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T O P I C S C O V E R E D
What are Derivatives?
Cash Market v/s Forwards Market
Forwards
Futures
Options
M E A N I N G
A derivative is a contract or a product whose value is derived from the value of some
other asset known as the underlying. Derivatives are based on a wide range of
underlying assets.
These include:
Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead, etc.
Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural
Gas, etc.
Agri commodities such as Wheat, Sugar, Coffee, Cotton, Pulses etc.,
Financial assets such as Shares, Bonds and Foreign Exchange
HEDGERS
They face risk associated with the prices of underlying assets and use derivatives to
reduce their risk. Corporations, investing institutions and banks all use derivative
products to hedge or reduce their exposures to market variables such as interest
rates, share prices, bond prices, currency exchange rates and commodity prices.
SPECULATORS/TRADERS
They try to predict the future movements in prices of underlying assets and based on
the view, take positions in derivative contracts. Derivatives are preferred over
underlying asset for trading purpose, as they offer leverage, are less expensive (cost of
transaction is generally lower than that of the underlying) and are faster to execute in
size (high volumes market).
ARBITRAGEURS
Arbitrage is a deal that produces profit by exploiting a price difference in a product in
two different markets. Arbitrage originates when a trader purchases an asset cheaply
in one location and simultaneously arranges to sell it at a higher price in another
location. Such opportunities are unlikely to persist for very long, since arbitrageurs
would rush into these transactions, thus closing the price gap at different locations.
Products in the Derivatives Market
FORWARDS FUTURES OPTIONS SWAPS
FORWARDS
A forward contract is an agreement made directly between two
parties to buy or sell an asset on a specific date in the future, at the
terms decided today. Both the contracting parties are committed
and are obliged to honour the transaction irrespective of the price
of the underlying asset at the time of delivery. Since forwards are
negotiated between two parties, the terms and conditions of
contracts are customized. These are Over-the-counter (OTC)
contracts.
Example-
Rajesh is a farmer in Punjab who grows Wheat and ABC is Food Processing company
Rajesh sows’ wheat in November, harvests in April and ABC needs a consistent
wheat supply year-round
Current wheat price: ₹2,000 per quintal (100 kg)
The problem:
Rajesh is concerned about potential price drops due to bumper crops
ABC company worries about price hikes during lean seasons
The solution:
Rajesh and ABC company agree on a price of ₹2,000 per quintal
Rajesh will deliver 1,000 quintals to ABC in 6 months
Possible outcomes:
Scenario A:
Price rises to ₹2,200 per quintal due to lower-than-expected yield
Market value: ₹22,00,000
Contract value: ₹20,00,000
Rajesh misses extra profit, but ABC company saves ₹2,00,000
Scenario B:
Price falls to ₹1,800 per quintal due to surplus production
Market value: ₹18,00,000
Contract value: ₹20,00,000
Rajesh gains ₹2,00,000 over market price, ABC company pays more
Liquidity Risk:
Liquidity refers to the ability of the market participants to buy or sell the desired
quantity of an underlying asset. As forwards are tailor-made contracts i.e., the
terms of the contract are according to the specific requirements of the parties,
other market participants may not be interested in these contracts. Forwards are
not listed or traded on exchanges, which makes it difficult for other market
participants to easily access these contracts or contracting parties.
Counterparty risk:
Counterparty risk is the risk of an economic loss from the failure of the
counterparty to fulfil its contractual obligation.
In addition to the illiquidity and counterparty risks, there are several issues like:
Lack of transparency
Settlement complications as it is to be done directly between the contracting
parties.
A simple solution to all these issues is to bring these contracts to the centralized
trading platform.
This is what futures contracts do.
FUTURES CONTRACTS
Futures contracts were created to overcome the limitations of forwards. A futures
contract is an agreement made through an organized exchange to buy or sell a fixed
amount of a commodity or a financial asset on a future date at an agreed price. In
simple terms, futures are standardised forward contracts that are traded on an
exchange. The clearing corporation associated with the exchange guarantees
settlement of these trades.
FUTURES CONTRACTS
Accordingly, futures contracts have following features:
Contract between two parties through Exchange
Centralised trading platform (i.e., Exchange)
Price discovery through free interaction of buyers and sellers
Margins payable by both the parties
Quality decided today (standardized)
Quantity decided today (standardized)
Contract specifications of futures contracts:
Contract multiplier or Contract Size: Futures and options contracts are traded in lots. The
lot size or contract size for the index and stock futures is determined by the exchange.
Contract sizes are different for each stock and index traded in the derivatives segment.
