Derivatives

Gaining a fair idea on the basics of stock markets and equity and debt instruments, we now dwell further to some extensive study in financial markets.

Derivatives

Derivative is a financial product whose value is derived from the underlying assets. The underlying assets can be equity, index, currencies, commodities, bonds etc. Derivative products were developed initially as hedging instruments against fluctuations in commodity prices. The financial derivatives came into being post 1970, due to growing instability in financial markets and since then, financial derivatives have became very popular and they accounts for two-thirds of total transactions. Investors of financial markets are broadly categorized on the basis of time horizon of their investment.

Derivative is basically hedging and trading instrument. Being a margin based trading instrument, it provides good leverage opportunity which ultimately gives the rise of speculations.

A futures contract gives the right to buy or sell a given amount of underlying at specified price and on or before specified date. Both parties of futures contract must exercise the contract unless they are deliverable on or before the settlement date.

Features of Futures Trading:

• Initial margin amount of contract value is required for taking positions which is determined by exchange on the basis of SPAN plus exposure margin.
• Mark-to-market profit/loss will be adjusted on daily basis.
• Positions need to be squared off by last trading day of the contract failing which exchange will square off those positions.

Index futures have indices as underlying.

Contracts of different maturities available for trading are called current month (1 month), near month (2 months) and far month (3 months) contracts. The month in which a contract expires is called the contract month.

Options

It gives the buyer the right to buy or sell the underlying without any obligation. While buyer of an option pays the premium and thereby acquires the right to exercise his option, the seller or writer of an option receives the option premium and thus become obliged to sell/buy the asset if the buyer exercises his rights.

While ''Call Option'' gives the buyer the right but not the obligation to buy the underlying asset at a given price before given future date, ''Put Option'' gives the buyer the right but not the obligation to sell the underlying asset at a given price in future.

Buying of Call and Put options require premium to be paid and expose traders to risk limited by to the size of premium paid while selling/writing of options require margin to be paid and expose to risk similar to futures market.

Style of options

European Options can only be exercised i.e., delivery can be taken by buyer of options on expiry date of contract.

American Options can be exercised i.e., delivery can be taken by the buyer any time on or before the expiration date.

Contract Cycle:

Contract Cycle is the period over which a contract trades. The index futures contracts on the NSE have one-month, two- months and three- month’s expiry cycles.

Option Strategies

A trader having long/bullish directional view on the underlying can buy a Call option or write /short Put option. Similarly, a trader having short/bearish directional view on the underlying can sort/write Call option or long/buy Put option

Besides, we have combination strategies which are very useful when market view is moderately bullish/bearish, range bound or uncertain and the objective is to reduce overall payout of option premium. Instruments include, Bull & Bear Call-Put Spread, Strangle, Straddle, Butterfly, Covered and Protective Call and Put etc.

Marked to Market in futures:

It provides for adjustment trading account which is necessitated on account of changes in prices.

Hedging:

Hedging is a strategy to minimize the risk inherent in investment.

Speculation:

It is trading strategy aimed at making profit in short period of time with price fluctuations.

Benefits of Derivatives:

Hedging: It helps to safeguard against future price uncertainties

Leverage:As margins required are very low, it allows higher trading exposure

Potential Return:Irrespective of market conditions, one can make money

Longer position taking: It gives a time leverage of up to 3 months as against 1-3 days offered in other margin products