When we talk of Derivatives the first thing that comes to mind are Options and Futures. Derivatives are nothing but financial instruments which derive (get their value), from an underlying asset.
The underlying asset can be gold, currency (rupee) or even shares. Derivatives can be of two types:
Exchange traded derivatives are traded mainly through organized exchanges across the world. They can be traded just like stocks on the NSE and BSE.
Over the Counter (OTC) derivatives are not traded on exchanges. Popular OTC instruments are Forwards and Swaps.
Let’s understand the popular Derivatives, Options and Futures. Want to know more on Investment Planning? We at IndianMoney.com will make it easy for you. Just give us a missed call on 022 6181 6111 to explore our unique Free Advisory Service. IndianMoney.com is not a seller of any financial products. We only provide FREE financial advice/education to ensure that you are not misguided while buying any kind of financial products.
Option is a financial instrument that represents a contract sold by one party (option writer) to another party (option holder).
Consider you are the buyer of the call option and you buy from the seller of the call option.
You can buy a Call Option where you (buyer) get the right, but not the obligation (you are not forced) to buy a certain quantity of shares of a Company at a predetermined price called exercise price, on or before a fixed date (expiry date), in the future from the seller of the call option. To enjoy this privilege you pay money called option premium to the seller of the call option.
If the price of the share goes above the exercise price before the expiry date, you will exercise the option, rather than buy shares at a higher price in the open market. For the seller of the call option the contract is obligatory (compulsory to honor) and he suffers a loss (share price - exercise price).
If the share price is below exercise price till the expiry date, you the buyer of the call option will not exercise this option and will buy shares in the open market at a lower price. The seller of the call option gets to keep the option premium.
You can also buy a Put option from the seller of a Put option.
You can buy a Put option from the seller of the Put option, where you have the right but not the obligation to sell a certain quantity of shares at a pre-determined price (exercise price), on or before a specified date in the future (expiry date). You pay an option premium for this privilege.
If the price of the share is above the exercise price till the expiry date, you will not exercise the option and sell the shares in the open market. The seller of the Put option gets to keep the premium. If the price of the shares is below the exercise price till expiry, you will exercise the put option to sell shares, where the seller of the put has to sell the shares to you at a lower price, than what he would have got had he sold in the open market. (Share price - exercise price = loss).
Option contracts are for 1, 2 or 3 months.
Before we get to futures, you must understand what is a forward market contract. A forward market contract is a contract between the buyer and seller of an asset (stock/commodity), where the buyer agrees to purchase fixed quantity of assets from the seller, at a predetermined price (exercise price) at a future date (expiry date). This is an obligatory (compulsory) contract for both buyer and the seller. The buyer pays the premium to the seller.
When forward market contracts are standardized on exchanges (Price of asset /Quantity of asset/ Expiry date/Exercise price are all fixed) it is a futures contract.
Let’s understand how a futures contract works. In Futures, you buy a contract which will have a specific lot size (say 100 shares of XYZ Ltd.). The lot size is set for each futures contract and it differs from stock to stock.
When you buy a Futures contract, you don't pay the entire value of the contract, but just the margin (a certain percentage of the value of the contract). This margin amount too is prescribed by the exchange.
You have purchased a Futures Contract of shares of XYZ Ltd where the price of each share is Rs 50 and the lot size is 1,000. The value of the contract is Rs 50,000 (Rs 50 * 1000).
You have to pay a margin of just 20% of contract value to enjoy the benefits of trading or you pay 20% of Rs 50,000 = Rs 10,000.
You have purchased 1,000 shares (lot size) where each share costs Rs 50 by paying just Rs 10,000 (margin money).
An amount of Rs 1,000 is paid to your account. In futures language this is called mark to market, where market prices are determined each day to calculate profit/loss.
As the price has dipped, you have to pay this money or Rs 6 * lot size of 1,000 = Rs 6,000. This money is debited from your account.
This will go on till the contract expires. So, on a daily basis you make and lose money which makes futures extremely risky.
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