To arrive at the contract value, we must multiply the futures price with the contract
multiplier (i.e., multiply the futures price with the lot size). The contract size for the Nifty
futures contract is currently 50
Contract Cycle: It is a period over which a contract trade. Index and stock futures
contracts traded on the NSE follow a three-month trading cycle. Thus, on May 10, 2023,
index and stock futures contracts on the NSE are available for trading for the near month
(May 2023), the next month (June 2023) and the far month (July 2023). The NSE and BSE
offers trading on monthly as well as weekly futures contracts
Expiration Day: This is the day on which a derivative contract ceases to exist. It is the last
trading day of the contract. The monthly futures contracts on the Nifty Financial Services
Index expire on the last Tuesday of their expiry month.
Contract specifications of futures contracts:
Trading hours: The equity futures contracts can be traded during the normal market
hours between 9.15 am and 3.30 pm from Monday to Friday.
Price band: Price Band is essentially the price range within which a contract is permitted
to trade during a day. The band is calculated with respect to the previous day’s closing
price of a specific contract.
Long position: Outstanding / unsettled buy position in a contract is called “Long
Position”. For instance, if Mr. X buys 5 contracts on Sensex futures,then he would be long
on 5 contracts of Sensex futures.
Short Position: Outstanding / unsettled sell position in a contract is called “Short
Position”. For instance, if Ms. P sells 5 contracts on Sensex futures, then she would be
short on 5 contracts on Sensex futures.
Futures contracts are traded in lots. The lot size or contract size for the index and stock
futures is determined by the exchange
FEATURE FORWARD CONTRACTS FUTURES CONTRACTS
OPERATIONAL
It is not traded on the exchanges It is an exchange-traded contract
MECHANISM
Terms of the contracts differ from Terms of the contracts are
CONTRACT trade to trade (tailor made contract) standardized. Except the price, all
SPECIFICATIONS according to the need of the other terms of the contract are
participants already fixed
The clearing agency associated
with exchange becomes the
COUNTER- Exists, but at times gets reduced by
counter-party to all trades
PARTY RISK a guarantor
assuring guarantee on their
settlement
FEATURE FORWARD CONTRACTS FUTURES CONTRACTS
Low, as contracts are tailormade
catering to the needs of the parties High, as contracts are
LIQUIDITY
involved. Further, contracts are not standardised and exchange
PROFILE
easily accessible to other market traded
participants
Efficient, centralised trading
platform helps all buyers and
PRICE Not efficient, as markets are
sellers to come together and
DISCOVERY scattered.
discover the price through
common order book
OPTIONS
An Option is a contract that gives the right, but not an obligation, to buy or sell the
underlying on or before a stated date and at a stated price. While the buyer of an option
pays the premium and buys the right, the writer/seller of an option receives the premium
with the obligation to sell the underlying asset, if the buyer exercises his right.
OPTION TERMINOLOGY
STOCK OPTION AMERICAN OPTION
INDEX OPTION
These options have individual The owner (buyer/holder) of an
These options have a stock index
stocks as the underlying asset. For American option can exercise his
as the underlying asset. For
example, option on ONGC, NTPC, right at any time on or before the
example, options on Nifty, Sensex,
etc. expiry date/day of the contract.
etc.
EUROPEAN OPTION SPOT PRICE STRIKE PRICE OR
(S) EXERCISE PRICE (X)
The owner (buyer/holder) of a It is the price at which the Strike price is the price per share
European option can exercise his underlying asset is trading in the for which the underlying security
right only on the expiry date/day spot market. may be purchased by the call
of the contract. In India, all index option holder (or sold by the put
and stock options are European- option holder)
style options
OPTION TERMINOLOGY
BUYER OF AN OPTION WRITER OF AN OPTION
The buyer of an option is one who The writer of an option is one who
has a right but not the obligation receives the option premium and
in the contract. For owning this is thereby obliged to sell/buy the
right, he pays a price called asset if the buyer of option
‘option premium’ to the seller of exercises his right. He has a sell
this right. He has a right to buy obligation in case of a call option
the underlying asset in case of a (i.e., when the call option holder
call option and the right to sell exercises his right to buy) and a
the underlying asset in case of a buy obligation in case of a put
put option. option (i.e., when the put option
holder exercises his right to sell).
TYPES OF OPTIONS
CALL PUT
CALL OPTION
A call option is a type of options contract which gives the call owner the right, but not the
obligation to buy a security or any financial instrument at a specified price (or the strike
price of the option) within a specified time frame.
To buy a call option one needs to pay the price in the form of an option premium. As
mentioned, it is upon the discretion of the owner on whether he wants to exercise this
option. He can let the option expire if he deems it unprofitable. The seller, on the other
hand, is obliged to sell the securities that the buyer desires. In a call option, the losses are
limited to the options premium, while the profits can be unlimited.
CALL OPTION
Let us understand a call option with the help of an example. Let us say an investor buys a
call option for a stock of XYZ company on a specific date at Rs 100 strike price and expiry
date is a month later. If the price of the stock rises anywhere above Rs 100, say to Rs 120
on the expiration day, the call option holder can still buy the stock at Rs 100. If the price of
a security is going to rise, a call option allows the holder to buy the stock at a lower price
and sell it at a higher price to make profits.
