Derivatives, as the name suggests, are financial instruments that derive their value from an underlying security or asset. Any security or asset that varies in value from time to time could be used as the underlying asset. The underlying asset could therefore be securities, bullion, commodities, bonds, etc. With variation in value comes risk – the risk that the value of an asset that you wish to buy may rise when you hoped that it will remain steady or still better fall; or the value of an asset that you wish to sell may fall when you hoped that it will remain steady or at best rise. Derivatives essentially enable the transfer of this risk from one individual who is risk averse to another who welcomes the risk in the hope of making returns. This section discusses derivatives where the underlying asset is equity or a stock index.

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Derivative products in some form or the other have existed for centuries. As far back as 580 B.C., or there about, specific instances of “option contracts” based on the price of olives, are known to have been written. The first "futures" contract is traced to the rice market in Osaka, Japan, in approximately 1650 AD. These were evidently standardised contracts, which made them similar to today's futures, although it is not known if the contracts were frequently traded and whether there were any credit guarantees attached to them.

The biggest step towards a formal futures market came in 1848, with the setting up of the Chicago Board of Trade. This organisation changed its perspective and trading patterns over the years until, in 1919, it finally became the Chicago Mercantile Exchange, as we now know it. Other exchanges have come up around the US and across the world since then.

Interestingly, from time to time, governments and regulators have developed discomfort with futures/options/derivatives trading. As a result, these have been banned in part or totally numerous times in Europe, Japan and United States ever since the 1800s, though these laws have eventually been repealed. In India too, futures trading in various commodities was widespread until it was unceremoniously banned in the 1960s. Then, in 2000, trading in derivative products took on a whole new face when trading in equity-based derivatives was allowed on the Indian stock exchanges. This step proved to be a shot in the arm for the capital market and volumes soared within three years. The success of the capital market reforms motivated the government and the Forward Market Commission in India to kick off similar reforms in the commodities market as well. As a result, in April 2003 the ban on trading in commodity futures was finally lifted.

Today, both equity and commodity derivatives are thriving in India. Not only do they give investors a chance to hedge against price movements in the underlyings, they bring stability to the cash markets as well, due to the arbitrage opportunities (an opportunity to make a quick return using the price differentials of the underlying in two different markets) that are available between the cash and the derivatives markets.

Since the introduction of futures and options in the Indian equity markets, the turnover in this segment has increased manifold.

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Comparatively low capital investment required
When you trade in the cash market, if you have undertaken a ‘buy’ trade, then you need to deposit the total value of the trade with the broker within two working days. However, in case of derivatives, you need to deposit only a fraction of the value of the trade – termed as the ‘margin’ amount. As a result, with a limited amount of capital, you can gain exposure to relatively high value transactions.

Cap potential losses:
Derivatives are efficient risk management tools, which allow you to cap your potential losses in the underlying asset.

Allow you to speculate
– By buying and selling derivative instruments you can book profits (which can be limited or unlimited) on the basis of your view on how the price of the underlying will move. However, keep in mind that you can also incur losses, which can once again be limited or unlimited.

Offers opportunities for arbitrage
- You can profit from the price differential of the underlying asset in the cash market and the derivatives market.

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Forwards are derivative contracts wherein you agree to sell or buy the underlying asset at an agreed price, on a predetermined date in the future. The quantity and quality specifications of the underlying and the place of delivery are mutually decided while entering into the agreement.

Essentially, the agreement takes place on a one-to-one level, between you and the buyer/seller (as the case may be) and hence, is more or less tailor-made to meet the specific needs of both the parties involved. The duration of the contract, the quality and quantity of the underlying, etc. are decided upon after mutual negotiation.

In India, forward contracts are used in the foreign exchange markets to reduce currency risks and in the commodities market to reduce the price risk.

Illustration
Company ABC India Limited, which is in the business of importing toys, requires US $ 50,000 to pay for a consignment that is due 3 months from now. Suppose one US $ 1 is currently worth Rs 48. The company expects the price of the US $ to strengthen against the Rupee three months hence. This means that it fears that it may even have to pay Rs 48.25 per US $ by then. It could request its bank to make an agreement with a foreign exchange dealer wherein ABC India Limited will pay Rs 48.10 per US $ three months later. This would constitute a forward agreement.

