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28
Jun,18

Understanding Options and Futures

Understanding Options and Futures

Introduction to Derivatives (Futures and Options)
Derivatives are contracts that were conceived basically to overcome future problems. The investments in capital and the expected profits were traditionally protected using derivatives. Considering the agricultural commodities, derivatives are beneficial for traders and farmers. Today, forwards market dominates derivatives markets for foreign exchange deals between companies and their bankers. The volume of trade in India in the derivatives market for stocks is very high.

Basic definition:

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying".

Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets.

Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps.

Derivatives in India:

Most derivatives are traded on an exchange such as the NSE, BSE, MCX and NCDEX.

The National Stock Exchange of India Limited - NSEL commenced trading in derivatives with the launch of Index Futures on June 12, 2000. The Futures Contracts are based on the popular benchmark Nifty 50 Index. The Exchange introduced trading in Index Options (also based on Nifty 50) on June 4, 2001., while Commodities Derivatives Contracts were allowed and MCX started its operations in November, 2003.

Common Forms of 'Derivatives'

Options and Futures are derivatives traded on exchanges. The value of derivatives depends on the value of some underlying assets.

Futures Contracts are one of the most common types of derivatives. A futures contract (or simply futures, colloquially) is an agreement between two parties for the sale of an asset at an agreed upon price. One would generally use a futures contract to hedge against risks during a particular period of time.

Options are another common form of derivative. An option is similar to a futures contract in that it is an agreement between two parties granting one the opportunity to buy or sell a security from or to the other party at a pre-determined future date. Like with futures, options may be used to hedge the seller’s stock against a price drop and to provide the buyer with an opportunity for financial gain through speculation. An option can be short or long, as well as a call or put.

Key difference between Options and Futures:

The key difference between options and futures is that with an option, the buyer is not obligated to make the transaction if he or she decides not to, hence the name “option.” The exchange itself is, ultimately, optional.

Contracts to buy or sell an underlying (share or commodity) which expire at a particular time are termed as “Futures”. In Options, you will have to pay premium for entering into the contract. Futures only require a margin to be maintained and they have no value after the expiry of the time. Derivatives are neither assets nor investments because the value of the contract expires automatically. Futures and Options are part of the broader tools called derivatives used for hedging of assets as well as to protect profits. The good and bad side of derivatives is that they are highly leveraged. Futures and Options are generally used by speculators.

Illustrative Examples: Let us consider some examples –

Futures: If you want to purchase a single July futures contract of ABC Ltd., you would have to do so at the price at which the July futures contracts are currently available in the derivatives market. Let's say that ABC Ltd. July futures are trading at Rs 1,000/- per share. This means, you are agreeing to buy / sell at a fixed price of Rs. 1,000/- per share on the last Thursday in July. However, it is not necessary that the price of the stock in the cash market on Thursday has to be Rs. 1,000/-. It could be Rs. 992/- or Rs. 1,005/- or anything else, depending on the prevailing market conditions. This difference in prices can be taken advantage of to make profits.

Options: Assume a stock is trading at Rs. 67/- today. You are given a right today to buy the same one month later, at say Rs. 75/-, but only if the share price on that day is more than Rs. 75/-, would you buy it? Obviously you would, as this means to say that after 1 month, even if the share is trading at Rs. 85/-, you can still get to buy it at Rs. 75/-.

In order to get this right, you are required to pay a small amount today, say Rs. 5.0/-. If the share price moves above Rs. 75/-, you can exercise your right and buy the shares at Rs. 75/-. If the share price stays at or below Rs. 75/-, you do not exercise your right and you do not need to buy the shares. All you lose is Rs. 5/- in this case. An arrangement of this sort is called Option Contract, a ‘Call Option’ to be precise.

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