9 Futures and options

Introduction

‘Derivatives are financial weapons of mass destruction.’

Warren Buffett

This chapter is mainly concerned with the index futures markets and their influence on stock market trading and investing.

A security is a financial instrument capable of having a negotiable value ascribed to it. Types of security include shares, bonds, and commodities.  A derivative security derives its value from an underlying tangible security.  An index futures price – just a number – is a derivative security and tradable. The futures markets trade a wide range of securities.  In shares, they trade stock market indices, sector indices, and individual shares, all with high leverage.  They are used by traders for speculation, hedging, and arbitrage.  Index trading dominates the futures markets for shares.

Futures trading developed from forward contracts, which allow a producer of a commodity to agree a selling price at a convenient future time for his commodity.  This would perhaps be a modest price that he would be content to have, and he is prepared to give up some upside to protect against an unattractive downside price.  The speculator who enters into the forward contract takes the chance that he will ultimately obtain a better price than the forward contract price, i.e., he buys at the forward price and then sells for a higher price.  Both parties then have the possibility to trade their futures contracts, which has led to the development of exchange trading.

There are now modern, regulated exchanges that enable futures trading between parties – on the one side, a party who believes that an index or share price will rise, and on the other side, a party who believes it will fall.  The party who is wrong pays the party who is right – very different conceptually from a forward contract between a farmer wanting to lock in a price for his harvest and a speculator, both of whom can benefit from the arrangement. Or a mining company wanting some protection against a sharp fall in the price of the commodity that it is producing. […]