Derivatives

Derivatives

What Are Derivatives?

Derivatives are contracts which derive their value from the value of one or more other assets known as underlying assets. The value of derivatives is dependent on the value of underlying assets. The underlying assets could be stocks, market indexes, commodities, currencies, etc. The derivatives whose value is dependent on the value of stocks or market indexes are called as equity derivatives, the derivatives whose value is dependent on the value of commodities are called as commodity derivatives, the derivatives whose value is dependent on the value of currencies are called as currency derivatives and so on.

Types Of Derivatives:-

Futures:-

Future is a standardized contract to buy or sell an underlying asset at a specified future date at a specified price. In the futures contract both the buyer and seller are obligated to buy and sell the underlying asset i.e both the buyer and seller are obligated to fulfill the contract.

Futures contracts based on the underlying assets stocks and market indexes are called as equity futures, futures contracts based on the underlying assets commodities are called as commodity futures, futures contracts based on the underlying assets currencies are called as currency futures and so on.

A person buys a futures contract when he expects the price of an underlying asset to increase and so buys the futures contract of that underlying asset. He makes a profit if the price of that underlying asset increases as expected by him or incurs a loss if the price of that underlying asset decreases. On the other hand a person sells a futures contract when he expects the price of an underlying asset to decrease and so sells the futures contract of that underlying asset. He makes a profit if the price of that underlying asset decreases as expected by him or incurs a loss if the price of that underlying asset increases.

A person has to deposit certain amount of money in his brokerage account before entering into futures contract which is called as initial margin. The initial margin money is a certain percentage of the total value of futures contract. Futures contract is marked-to-market daily which involves daily settlement of profit and loss. The daily loss is deducted from the money in the person’s brokerage account and daily profit is added in his brokerage account. This process is called as mark-to-market settlement. If a person’s loss exceeds the amount of money in his brokerage account before the expiry of futures contract, then he gets a margin call which requires him to put additional money in his brokerage account to the extent of the excess loss incurred to settle that day’s loss.

After the expiry of the futures contract it can be settled either by (1) physical delivery of the underlying asset i.e the buyer of futures contract gets delivery of the underlying asset and makes payment at the price specified in the futures contract and the seller of futures contract gives delivery of the underlying asset and receives payment at the price specified in the futures contract or (2) the futures contract can be cash settled i.e the difference between the price specified in futures contract and the current market price of the futures contract is calculated. If the current market price of futures contract is more than the price specified in futures contract then that difference is a profit for the buyer of futures contract and his brokerage account is credited by that amount and the seller’s brokerage account is debited by that amount as it is a loss for him and if the current market price of futures contract is less than the price specified in futures contract then that difference is a profit for the seller of futures contract and his brokerage account is credited by that amount and the buyer’s brokerage account is debited by that amount as it is a loss for him.
(generally all futures contracts are settled in cash and physical settlement does not take place).

Futures contract can be squared off i.e closed before the expiry date. A person who has bought the futures contract can sell it to square off and a person who has sold the futures contract can buy it to square off. In this way futures contract can be closed before the expiry date and the person can book his profit or loss. The futures contract must be of the same underlying asset and same expiry date to square off.

Futures contract can be of 1 month (near month), 2 months (next month) or 3 months (far month) duration and always expires on the last Thursday of the expiry month and if the last Thursday of the expiry month is a holiday, then it expires on the previous business day.

Example of futures:-
Lets take an example of equity futures contract with the underlying asset stock. Suppose a person buys a futures contract of ABC co Ltd as he feels that the stock price of ABC co Ltd is going to rise. He decides to buy one futures contract i.e one lot of ABC co Ltd which consists of 300 shares. The futures price of ABC co Ltd is rs 2100 per share and the initial margin required is 20% of the total futures value of Rs 630000 (2100*300). So he deposits Rs 126000 (20% of 630000) in his brokerage account and buys one futures contract of ABC co Ltd.

On the expiry day lets assume that the futures price of ABC co Ltd is rs 2400 per share. So he earns a profit of Rs 90000 (300*300) as the price of ABC co Ltd’s stock has gone up as he expected. If on the other hand lets assume that the future price of ABC co Ltd is rs 1900 per share on the expiry day. In this case he would incur a loss of rs 60000 (300*200) as the price of ABC co Ltd’s stock  has gone down.

He can also square off his position in the futures contract before the expiry date by selling the futures contract of ABC co Ltd of the same expiry date and book his profit or loss as the case maybe.

Options:-

Option is a contract which gives the buyer/holder of the contract the right but not the obligation to buy or sell an underlying asset at a specified date at a specified price known as the strike price and the seller/writer of the options contract is obligated to settle the contract as per the terms when the buyer/holder of the contract exercises his right. The buyer/holder of the options contract purchases this right from the seller/writer of the options contract for a consideration which is called as premium. In the options contract only the seller/writer is obligated to buy and sell the underlying asset and not the buyer/holder i.e only the seller/writer is obligated to fulfill the contract and not the buyer/holder.

