Derivatives are referred to as the security or financial contracts that derive its value from an underlying asset.
The common underlying assets are market indices, stocks, currencies, commodities, interest rates etc.
Derivatives can be used for hedging, speculation and arbitrage opportunities on the price movement of underlying assets
Types of Derivatives:
Equity Derivative Futures and Options
Equity derivative is a class of derivatives whose value is derived from one or more underlying equity securities.
Futures and Options and futures are the most common equity derivatives.
A futures contract is an agreement between two parties to buy or sell a underlying stock / index at a certain
time in the future at a certain price. When you buy a stock future, you promise to pay for the stock at a
future date. If you sell a stock future that means you to deliver a stock at a future date.
The futures contracts are available on 162 securities stipulated by the Securities & Exchange Board of India (SEBI).
Futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and
the far month (three). New contracts are introduced on the trading day following the expiry of the near month
contracts. The new contracts are introduced for a three month duration. This way, at any point in time, there
will be 3 contracts available for trading in the market (for each security) i.e., one near month, one mid-month
and one far month duration respectively.
Futures contracts expire on the last Thursday of the expiry month and are settled physically .If the last Thursday
is a trading holiday, the contracts expire on the previous trading day.
The value of the futures contracts on individual securities may not be less than Rs. 5 lakhs at the time of
introduction for the first time at any exchange. The permitted lot size for futures contracts & options contracts
shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time
Equity Derivatives Futures Advantages:
Exchange Traded:Futures contracts are standardized contracts and are traded on the exchange.
It eliminates the counter party risk
Hedging is buying and selling futures contracts to offset the risks of changing underlying market
prices. Thus it helps in reducing the risk associated with exposures in underlying market by taking a
counter- position in the futures market. For example, an investor who has purchased a portfolio of stocks
may have a fear of adverse market conditions in future which may reduce the value of his portfolio. He can
hedge against this risk by shorting the index which is correlated with his portfolio, say the Nifty 50.In
case the markets fall, he would make a profit by squaring off his short Nifty 50 position. This profit would
compensate for the loss he suffers in his portfolio as a result of the fall in the markets.
Leverage: Since the investor is required to pay a small fraction of the value of the total contract
as margins, trading in futures is a leveraged activity since the investor is able to control the total value
of the contract with a relatively small amount of margin. Thus the leverage enables the traders to make a larger
profit (or loss) with a comparatively small amount of capital.
Highly Liquid: Future contracts are traded in huge numbers every day and hence futures are highly liquid.
The constant presence of buyers and sellers in the future markets ensures market orders can be placed quickly
The prices do not fluctuate drastically, especially for contracts that are near maturity.
Derivatives Options:
Options:
An option gives a person the right but not the obligation to buy or sell something. An option is a contract between
two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation
for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who
buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short
in the option.
Option contracts are European style and physically settled and are available on 162 securities stipulated by the
Securities & Exchange Board of India (SEBI).
Options Types:
Call Option
“Call” give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given
price on or before a given future date.
Put Option
“Put” give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given
price on or before a given future date.
Advantages:
Participate in the market without trading or holding a large quantity of stock.
Protect their portfolio by paying small premium amount.
Able to transfer the risk to the person who is willing to accept them
Lower transaction costs
Provides liquidity, enables price discovery in underlying market.