With the introduction of options and futures, investment risk management has assumed a new dimension. Though the manager can achieve a high degree of freedom, it does not alter the market profile of an equity portfolio economically or quickly. They however offer these managers risk and return patterns that did not exist earlier. We must realize that the options and future markets are solely and wholly dependent on the performance of the underlying financial instrument, that is the equity market.
An option is basically a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer an underlying security at a specified price, i.e. the strike price within a specified period of time. In exchange for the option the buyer pays the writer money called the option premium or price.
A "call" option, is when the option grants the buyer the right to buy the underlying security at the specified price during or at the end of the option period.
A "put" option, is when the option grants the buyer the right to sell the underlying security at the specified price during or at the end of the option period.
A future contract is an agreement between a buyer and seller, in which the buyer agrees to take delivery and the seller agrees to give delivery of some product at the end of the designated period of time, called the settlement date.
Aside from the purely speculative application of these instruments, options and futures can be used to create a synthetic instrument that offers a higher return than a cash market instrument or an index. They can be used to adjust the risk exposure i.e. hedge a stock or bond portfolio quickly. They can also be used to alter the stock/bond mix of a portfolio quickly. Future contracts can be used to reduce the transaction cost of creating an index fund. These instruments are also used for portfolio insurance.
We would expect the investor to realize that, options and futures are contracts based on the expected movement of an underlying security; and are not in themselves investments. The individual investor should avoid indulgence in options and futures, unless of course he has gained the knowledge on how to trade successfully in these instruments. Due to the speculative nature of these instruments we have not discussed them in detail.
For a better understanding of options, we would suggest that the investor read through the above listed topics. We would strongly recommend that the investor first study these investment instruments; conduct dry runs with pen and paper; understand the nuances of the dynamics of the underlying security and the connectivity between the various risks that he or she would be taking on during the pendency of a futures or options position held by him.