What
are Derivatives
Derivatives are
financial instruments which derive their value
from the underlying assets or securitues. For
example if a Buyer enters into a contract with a
Seller to buy a specified number of shares (or
Index/ Commodity) of a particular company at a
specified price after a specified period, the
buyer is said to have entered into a Futures
contract.
It is interested to note that Buyer has bought
the contract and not the stock of shares(or Index/
Commodity) under reference. This type of Future
contract is called Derivative. There are many
other type of Derivatives commonly used all over
the world like Options, Convertibles and Warrants
etc.
What
are Futures
It is an
Agreement between the Buyer and the Seller for
the Purchase or Sell of a Particular Asset ( like
Equity Stock/ Index etc) at a Specified Price and
on a specified future date (1 Month/ 2 Months/ 3 Months). It conveys an
OBLIGATION on both Buyer and Seller to Fulfill
the Terms of the Agreement. Futures are Settled
on Last Thursday of the Specified Month and both
buyer and seller have to pay minimum Initial
Margin as per the requirement of stock exchange
and account between buyer and seller is settled
Everyday till the expiry of the Futures contract.
Nifty Future contract have a multiplier of 200
whereas in case of BSE Sensex, the multiplier is
50 that means Nifty Futures contract gives rise
to an obligation to deliver at settlement cash
payment equal to 200 times ( 50 times in case of
BSE Sensex Futures) the difference between the
Nifty Index value at the close of the last
trading day of the contract and the price at
which the Futures Contract was negotiated.
Example
Suppose 'A' enters (Buys) a Nifty futures
contract at 1225 for July (expiring on last
Thursday of July) with 'B'. Both 'A' & 'B'
will deposite the required margin with the Stock
exchange. On last Thursday of July, Nifty closes
at 1267. Now 'A' will get Rs. 8400/- {( 1267-1225)
x 200 = 8400} from 'B'. In case Nifty closes at
1157, 'B' will get Rs. 13600/- {(1225-1157) x 200
= 13600 } from 'A'. ( BSE Sensex contract will
carry a multiplier of 50 instead of 200 as in
case of Nifty.)
But their account will be credited or debited
from their Margin Account and their position will
be 'marked to market' at the end of session each
day. In case the Margin account falls below the
maintenence level, cash is sought from the
customer to replenish the margin account back to
original level. Either of the customers having
surplus margin beyond original margin can
withdraw the funds.
What are Options
An option is a contract, which gives the Buyer of
Option (holder) the right, but not the obligation, to Buy or Sell specified
quantity of the underlying assets, at a Specific
(Strike) Price on or before a Specified Time (expiration
date) i.e 1 Month/ 2 Months/ 3 Months etc.
The underlying may be physical commodities like
wheat/ rice/ cotton/ gold/ oil or financial
instruments like equity stocks/ stock index/
bonds etc.
There are 2
types of Options i.e. Call Options and Put Options.
CALL OPTIONS
A Call Option gives the holder (buyer/ one who is
long call), the
right (No obligation) to buy specified quantity of the
underlying asset at the strike price on or before
expiration date. The seller (one who is short
call) however, has the obligation to sell the
underlying asset if the buyer of the call option
decides to exercise his option to buy.
Option
buyer or option holder - Buys the right (No obligation)
to buy the underlying asset at the
specified price
Option
seller or option writer - Has the obligation to sell the
underlying asset (to the option holder) at the
specified price
PUT OPTIONS
A Put Option gives
the holder (buyer/ one who is long Put), the right (No obligation) to sell
specified quantity of the underlying asset at the
strike price on or before a expiry date.
The seller of the put option (one who is short
Put) however, has the obligation to buy the
underlying asset at the strike price if the buyer
decides to exercise his option to sell.
Option
buyer or option holder - Buys (No obligation) the right
to sell the underlying asset at the specified
price
Option
seller or option writer - Has the obligation to buy the
underlying asset (from the option holder) at the
specified price.
When to Buy a Call Option.
If you are Bullish on a particular Scrip/Index.
For example, you are Bullish on Reliance (CMP- Rs.350/-)
and expecting it to touch 450 in a month's time (or
any particular period say 2/3 months). So you
will Buy Reliance Call Option for 1 month (or any
particular period) by paying a premium of Rs.10/share
(Say). During the course of month you will get
Right to excercise your Call Option to Buy
Reliance at 350 from the seller of Call Option.
Suppose it does not move up, you are free NOT to
excercise your option to Buy and your loss is
limited to the Premium you have paid.
When to Buy a Put Option.
If you are Bearish on a particular Scrip/Index.
For example, you are Bearish on ACC (CMP -Rs.150/-)
and expecting it to touch 100/- in a month's time.
So you will Buy ACC Put Option for 1 month by
paying a premium of Rs.5/share (Say). During the
course of month (you are Free to Buy ACC from
market any time at lower price) you will get
Right to excercise your Put Option to Sell ACC at
150/- to the seller of Put Option. Suppose it
does not decline, you are free NOT to excercise your
option to Sell and your loss is limited to the
Premium you have paid.
When to Sell a Call Option.
If you are Bearish on a particular Scrip/Index.
For example, you are Bearish on Infosys (CMP- Rs.3800/-)
and expect that it will not move up significantly(or
rather decline) in a month's time. So you will
Sell Infosys Call Option at a strike rate Rs.3900/-
(say) for 1 month and Receive the Premium. (Say
Rs.100/share). During the course of month Buyer
of Call Option will have Right (Not the
Obligation) to take Infosys at 3900/- from you
and you are obliged to honour your commitment. Remember that you are
Holding risk of umlimited loss if Price of
Infosys moves up significantly just at the cost
of Premium you have received.(you should sell Call Option Only
if you are sure that Price of Share will Fall/or
not move up or you are holding shares with you to
part with, if required)
When to Sell a Put Option.
