- Derivatives have no independent value. Its value is derived from some other asset, which is called the “underlying asset”.
- The underlying asset can be an index, a stock, a commodity, a bullion item or a currency. For example, derivatives of ITC shares will derive its value from the current share price of ITC.
- The underlying asset could be index, stock, commodities bullion or currency.
- Derivative contract is priced separately based on the underlying asset
- The contract is traded not the underlying asset.
- It acts as a good hedging tool against price volatility
- You can take a high exposure on a stock or security by paying a small margin.
- EXAMPLE: If the stocks are priced at Rs 10 lakh and you have only Rs 2 lakhs in hand, this product will still help you take a position.
- It offers huge time leverage, which is a big plus for traders who do margin trading.
- You can hold the position for 3 months. Normal margin product- 1 day, E-Margin product T+2 days
Types of Derivatives
- Futures: The owner has the obligation to buy or sell a contract at a pre-defined time and price. Conditions are standardised
- Forward: The owner has the obligation to buy or sell a contract at a pre-defined time and price. Conditions are customised between buyer and seller
- Option: The owner has the option to buy or sell something at a pre-defined price and time
- Swap: It is an agreement of barter or exchange of sequence of cash flows
- It is a contract to buy /sell pre-defined quantities of an instrument at a specified price and time
- Future contract has standardised conditions such as price, quantity and time
- The owner of the contract has the obligation to buy or sell in future
- Price is determined by supply and demand factors in secondary market
- Index futures was the financial derivative launched in India
- Every contract expires on last Thursday of the expiry month
Terminologies used in Futures
- Spot Price: the trading price of the asset in the spot market
- Future price: the price of future contracts in futures market
- Contract Cycle: Validity period for trading in contracts
- Contract Size: Amount of the asset to be delivered in specified time
- Expiry date: The date on which validity of contract ends
- Initial Margin: Amount to be deposited in margin account to start trading
- Maintenance Margin: Minimum amount to be maintained for trading
- Cost of Carry: Storage cost plus interest paid to finance the asset
- Mark to Market: Adjustments (Profit or Loss) made to investor’s margin account based on future closing price
Types of Futures Contracts
In terms of Underlying Asset
- Index Futures
- Stock Futures
In terms of Expiry
- Near Month
- Next Month
- Far Month
- The owner has an option to buy or sell the contract at a pre-defined price
- Purchaser of option has to pay something for this contract – in form of a premium.
- You can sell/write options and receive an option premium from the buyer.
- A seller is obliged to sell/buy an asset if the buyer exercises it on him.
Types of Options
- CALL Option- Right (not an obligation) to BUY the contract
- PUT Option- Right (not an obligation) to SELL the contract
- Index Options – An Index is the underlying asset.
- Stock Options – Stocks act as the underlying asset.
Terminologies used in Options
Please refer our separate blog dedicated on this topic here.
Difference between Futures & Options
- Futures and unlimited profit or loss potential.
- Options have limited risk and unlimited profit potential. (Only applicable to Long positions)