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Futures and options - they're so very different

Friday 4th May 2001

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There is a fundamental distinction between futures and options. A futures contract runs to expiry and ties both parties. Settlement obligations apply to both parties at expiry and the only way to get relief from the obligations before or at expiry is to buy/sell the other side of the contract. That is known as a "swap" and the technique results in one contract cancelling the other.

Options, by contrast, can be closed out at any time before expiry and are referred to as "American" options, as opposed to "English" options, which are open until the expiry date. An option can be exercised at the choice of either party to the transaction during its lifetime and elapses at expiry if not exercised.

Most New Zealand financial institutions have strict guidelines on the use of derivatives.

They normally must be related to the types of physical securities the fund managers have authority to invest in and limits are usually placed on the level of derivatives, again related to allowable holdings of physical securities.

Depending on particular institutions' investment rules, it is common for positions on NZFOE futures contracts to be confined to a level that, if the options were exercised, the exercise value is not more than the limit allowed for a full futures contract.

It also seems to be normal institutional practice to limit investment in equity options to situations where there are underlying physical shares to back up the position if the options were exercised.

That effectively means the dealers are not allowed to go "short" (dealing in securities in a situation where they may have to buy back later to cover positions).

It is unlikely any New Zealand institution would allow its dealers to get involved in what are generally termed "exotics" in fringe derivative markets, usually based in Asia.

Such "products" seem to be first cousins to the range of well-known financial scams, including weird offerings from people who claim to have access to vast sums available from various Nigerian organisations. The more extra-
ordinary the name of the exotic, the more likely an investor is increasing the risk of loss.

Equity options, whether on the NZSE Top 10 index or over the individual company shares listed in Table 1, are useful for protecting portfolio holdings.

Equity futures (NZSE10 capital share price index) and options (the 10 index and the individual company shares listed in Table 1) are useful for portfolio protection, cashflow management, asset allocation and arbitrage (taking advantage of different prices in two or more markets).

In the case of share options, a protective position for a portfolio or an individual can be taken for low cost. The underlying shares held would be protected through the strategy.

A buyer of the options gets limited risk and unlimited profit potential, because the buyer can never lose more than the premium paid, no matter what happens on the sharemarket. As the NZFOE says, "At the same time, the profit which can be earned by the buyer of an option is potentially unlimited. The reverse applies for option sellers."

Derivatives are a legitimate feature of soundly based investment markets but personal investors taking positions in them need to make a sober assessment of their risk tolerance.

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