Derivatives

What are Derivatives?

The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else.
In other words, derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act, 1999, derivatives have been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act. The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion etc.

What are the different types of Derivatives?

Forwards, Futures and Options are the different types of Derivatives.

What is a Forward Contract?

A forward contract is a customized non-standardized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. These are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is a high counterparty risk i.e. a chance that a party may default on its side of the agreement.

What is a Futures Contract?

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.

What is an Option Contract?

Options Contract in trading is a type of Derivatives Contract which gives Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option purchases the right from the seller/writer for a consideration which is called ‘Premium’. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined.

What are the types of Options?

  • Call Option: When any option contract grants the buyer the right to purchase the underlying asset from the writer or seller, it is called call option or simply "Call"
  • Put Option: When the option buyer has the right to sell the underlying asset to the writer, then it is called Put Option or "Put"
An option contract can also be categorized on the basis of when the option buyer exercises it, as follows:
  • American Option: A contract with American option entitles buyer to exercise it any time up to expiry date
  • European Option: When an option can be exercised on only the expiration date, then it is called the European Option
  • Bermuda Option: An Option which can be exercised before the expiry date but only on certain specified dates, then that’s called a Bermuda Option

What are Index Futures and Index Option Contracts?

  • Index Futures :Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and SENSEX Index. These contracts derive their value from the value of the underlying index. Stock portfolio managers who want to hedge risk over a certain period of time often use index futures to do so.
  • Index Options Contract : A financial derivative that gives the holder the right, but not the obligation, to buy or sell a basket of stocks, at an agreed-upon price and before a certain date
Options contracts, including index options, allow investors to profit from an expected market move or to reduce the risk of holding the underlying instrument.

Unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date. An index in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectoral indices.

By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore; these contracts are essentially settled in cash on expiry.

What is the lot size of contract in the equity derivatives market?

Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scripts stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

What is a Strike Price?

The strike price (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity.

What are In-the-money, At-the-money and Out-of-the-money options?

  • In-the-money option is an option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.
  • At-the-money Option is an option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.
  • Out-of-the-money Option is an option that has no intrinsic value. That is an option which theoretically, it would not be worthwhile to exercise immediately e.g. a call option whose exercise price is above the current underlying share price or a put option whose exercise price is below the current underlying share price.

What is Intrinsic Value of an Option?

The amount, if any, by which an option is currently in the money. An option that is not in-the-money has no intrinsic value.

What is Time Value of an Option?

The amount, if any, by which an option's premium exceeds its intrinsic value. If an option is not in the money, its premium consists entirely of time value.

What is Open Interest?

It is the net long and short amount of outstanding positions in a particular contract.

Who is a Writer of Options?

The Writer is the seller of an option contract who is obliged to deliver or take delivery of the underlying instrument upon notification by the buyer (holder).

What is the margining system in the equity derivatives market?

Two type of margins have been specified –
  • Initial Margin : Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected.
  • Mark to Market Margin (MTM) :collected in cash for all Futures contracts and adjusted against the available Liquid Net worth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement.

What is Straddle?

It is the simultaneous purchase (sale) of a call and put option in the same expiry month with the same exercise price.

What is Strangle?

It is the simultaneous purchase (sale) of a call option at one exercise price and a put option at a lower exercise price but with the same expiry date.