However, if the stock price goes down to 80 and the option holder does not wish to buy
the stock his maximum loss would only be the premium.
CALL OPTION
Payoff chart- Long Call
400
300
200
100
-100
17100 17200 17300 17400 17500 17600 17700 17800 17900 18000
PUT OPTION
Put options give the option holder the right to sell an underlying security at a specific
strike price within the expiration date. This lets investors lock a minimum price for selling
a certain security. Here too the option holder is under no obligation to exercise the right.
In case the market price is higher than the strike price, he can sell the security at the
market price and not exercise the option.
PUT OPTION
Let us take an example to understand what a put option is. Suppose an investor buys a
put option of XYZ company on a certain date with the term that he can sell the security
any time before the expiration date for Rs 150. If the price of the share falls to below Rs
150, say to Rs 80, he can still sell the stock at Rs 150. In case the share price rises to Rs 180,
the holder of the put option is under no obligation to exercise it.
PUT OPTION
Payoff chart- Long Put
300
200
100
-100
-200
17100 17200 17300 17400 17500 17600 17700 17800 17900 18000
The answer lies in the concept of financial leverage.
Financial Leverage:
Financial leverage refers to using borrowed amount for purchasing 2 assets to
build capital and expand a business, with an expectation of earning or reaping
gains, which would be more than the cost incurred in borrowing from lenders.
Let's assume we have the opportunity to invest in XYZ stock on November 24th,
with the current stock price at Rs.2000 per share. We'll compare two strategies
with Rs.100,000 to invest:
Option 1 – Buy XYZ stock in the spot market
Option 2 – Buy XYZ call options
Scenario 1: Stock price increases to Rs.2500 on December 23rd
Option 1 – Buy XYZ Stock in Spot Market:
With Rs.100,000, we can buy 50 shares at Rs.2000 each (50 * 2000 = 100,000)
When the stock reaches Rs.2500, we sell for a profit
Proceeds from sale: 50 * 2500 = Rs.125,000
Total profit: Rs.25,000
Scenario 1: Stock price increases to Rs.2500 on December 23rd
Option 2 – Buy XYZ Call Options:
Let's assume we can buy at-the-money call options with a strike price of
Rs.2000, expiring on December 23rd
The option premium is Rs.100 per share
With Rs.100,000, we can buy options for 1000 shares (100,000 / 100 = 1000)
When the stock price reaches Rs.2500, each option is worth Rs.500 (2500 -
2000 strike price)
Proceeds from selling options: 1000 * 500 = Rs.500,000
Total profit: 500,000 - 100,000 (initial investment) = Rs.400,000
Scenario 2: Stock price decreases to Rs.1800 on December 23rd
Option 1 – Buy XYZ Stock in Spot Market:
We bought 50 shares at Rs.2000 each
When the stock drops to Rs.1800, we sell for a loss
Proceeds from sale: 50 * 1800 = Rs.90,000
Total loss: Rs.10,000
Option 2 – Buy XYZ Call Options:
We bought options for 1000 shares at Rs.100 per share
When the stock price drops to Rs.1800, the options expire worthless
Total loss: Rs.100,000 (entire initial investment)
Thanks to the existence of ‘Margins’ we require a much lesser amount to enter
into a relatively large transaction. Thus, if our directional view is right, our profits
can be huge. Leverage, however, is a double-edged sword. If used in the right
spirit and knowledge, leverage can create wealth, if not it can destroy wealth. The
higher the leverage, the higher the risk, and the higher the profit potential.
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Options can be classified into three categories, viz., in-the-money, at-the-money and
out-of-the-money options.
[Link]-the-Money Option: This option would give the option holder a positive cash flow, if
it were exercised immediately. A call option is said to be ITM, when spot price is higher
than strike price. A put option is said to be ITM when spot price is lower than strike
price. In our examples, the put option is in-the-money.
2. Out-of-the-Money Option: This option is one with a strike price worse than the spot
price for the holder of option. In other words, this option would give the holder a
negative cash flow if it were exercised immediately. A call option is said to be OTM,
when spot price is lower than strike price. A put option is said to be OTM when spot
price is higher than strike price. In our examples, the call option is out-of-the-money.
Options can be classified into three categories, viz., in-the-money, at-the-money and
out-of-the-money options.
3. At-the-Money Option:
This option would lead to zero cash flow if it were exercised immediately. Therefore,
for both call and put ATM options, strike price is equal to spot price. In reality, because
the strike prices are at fixed intervals of say, Rs.5, Rs.10 or Rs.50, while the spot price
moves in much smaller increments, the two prices may rarely be equal. Hence an ATM
option can be defined as an option with a strike price which is closest to the spot
price.
For example, if the index is at 18415 and three options on the index with strike prices of
18350, 18400 and 18450 are available for trading, the option with the strike price of
18400 is an ATM option.