Unravelling contingent & commitment contracts
Such contracts can be used for both speculation, which implies the assumption of a calculated risk, and for hedging, which refers to the assumption of a derivatives position to mitigate, if not eliminate, a trader’s prior exposure to price risk.
If such contracts are used for speculation, there is the potential for handsome profits if the trader reads the market movement correctly, but there is always the possibility of a significant loss if he were to misread it. This is true from the standpoint of both bulls as well as bears. Similarly, while hedging represents an attempt to avoid risk, there is no assurance that the outcome with hedging will be superior to what would have transpired had the trader chosen to remain unhedged.
Options contracts work a little differently from forward and futures contracts and are termed as ‘contingent contracts’. This is because the holder or buyer of an option is bestowed with a right to transact, while the seller or the writer of an option is required to assume an obligation. An option holder may acquire the right to buy the underlying asset, or else, he may acquire the right to sell the underlying asset. Consequently, we have two categories of
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