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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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