In the world of commerce, uncertainties regarding the future can be hedged. A hedge, you could say, is the opposite of a bet. A hedge allows producers, investors and consumers the opportunity to protect themselves against financial loss and other adverse circumstances. It is the financial equivalent of erecting a boundary around oneself and one’s enterprise.
Futures markets allow commodities producers and consumers to engage in hedging in order to limit the risk of potential downsides as commodity prices change–which they tend to. Hedging helps the economy function by allowing producers and consumers to conduct their businesses with greater certainty. It establishes how much they can expect to earn from and pay for commodities.
Price volatility is the most pressing issue facing producers of primary commodities. The impact of volatility on the producers of commodities is much greater than it is for those in developed economies. Of particular relevance here is the degree to which a nation or a producer is reliant on a particular commodity for their earnings. This could leave their finances very vulnerable to any considerable changes in the prices of commodities.
Futures markets sprang into existence in the 17th century. They were informally established in coffee shops in Amsterdam and centred on the trade in tulips. A futures contract establishes an agreement to buy or sell an asset at a future date at an agreed-upon price. That asset might be soybeans, coffee, oil, individual stocks, ETFs, cryptocurrencies and a range of others. The futures market is mainly used to manage exposure to the risk of price changes.
Futures and options are often mentioned together, leading many to believe that they are related. Both futures and options involve a contract to trade an asset, but the essential difference is that:
- an option gives you the right (but not the contactual obligation) to execute the trade; you can choose to let the options expire
- a futures contract is more straightforward than an options contract; options have a higher number of possible outcomes.
An option is a contract that gives the buyer the right—but not the obligation—to buy (call) or sell (put) the underlying asset at a specific price on or before a certain date. Unlike futures, which are used to hedge against price volatility, investors use options for income, to speculate, and to hedge risk.
Options are known as derivatives because they derive their value from an underlying asset. Options possess the potential to generate recurring income. They are often used for speculative purposes, such as wagering on the direction of a stock.
Options can be analogous to an insurance policy. It reduces risk at a fraction of the cost. Just as we insure our houses and cars, options can be used to ‘insure’ your investments against a downturn. In the event of a sudden and unexpected volatility, we can exercise our options and therefore minimise a large downturn.
Unlike an insurance policy, which can only be used when there is an injury of some sort, we can use an option to benefit and profit from an unexpected upturn in the market.
I suppose, you could say, that options allow us to keep our options open.
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