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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.
IMPORTANT TERMINOLOGY
Underlying - The specific security / asset on which an options
contract is based.
Option Premium - Premium is the
price paid by the buyer to the seller to acquire the right to
buy or sell
Strike Price or Exercise Price - The strike or exercise price of
an option is the specified/ pre-determined price of the
underlying asset at which the same can be bought or sold if the
option buyer exercises his right to buy/ sell on or before the
expiration day.
Expiration date -The date on which
the option expires is known as Expiration Date. On Expiration
date, either the option is exercised or it expires worthless.
Exercise Date – is the date on
which the option is actually exercised. In case of European
Options the exercise date is same as the expiration date while
in case of American Options, the options contract may be
exercised any day between the purchase of the contract & its
expiration date (see European/ American Option)
Open Interest - The total number of
options contracts outstanding in the market at any given point
of time.
Option Holder - is the one who buys
an option which can be a call or a put option. He enjoys the
right to buy or sell the underlying asset at a specified price
on or before specified time. His upside potential is unlimited
while losses are limited to the Premium paid by him to the
option writer.
Option seller/ writer - is the one
who is obligated to buy (in case of Put option) or to sell (in
case of call option), the underlying asset in case the buyer of
the option decides to exercise his option. His profits are
limited to the premium received from the buyer while his
downside is unlimited.
Option Class - All listed options
of a particular type (i.e., call or put) on a particular
underlying instrument, e.g., all Sensex Call Options (or) all
Sensex Put Options
Option Series - An option series
consists of all the options of a given class with the same
expiration date and strike price. E.g. BSXCMAY3600 is an options
series which includes all Sensex Call options that are traded
with Strike Price of 3600 & Expiry in May. (BSX Stands for BSE
Sensex (underlying index), C is for Call Option , May is expiry
date & strike Price is 3600)
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