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What are Derivatives?
As the name suggests, derivative contracts are those contracts which derives
their value from the price of something else.
Typically derivatives contracts derive their value from underlying cash market
for e.g. derivative of the Reliance, will derive its value from the cash market
price of Reliance.
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What are different types of Derivatives?
Although there are many types of derivatives, in Indian stock market currently
we have futures and options.
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What are Futures and How they function?
Futures are derivative contracts to buy or sell a specified quantity or
underlying assets at an agreed price, on or before a specified time. They are
standardized forward contracts, which are traded on the exchanges mainly BSE
& NSE. Since they are traded on the exchange on electronic platform, it
provides them transparency, liquidity, anonymity of trades, and also eliminates
the counter party risk due to guarantee provided by the exchange.
Derivative market is a leverage market since Investor/Trader has to pay only
fraction of total value of the contract as a margin to his broker, who in turn
has to pay to the exchange, for e.g if Rs. 100/- is required to be deployed in
cash market for taking a delivery the same stock if available in derivatives
market can be bought by paying an average margin of around 15%.
Currently in India we have 3 types of contracts available for trading i.e for
current month, next month and far month. On last Thursday of
each month these contracts expires and then they are settled at a closing price
of underlying cash market. In India contracts are settled in cash. Further day
to day mark to market difference is also debited/credited to the client and
broker’s account by the Exchange.
This can be explained by following e.g. say an investor has a bullish view on
Reliance and hence buys a Reliance in a futures market at a start of current
month at Rs.750/- wherein price in cash market is Rs.747/-.
He has to pay 15% margin on Rs.750/- i.e. approx 112.5 per share to his broker
as a margin, unlike entire Rs.747/- for buying the same share in cash market.
Now say for e.g. on the next day the price of the Reliance in the futures
market moves upto Rs.760/- then he will be credited Rs.10/- in his account
(760-750). Supposing next day price falls by Rs.5/- to Rs.755/- he will be
debited by Rs.5/- in his account.
Thus, on a daily basis his account will be debited/credited to the extent of
difference in price compared to previous day. On the last day of the contract
the difference will be settled by taking the closing price in the cash market
for Reliance.
In the similar manner if investor has a bearish view on Reliance he can short
sell in futures market unlike in cash market where he can sell only if he has
shares in his hand.
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How the Future price is arrived?
The pricing of the futures depends on cash market price and the cost of carry.
The Cost of carry is the sum of all costs incurred if a similar position is
taken in cash market and carried to maturity of the futures contract less any
revenue which may result in this period. Generally the cost comprises interest
while revenue comprises of dividend. Say for e.g. the interest rate is 12% and
the dividend declared by the company is say 0.50ps. on the stock that is
quoting at Rs.100/- in cash market then the theoretical value of this stock in
the futures market should be 100 + 1 – 0.50 = 100.50.
Although generally by definition futures prices should be higher than the cash
prices to the extent of the interest element (assuming no dividend). However,
many a times it is not so and it may be significantly higher or lower than the
cash price because of built-in market expectations for that stock in futures
prices.
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What is Basis?
The difference between spot price and futures price is known as basis. Although
the spot price and futures price generally move in line with each other, the
basis is never constant. It gradually decreases with time and on expiry since
futures and cash prices becomes equal basis becomes ‘zero’.
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What are Options & How they function?
Options are derivative contracts where the person gets a right (but not
obligation) to buy or sell a specified quantity of the underlying asset at an
agreed price (strike price) on or before the specified future date (expiration
date) at an agreed price (premium).
This can be explained by an e.g. as follows :
Suppose an investor is bullish on Reliance at the start of the current month
when the price is Rs.750/- say for e.g. he is expecting a price of Rs.850/- by
end of the month. Although he is expecting an upward price movement, he wants
to limit his downside risk and hence he buys an option contract of Rs.750/-
(strike price) for a price of say Rs.30/- (premium) By paying Rs.30/- what he
gets is right (not an obligation) to buy Reliance at any time before the month
end at Rs.750/- only, irrespective of cash market price.
Obviously he will exercise his right if cash market price is higher than
Rs.750/- any time before expiry of the contract. Since he has already incurred
Rs.30/- as a cost for buying this right his break even point is Rs.780/- so if
Reliance moves to Rs.850/- he makes Rs.80/- (850-750-30) on an investment of
Rs.30/- (cost of buying an option). Now suppose that Reliance moves down to Rs.
