Options, Futures and Currencies 101

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (The LFB-Forex) -- Futures and options markets provide a method for the global exchange of goods and services in different currencies, allows producers to hedge forward contract costs, and offers speculators the chance to provide liquidity.

Futures contracts are used by international banks to balance capital reserves, multi-national companies to repatriate overseas profits, and inter-bank markets to create near-term lending liquidity. This creates a global market-place with high liquidity that is open virtually 24-hours a day in which futures programs can track the ebbs and flows of international trade across each regional time-zone.

Options and futures contracts are used to speculate in a particular market without all of the inherent risks that the cash market poses.

Traders who are only on one side of an option, or have no underlying asset to insure, are referred to as speculators. Producers of goods for future delivery that need to eliminate potential loss are referred to as hedgers.

Speculators and market makers provide liquidity to the hedgers, and in turn, the hedgers provide a reciprocal means by which both then have the opportunity to make profits.

Hedgers

If a client has entered into a long cash position that he or she plans to hold for a period of time to allow for maximum profit, or is producing a product to sell at a later date, he or she may also place a buy option puts or futures contracts in that same market, to hedge against a rash move down on their long position. The hedger may make up any loss sustained in the cash position by maximizing the premium of the long put he or she purchased.

The opposite side of the hedger's contract position was provided by a speculator or a market maker. Each of these participants understand that the chances of the contract being in-the-money by expiration are low, but they each also understand the importance of the liquidity that was provided.

The nature of option and futures trades, and the job that they are designed to do, has a hedger expecting that their contract expires worthless. That means they made a profit on the long cash position, and paid the option or futures contract premium for peace of mind insurance.