Options contracts based on the underlying assets stocks and market indexes are called as equity options, options contracts based on the underlying assets commodities are called as commodity options, options contracts based on the underlying assets currencies are called as currency options and so on.

There are two types of options:-
(1) Call option:- Call option gives the buyer/holder of the option the right to buy an underlying asset at the specified price i.e strike price at a specified date. But the buyer/holder does not have the obligation to buy it. The seller/writer of the option on the other hand has the obligation to sell the underlying asset to the buyer/holder if he decides to exercise his right to buy. Call option is purchased by a person when he expects the price of underlying asset to increase.
(2) Put option:- Put option gives the buyer/holder of the option the right to sell an underlying asset at the specified price i.e strike price at a specified date. But the buyer/holder does not have the obligation to sell it. The seller/writer of the option on the other hand has the obligation to buy the underlying asset from the buyer/holder if he decides to exercise his right to sell. Put option is purchased by a person when he expects the price of underlying asset to decrease.

The buyer/holder of the options contract has to pay a certain amount of money called as premium to the seller/writer of the options contract at the time of buying the options contract and the loss of buyer/holder is limited to this amount of premium and his profit potential is unlimited. Whereas the seller/writer of the options contract has to deposit certain amount of money called as margin in his brokerage account before selling/writing the options contract and the profit of seller/writer is limited to the amount of premium he receives from the buyer/holder and his risk of loss is unlimited.

Options can be American or European:-
(1) American option:- American style option can be exercised on or before its expiry date. In India all the stock options are American style options.
(2) European option:- European style option can be exercised only on its expiry date and not before. In India all the index options are European style options.

options can be at-the-money, in-the-money or out-of-money:-
(1) At-the-money:- An option is said to be at-the-money when the strike price of the option is equal or nearly equal to the current market price of the underlying asset. This is true for both the call and put options.
(2) In-the-money:- An option is said to be in-the-money when the strike price of the option is below the current market price of the underlying asset in case of call option and if the strike price of the option is above the current market price of the underlying asset in case of put option.
(3) Out-of-money:- An option is said to be out-of-money when the strike price of the option is above the current market price of the underlying asset in case of call option and if the strike price of the option is below the current market price of the underlying asset in case of put option.

Intrinsic value and time value of options:-
Intrinsic value of the options contract is the amount by which the strike price of the option is in-the-money. It is the difference between the current market price of the underlying asset and the strike price of the option. It can be viewed as the immediate exercise value of the option. For a call option, intrinsic value= current market price of the underlying asset- strike price of the option. For a put option, intrinsic value= strike price of the option- current market price of the underlying asset. The intrinsic value of an option must be a positive number or zero. It cannot be negative. If an option is at-the-money then the intrinsic value of that option is zero.
Time value of the options contract is the amount by which the price of the option i.e premium exceeds its intrinsic value. It is also called as extrinsic value of the option. For a call option, time value= call premium- intrinsic value. For a put option, time value= put premium- intrinsic value.

After the expiry of the options contract it can be settled either by (1) physical delivery of the underlying asset i.e the buyer/holder of options contract (with call option) gets delivery of the underlying asset and makes payment at the strike price to the seller/writer in case he exercises his right to buy and the seller/writer gives delivery of the underlying asset and receives payment at the strike price or the buyer/holder of options contract (with put option) gives delivery of the underlying asset and receives payment at the strike price in case he exercises his right to sell and the seller/writer gets delivery of the underlying asset and makes payment at the strike price. If the buyer/holder of the option does not exercise his right to buy or sell then the option expires unexercised and the buyer/holder loses the premium amount paid by him and the seller/writer keeps the premium amount. (2) The options contract can be cash settled i.e if the current premium value of the option on expiry day is more than the premium value at the time of purchasing the options contract, then that difference is a profit to the buyer/holder and his brokerage account is credited with the profit amount and he also gets back the premium amount which he paid. The seller/writer’s account is debited with the loss amount. If the current premium value of the option on expiry day is less than the premium value at the time of purchasing the options contract, then that difference is a loss to the buyer/holder and this loss is deducted from the amount of premium which he paid at the time of purchasing the option contract and he gets the remaining amount of premium back after deducting the loss. The seller/writer gets to keep the amount of premium which is lost by the buyer/holder as his profit. Sometimes the premium value of an option becomes zero on the expiry date. In such a case the buyer/holder loses the entire amount of premium which he paid at the time of purchasing the options contract and the seller/writer gets to keep that whole amount of premium as his profit.
(generally all options contracts are settled in cash and physical settlement does not take place).