650/- in this case since it makes more sense to buy Reliance from the cash
market, he will not exercise his right to buy at Rs.750/- and hence he loses
the premium amount of Rs.30/-. At the same time he avoids the downside risk of
Rs.100/- which otherwise he would have taken had he bought the Reliance from
the cash market at Rs.750/-.
Thus, options in a way, are like an insurance contract where by paying certain
premium, option buyer passes on his risks to option seller. The risk of option
buyer is limited while that of an option seller is unlimited. In a similar
manner, option buyer has an unlimited gain potentials while option seller has a
limited income potential to the extent of premium income only.
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What are the different types of Options?
There are basically 2 types of option contracts:
(a) Call Options
(b) Put Options
Call Options:
A call option gives the holder (option buyer), the right to buy a specified
quantity of the underlying asset at a strike price on or before expiration
date. The seller however, has the obligation to sell the underlying asset if
the buyer of the call option decides to exercise his option to buy.
Put Options:
A Put Option gives the holder (i.e. the buyer), the right to sell a specified
quantity of the underlying asset at a strike price on or before an expiry date.
The seller of the put option however has the obligation to buy the underlying
asset at the strike price if the buyer decides to exercise his option to sell.
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What are the different style of Options?
Broadly there are 2 styles of options,
(i) American style option and
(ii) European style option
American style option An American style option is one, which
can be exercised by the buyer on or before the expiration date, i.e anytime
between the time of purchase and the time of its expiry.
Technical Analysis The European kind of option is one, which
can be exercised by the buyer on the expiration day only and not anytime before
that. In India, stock options are of the American style while index options are
of the European style.
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What factors determine option prices (premium)?
There are two types of factors that affect the value of the option (premium) :
(i) Quantifiable factors, they are strike price, underlying asset price, the
volatility of the underlying asset, the time to expiration and the risk free
interest rate:
(ii) Non-quantifiable factors, they are market participants varying estimates
of the underlying assets future volatility and future performance.
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What is a difference between Futures and Options?
The significant differences between them are as under:
In case of futures, both the parties have an obligation to buy/sell the
underlying asset. Whereas in the case of options the buyer enjoys the right and
not the obligation, to buy or sell the underlying asset.
In case of Futures the risk/return profile of both buyers and sellers is equal
whereas in case of options the buyer has a limited risk and unlimited gain
potential and seller of the option has a unlimited risk and limited gain
potential.
Future prices are mainly affected by the prices of underlying asset while
option prices are affected by not only the prices of underlying asset, but also
by volatility and time to expiry.
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Can Futures & Option be traded or one has to wait till expiry?
Yes, Once the position is taken in futures, it can be squared off by taking a
reverse position any time before the expiry of the contract.
Similarly once the position is taken in the option contract, it can be squared
off by taking a reverse position any time before the expiry.
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What are various derivative Strategies and how it can be utilized?
Option strategies are various combination of futures and options in such a
manner that it offers optimal risk to reward ratio based on the view of a
market player for e.g. an investor having a moderately bullish view on a market
can buy a stock or futures and correspondingly sell call of higher price at
some premium and thus not only participate in rally but also earn some premium
income. This is called a covered call writing. Bullish and bearish option
spread, Strangle, straddle are few of other option strategies which can be
utilized by the market players.
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What is Index Futures and how one can utilize that?
Index futures are the futures on index. Currently on NSE we have 3 types of
index futures. They are Nifty futures, CNX IT futures and Bank Nifty futures.
While Nifty future is future on cash Nifty CNX IT and Bank Nifty are futures on
IT and bank index respectively.
An investor can utilize this futures as a hedging tool or for a trading based
on his view about that index.
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What are the Usage/Advantages of Derivatives?
Versatility : The major advantage of derivatives is their
versatility. An investor can use derivative in a most conservative to most
riskiest manner as his risk profile dictates.
High Leverage : Derivative contracts enables the investor to
take an exposure to the full value of underlying shares for a fraction of its
value in the form of margin.
High Liquidity : Derivative contracts offers very high
liquidity compared to cash market.
The Derivatives offers the following usages :
Speculation : One can take a view of the market and buy or
sell derivatives accordingly at a fraction of a total cost.
Hedging : It reduces the risk associated with market exposure
by taking a counter position in the derivatives market.
Arbitrage : It offers an opportunity to take an advantage of
the price difference between the derivatives market and the cash market.
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