What are Derivatives?

After gaining a basic understanding of the stock market and equity and debt instruments we will now dive deeper into financial markets.

Derivatives

Derivative is a financial product whose value is derived from other assets known as underlyings. Equity, index, currencies, commodities, bonds etc can be the underlying assets. Derivative products were developed initially as hedging instruments against fluctuations in commodity prices. Financial derivatives were created in 1970 due to increasing instability in the financial markets. They have become very popular since then and account for almost two-thirds total transactions. Financial market investors are classified based on their time horizon.

The derivative is essentially a hedging or trading instrument. It is a margin-based trading instrument that allows for good leverage, which eventually leads to speculations.

Futures contracts allow you to purchase or sell an underlying amount at a specified price and on or prior to a specified date. Both the parties to a futures contract must exercise it unless they are delivered on or before settlement.

Futures Trading Features:

• For taking positions, an initial margin amount of contract price is required. This is determined by exchange using SPAN plus exposure margin.
• Daily adjustments will be made to mark-to-market profit/loss.
• If positions are not squared by the last trading day of a contract, an exchange will take them off.

Index futures can have indices as an underlying.

There are three types of contracts that can be traded: current month (1 month), near-month (2 months) or far month (3 month) contracts. The contract month is the month when a contract expires.

There are many options

The buyer has the option to purchase or sell the underlying at his choice without being bound. The buyer of an option pays the premium, and acquires the right of exercising his option. However, the seller/writer of an option receives a premium and is obligated to sell/buy any asset that the buyer exercises.

While "Call Option" gives the buyer the option but not the obligation, "Put Option" gives the buyer both the right and the obligation to purchase the underlying asset at the given price at some future date.

Buy of Call and Put options requires premium to be paid. Traders are exposed to risk due to the premium paid. Selling and writing options require margin and expose traders to similar risks to futures markets.

Style options

European Options cannot be exercised, i.e. the buyer can take delivery of options after the expiry date of the contract.

American Options are available for the buyer to exercise, i.e. delivery can be taken at any time before or after the expiration date.

Contract Cycle

The Contract Cycle refers to the time period that a contract can trade. The expiry periods for index futures contracts on NSE are one, two, and three months.

Options Strategies

Traders with a bullish or long directional view of the underlying can either buy Call options or write /short put options. A trader with a short/bearish view of the underlying can also sort/write Call option, or long/buy Put option

We also offer combination strategies that are extremely useful when the market view is moderately bearish/bearish or range bound. The objective is to lower overall option premium payouts. Bull & Bear Call - Put Spread, Strangle and Straddle, Butterfly and Covered and Protective call and put are some examples.

Futures marked to market:

It allows for adjustments trading accounts, which are necessary due to price changes.

Hedging:

Hedging is a strategy that reduces the risk associated with investment.

Speculation

This is a trading strategy that aims to make profit quickly with price fluctuations.

Benefits of derivatives:

Hedging: This helps to protect against future price uncertainty

Leverage: Because margins are extremely low, it allows for higher trading exposure

Potential Return: Market conditions are irrelevant. One can still make money.

Longer position-taking: This product offers a longer time leverage than other margin products, which is 1-3 days.