few months. However you don't want to sell your stock because you think the drop will be short-term, but you need to protect your investment against the decline. Well, you could resort to buying options.

Let's say the price of YYY starts to slip to RM12. You buy a put option for 1,000 YYY stock with a strike price of RM10. If the YYY share price keeps falling before the expiry date of your option, you could exercise your right to sell your YYY shares at RM10 a share, no matter what the market price falls to. Or you could hold your YYY shares and close your position by selling your put option. As long as the YYY share price drops to below RM10, you would make a profit because your put option is in-the-money. Remember your strike price is RM10. But if the share price rises, your put option would be out-of-money and your option will expire worthless with you losing the premium you paid for buying the put option.

Options can either be American style or European style. American style options can be exercised by the buyer at any time from the date of purchase up until (and including) the expiry date. European style options can be exercised by the buyer only on the specified expiry date.

On 1 December 2001, the Kuala Lumpur Options and Financial Futures (KLOFFE) launched the country's first options, the stock index options on the KLSE Composite, which is traded European style.

Last year, KLOFFE merged with COMMEX (Commodity & Monetary Exchange of Malaysia) to form MDEX (Malaysia Derivatives Exchange). MDEX currently offers trading in four derivatives: the KLSE Composite Index futures contract, crude palm oil futures contract, the KLIBOR futures contract and the KLSE Composite options contract.