Options contract can be squared off i.e closed before the expiry date. The buyer/holder of a call option can sell a call option and the buyer/holder of a put option can sell a put option to square off their position in the options contract. In this way options contract can be closed before the expiry date and the buyer/holder can book his profit or loss. The options contract must be of the same underlying asset, strike price and expiry date to square off.

options contract can be of 1 month (near month), 2 months (next month) or 3 months (far month) duration and always expires on the last Thursday of the expiry month and if the last Thursday of the expiry month is a holiday, then it expires on the previous business day.

Example of options:-
Lets take an example of equity options contract with the underlying asset being market index- nifty. Suppose a person feels that the nifty index value is going to decrease and hence buys a put option of nifty options contract with a strike price of 8300 and pays a premium of rs 50 per unit which is the premium value at that time. One contract i.e one lot of nifty options contract currently consists of 75 units and so he pays the total premium amount of rs 3750 (75*50). The current value of nifty index in the spot market at the time of purchasing the options contract is 8400. So he buys a out-of-money nifty options contract.

After purchasing the options contract, if the value of nifty index in spot market starts to decrease then the premium value of the options contract would start to increase and if the value of nifty index in spot market starts to increase then the premium value of the options contract would start to decrease. This is because he has purchased a put option with the expectation of decrease in nifty index value.

On the expiry day lets assume that the value of nifty index in spot market is 8275 and the premium value of the options contract has become rs 90 per unit. So he would earn a profit of rs 40 per unit (90-50) which amounts to Rs 3000 (40*75). He would earn profit as the nifty index value in spot market has gone down as he expected. Overall he would get Rs 6750 (90*25) credited in his brokerage account. The option seller/writer would suffer a loss of Rs 3000.  If on the other hand lets assume that value of nifty index in spot market is 8410 and the premium value of the options contract has become Rs 5 per unit on expiry day. In this case he would incur a loss of Rs 45 per unit (50-5) which amounts to Rs 3375 (45*75). He would incur loss as the nifty index value in spot market has gone up. He would get Rs 375 (5*75) credited in his brokerage account. The option seller/writer would earn a profit of Rs 3375. If in this case the premium value had become 0 on expiry day then he would have lost all his premium amount to the option seller/writer i.e his loss would have been Rs 3750 and the option seller/writer would have earned a profit of Rs 3750.

He can also square off his position in the options contract before the expiry date by selling the put option of nifty index of the same expiry date and strike price and book his profit or loss as the case maybe.

Difference Between Futures And Options:-

Futures Options
In the futures contract both the buyer and seller are obligated to buy and sell the underlying asset at the specified price and on the specified date. Both the buyer and seller are required to fulfill the contract. In the options contract only the seller/writer is required to fulfill the contract. The buyer/holder has the right to buy (in case of call option) or sell (in case of put option) the underlying asset at the specified price but not the obligation. Seller/writer has the obligation to sell or buy the underlying asset if the buyer/holder exercises his right.
 In the futures contract, both the buyer and seller have unlimited profit potential and also the risk of incurring unlimited loss.  In the options contract, the buyer/holder has unlimited profit potential and his risk of loss is limited. The seller/writer on the other hand has risk of incurring unlimited loss and his profit is limited to the amount of premium.
Upfront margin money is required to be deposited by both the buyer and seller before entering into the futures contract. The buyer/holder is required to pay premium money while the seller/writer is required to deposit margin money before entering into the options contract.

Forwards:-
Forward is a customized contract to buy or sell an underlying asset at a specified future date at a specified price. Forwards contract is similar to a futures contract but is a customized contract and not standardized. Forwards contract is not traded on the stock exchanges like NSE and is not exchange regulated. It is traded over-the-counter.

Difference Between Futures And Forwards:-

 Futures Forwards
Futures contract is a standardized contract. Forwards contract is a customized contract.
Futures contract is traded on the stock exchange. Forwards contract is traded on the over-the-counter exchange.
In the futures contract there is daily settlement of profit and loss as futures contracts are marked-to-market. In the forwards contract there is no daily settlement of profit and loss as forwards contracts are not marked-to-market.
In the futures contract there is no counterparty risk because of the presence of clearing house. In the forwards contract there is high counterparty risk because of the absence of clearing house.
In the futures contract there is liquidity for the parties as they can square-off their contract before the expiry date. In the forwards contract there is no liquidity for the parties as they cannot square-off their contract before the expiry date.

Minimum Contract Value Of Derivatives:-

The minimum contract value or size of equity derivatives traded in the Indian market is Rs 500000. It applies to both futures and options. SEBI has specified that the value of a equity derivative contract should not be less than Rs 500000 at the time of introducing the contract in the market.

 

 

 

 

 

 

 

 

 

 

 

 

 

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