HOW DO FINANCIAL CONTRACTS WORK?

What Are Financial Contracts?

Financial contracts are legally binding agreements between two or more parties to transact under defined conditions. These contracts govern a range of instruments in financial markets, such as options, futures, forwards, and swaps. Each contract type has unique features, but they generally share common elements like the strike price, expiration date, contract size, and premium. These components determine the value, obligations, and potential risk or reward associated with the agreement.

These financial derivatives often serve to hedge risk, speculate on underlying asset prices, or provide leverage. Typically, contracts derive their value from an underlying asset such as a stock, commodity, currency, or interest rate. Financial contracts have clearly defined terms and are either traded on exchanges — with standardised terms and central counterparty clearing — or over-the-counter (OTC), where contract terms are privately negotiated.

Let’s examine four key elements of financial derivative contracts to understand their role in structuring and evaluating these agreements:

• Strike Price: The pre-determined price at which the underlying asset can be bought or sold if the contract is exercised.
• Expiration Date: The last date on which the contract is valid and can be exercised.
• Contract Size: The quantity of the underlying asset represented by one contract.
• Premium: The cost or fee paid to acquire the contract, usually applicable in options trading.

Understanding the function and interaction of these elements helps investors and traders manage financial exposure more effectively. Whether used for speculation or risk mitigation, these components define the financial commitment and potential outcomes of the contract.

From institutional investors managing portfolios to retail traders exploring growth strategies, comprehending the terms and mechanics of financial contracts is essential for informed decision-making. As we examine each component in greater depth, we provide clarity on how these structural features help forecast potential profit, loss, and strategic application within broader investment strategies.

Understanding Strike Price and Expiry

Two critical features of most financial contracts, especially in derivatives like options and futures, are the strike price and the expiration date. These components together define the contract's time value, moneyness, and eventual profitability or loss.

Strike Price Explained

The strike price, sometimes called the "exercise price," is the agreed-upon price at which the underlying asset may be bought (call option) or sold (put option), depending on the contract type. This price remains fixed over the contract duration.

In the context of an options contract:

• If the market price of the underlying asset is above the strike price in a call option, the option is in-the-money, indicating potential profit upon exercise.
• If the market price is below the strike price in a put option, it is also in-the-money.
• Conversely, if the market conditions do not favour the strike price, the option is deemed out-of-the-money, and exercising it would result in a loss.

The relationship between the strike price and the current price of the asset determines the "intrinsic value" of the option. Investors often evaluate whether to exercise contracts or let them expire based on this valuation.

Expiration Date Defined

The expiration date is when the financial contract becomes void. For options and futures, this is the last trading day upon which the contract can be exercised or settled. After this date, the contract holds no value or enforceability.

Contracts can be crafted with different durations:

• Weekly Options – expire within one week; used for short-term trading strategies.
• Monthly Options – expire on a set day each month; commonly used by retail investors.
• Quarterly or Long Dated Contracts – spanning several months or years, suitable for longer-term hedges or speculation.

Traders often consider "time decay" — the gradual loss of extrinsic value as the expiration date nears. In options trading, contracts lose value as they approach expiry if the underlying doesn’t move favourably relative to the strike price.

Together, the strike price and expiry structure the core value dynamics of a derivative contract. Understanding both allows traders to develop strategies that align with their market expectations and risk profiles.

Contract Size and Premium Explained

In derivative markets, contract size and premiums play an essential role in determining the scale of an investment and associated costs. Understanding these components is crucial in assessing your exposure, required margin, and potential returns or losses from trading financial contracts.

What Is Contract Size?

The contract size represents the amount of the underlying asset covered by a single financial contract. Each asset class — whether equity, commodity, or currency — typically has its standardised lot size when traded on an exchange.

For instance:

• In equity options: one contract usually represents 100 shares of the underlying stock.
• In futures: a crude oil futures contract might cover 1,000 barrels of oil.
• In forex trading: contract sizes vary from standard lots (100,000 units) to mini and micro lots.

Contract size determines both scale and required capital. A larger contract size implies greater exposure and higher potential gains or losses. Brokers often require margin deposits — a percentage of the contract value — as collateral. Margin requirements vary depending on asset volatility and contract duration.

Understanding the Premium

A premium is the price paid by the buyer to the seller to acquire an option contract. It represents the upfront cost and is not recoverable unless the option is profitable when exercised or offset through a trading strategy. This premium is influenced by several factors:

• Intrinsic value – the difference between the strike price and the current market price when favourable.
• Time value – the remaining lifespan of the contract; longer durations increase the premium.
• Volatility – higher market volatility boosts premium due to increased probability of favourable movements.
• Interest rates and dividends – these can impact premiums, especially in equity options.

Option writers (sellers) receive the premium as compensation for the risk they assume in granting the right to exercise the option. Buyers of options invest the premium in hopes that favourable price movements will render the contract profitable before or at expiration.

While premiums are primarily associated with options contracts, they can appear in structured products and swap-related derivatives as upfront fees or periodic payments, depending on contract design.

Balancing contract size with premium cost enables traders to scale strategies appropriately and manage capital efficiency. It also supports informed decisions around leverage and risk management. Understanding these financial mechanics is crucial to navigating derivative markets prudently and successfully.