WHAT ARE FINANCIAL DERIVATIVES?

• 'Derivatives' have no independent value.
• The value is derived from “underlying asset"
• Example: A derivative of ITC share will derive its value from the share price (current market 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.

 

DERIVATIVES TRADING ADVANTAGES

• 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

 

TRADING IN FUTURES

• 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

 

FUTURE TRADING TERMINOLOGIES

• 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

 

EXAMPLE OF DERIVATIVES TRADING

• You buy 1 contract of Nifty Futures at Rs 5400
• Total contract value is 5400 x 50 (Size of the Lot) = Rs.2,70,000.
• Margin is approximately 15%. 
• This means you pay only Rs.40,500 and get control of the contract worth Rs.2,70,000.
• If Nifty moves to 5700, you make a PROFIT of Rs 300 (5700-5400)
• Total profit is 300 x lot size of 50 = 15000. 
• You earn a return of 37% (15000/40500) x 100 even as nifty moved only 5.55%.

 

WHAT IS OPTIONS TRADING?

• 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 CONTRACTS

• 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.

 

EXAMPLE OF OPTIONS TRADING

• You buy a stock option by paying a premium of Rs.25
• Lot size is 500, total premium paid is Rs.25 x 500 = Rs.12500.
• Current Market Price in cash market is Rs.900.
• Now if Tata Motors moves to Rs.1000, option premium would roughly increase to Rs.125.
• That translates into a return of 400% as against 11% return in cash market

 

TERMINOLOGIES USED IN OPTIONS TRADING

• Stock Options: A contract which gives buyer the right or buy or sell stocks at pre-fixed price
• Writer: The one who is obliged buy/sell asset if the buyer pays him premium 
• Buyer: The one who pays a premium and buys the right (not obligation) to exercise option on the writer/seller.
• Strike Price: Price specified in an Options Contract, which is also called exercise price.
• Premium/Option Price: The price a buyer pays to sell/writer of option
• In-the-money option – Brings a positive cash flow to the holder if exercised immediately. A call option is in-the-money if the current market price of underlying asset is higher than strike price.
• At-the-money option – Brings zero cash flow if exercised immediately. A call option is at-the-money if current market price of underlying asset equals strike price.
• Out-of-the-money option – Brings negative cash flow if exercised immediately. A call option is out-of-the-money if current market price of underlying asset is less than strike price.
• Expiration Date: Date specified in the contract, which is also known as strike date or maturity date
• American Options: Options that can be exercised at any time up to expiration date.
• European Options: Options, which can be exercised only on expiration date.

 

OPTION PRICING COMPONENTS

• Intrinsic Value: is the amount the option is in the money. If the option is OTM or ATM, its intrinsic value is zero.
• Time Value: Difference between Premium paid and intrinsic value.
• OTM and ATM options have only time value. Longer the time to expiration, greater is an option’s time value. At expiration, an option should have no time value. A contract has maximum time value when it is ATM

 

DIFFERENCE BETWEEN FUTURES AND OPTIONS

• Futures and unlimited profit or loss potential.
• Options have limited risk and unlimited profit potential.

 

HOW TO TRADE IN DERIVATIVES?               

Multiple Trading Platforms