If you are Bullish on a particular Scrip/Index.
For example, you are Bullish on Satyam (CMP - Rs.200/-)
and expect that it will not Decline significantly
(or rather move up) in a month's time. So you
will Sell Satyam Put Option at a strike rate Rs.215/-
(say) for 1 month and Receive the Premium. (Say
Rs.12/share). During the course of month Buyer of
Put Option will have Right (Not the Obligation)
to Sell Satyam at 215/- to you and you are
obliged to honour your commitment. Remember that you are
Holding risk of umlimited loss if Price of Satyam
goes down at the cost of Premium you have
received. (you
should Sell Put Option Only if you are sure that
Price of Share will Move up or you will take
Delivery of shares, if required)
How are Options different from
Futures
The
significant differences in Futures and Options
are as under:
1. Futures are agreements/contracts to buy or sell specified
quantity of the underlying assets at a price agreed upon
by the buyer & seller, on or before a specified time.
Both the buyer and seller are obligated to buy/sell
the underlying asset.
2. In case of Options the
buyer enjoys the right & not the obligation, to buy or sell the underlying
asset.
3. Futures Contracts have symmetric risk
profile for both the buyer as well as the seller,
whereas options have asymmetric risk profile.
In case of Options, for a buyer (or holder of the
option), the downside is limited to the premium (option
price) he has paid while the profits may be
unlimited. For a seller or writer of an Options however, the downside is
unlimited while profits are limited to the
premium he has received from the buyer.
4. The Futures contracts prices are affected
mainly by the prices of the underlying asset.
The prices of Options are
however, affected by prices of the underlying
asset, time remaining for expiry of the contract
& volatility of the underlying asset.
5. It costs nothing to enter into a Futures contract whereas there is a cost
of entering into an Options
contract, termed as Premium.
What is Assignment
When holder of an option exercises his right to
buy/ sell, a randomly selected option seller is
assigned the obligation to honor the underlying
contract, and this process is termed as
Assignment.
What are European &
American Style of options
An American style option is the one which can be
exercised by the buyer on or before the
expiration date, i.e. anytime between the day of
purchase of the option and the day of its expiry.
The European kind of option is the one which can
be exercised by the buyer on the expiration day
only & not anytime before that.
What is an Option Calculator
An option calculator is a tool to calculate the
price of an Option on the basis of various
influencing factors like the price of the
underlying and its volatility, time to expiry,
risk free interest rate etc. It also helps the
user to understand how a change in any one of the
factors or more, will affect the option price.
Who are the likely players in
the Options Market
Financial institutions, Mutual Funds, Domestic
& Foreign Institutional Investors, Brokers,
Retail Participants are the likely players in the
Options Market.
What are Stock Index Options
The Stock Index Options are options where the
underlying asset is a Stock Index for e.g.
Options on S&P 500 Index/ Options on BSE
Sensex etc. Index Options were first
introduced by Chicago Board of Options Exchange (CBOE)
in 1983 on its Index ‘S&P 100’.
As opposed to options on Individual stocks, index
options give an investor the right to buy or sell
the value of an index which represents group of
stocks.
What are the uses of Index
Options
Index options enable investors to gain exposure
to a broad market, with one trading decision and
frequently with one transaction. To obtain the
same level of diversification using individual
stocks or individual equity options, numerous
decisions and trades would be necessary. Since,
broad exposure can be gained with one trade,
transaction cost is also reduced by using Index
Options. As a percentage of the underlying value,
premiums of index options are usually lower than
those of equity options as equity options are
more volatile than the Index.
Who would use index options
Index Options are effective enough to appeal to a
broad spectrum of users, from conservative
investors to more aggressive stock market traders.
Individual investors might wish to capitalize on
market opinions (bullish, bearish or neutral) by
acting on their views of the broad market or one
of its many sectors. The more sophisticated
market professionals might find the variety of
index option contracts excellent tools for
enhancing market timing decisions and adjusting
asset mixes for asset allocation. To a market
professional, managing the risk associated with
large equity positions may mean using index
options to either reduce their risk or to
increase market exposure.
What are Options on individual
stocks
Options contracts where the underlying asset is
an equity stock, are termed as Options on stocks.
They are mostly American style options cash
settled or settled by physical delivery. Prices
are normally quoted in terms of the premium per
share, although each contract is invariably for a
larger number of shares, e.g. 100.
What are Over the
Counter Options
OTC ("over the counter") options are
those dealt directly between counter-parties and
are completely flexible & customized . There
is some standardization for ease of trading in
the busiest markets, but the precise details of
each transaction are freely negotiable between
buyer and seller.
What is the underlying in case
of Options being introduced by BSE
The underlying for the index options is the BSE
30 Sensex, which is the benchmark index of Indian
Capital markets, comprising of 30 scrips.
What will be the new margining
system in the case of Options and futures
A portfolio based margining model (SPAN), would
be adopted which will take an integrated view of
the risk involved in the portfolio of each
individual client comprising of his positions in
all the derivatives contract traded on the
Derivatives Segment. The Initial Margin would be
based on worst-case loss of the portfolio of a
client to cover 99% VaR over two days horizon.
The Initial Margin would be netted at client
level and shall be on gross basis at the Trading/Clearing
member level. The Portfolio will be
marked to market on a daily basis.
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