Drawbacks
Though forwards are highly flexible contracts, they have two disadvantages associated with it:

• Poor liquidity - Since forwards are customised to meet the specific needs of the two parties involved, it would be difficult to find a third party to sell the contract to.
• Default risk - Either of the parties could fail to fulfil their obligations in terms of delivery or even quality and quantity specifications of the underlying.

Futures contracts are derivative contracts wherein you agree to buy or sell a specified quantity of the underlying asset on a specified particular date in the future, at the price agreed upon at the time of entering into contract. In Indian equity futures market, this price is the spot price (i.e. the price of the underlying asset in the cash market) prevailing on the date of the expiry of the contract.

Futures are standardised contracts in terms of quantity, quality, delivery time, delivery place and date of delivery. Further, futures are legally binding and both parties are bound to uphold the agreement. As a result of these additional features, futures are easily tradable on exchanges and therefore offer better liquidity than forwards Contracts.

Types of Futures
The Indian markets offer trading opportunities in both stock and index futures. A stock future is one, where the underlying asset is shares of companies that are traded on the bourses. An index future is one, where the underlying asset is units of the index.

Features of Futures
Some of the salient features of a futures contract are:

• Standardised quantity: Each index/stock futures contract has a ‘market lot’ or a pre-determined number of index units/shares that constitute one contract.



• Standardised expiry dates and duration: At any point of time, there are three durations of which futures are available – 1 month, 2 months and 3 months. The expiry date for all the contracts is the last Thursday of the month in which the contract expires.



• Standard settlement procedures: All futures contracts are settled in cash by the stock exchange on the expiry date of the contract at the spot price (i.e. closing price of the underlying in the cash market prevailing on the date of the expiry of the contract).



• No counter party risk or risk of default: Futures are guaranteed by the exchange on which they are traded. For instance, if you buy or sell futures of Company ABC Limited, then the counter-party to the trade is the exchange. So, in effect, the exchange steps into every trade, between the buyer and the seller and there is a credit guarantee (guarantee of no default on payments) from the exchange behind every trade. In fact, in a futures contract you are unlikely to even know your counter party, just as is the case with buying or selling stocks through a stock exchange.

Pricing of a futures contract
Assuming that the underlying asset is shares of a company, the price per share of a futures contract should be the spot price, i.e., the price of the underlying stock on the day that you purchase the futures contract, plus the ‘cost of carry’. The ‘cost of carry’ comprises of all costs that you would have had to bear if you had purchased the underlying in the cash market and kept it until the maturity date of the futures contract, less any dividends received, if any, during this period. The costs that you would have to bear in the case of stocks typically consist of interest/financing charges, etc.

Therefore, in reality, there is always a difference between the futures price per share and the spot price per share in the cash market. This difference is called the ‘basis’ and could be positive, negative or zero.

If the basis is positive (which is the more common situation), it means that the futures price per share of the underlying asset is higher than the spot price per share in the cash market. This situation is termed as a ‘contango’ market.

However, sometimes the basis could turn negative, i.e., the futures price per share is lower than the spot price per share in the cash market. This situation is termed as a ‘backwardation’.

On the day of expiry of the futures contract, the basis necessarily becomes zero since futures contracts in India are settled at the spot price of the underlying asset as it prevails on the expiry date.

Trading in futures

Initial margin

Trading in futures
In order to trade in futures, irrespective of whether you buy or sell contracts, you are required to deposit a ‘margin’ with your broker. This amount is a fixed percentage of the value of your trade and varies from scrip to scrip. As the value of your outstanding position changes the amount that you need to maintain as the ‘initial margin’ also changes accordingly on a daily basis. The margin percent is dictated by the exchange and acts as a surety against any default in payment on your part (if the need arises).

Marking-to-market the contract
Additionally, at the end of each day, the value of your outstanding position as per the previous day’s closing price of the futures is compared to the value as per the current day’s closing price of the futures that you hold. If you have made a gain, your account is credited with the difference and if you have made a loss, you will have to make good the difference by depositing the requisite amount in your account. The net inflow/outflow that takes place from your account is after factoring in the margin that needs to be maintained that day.

Illustration
You purchase 1 futures contract (1 lot = 100 shares) of company ABC Limited. The margin that you need to maintain at all times is 10 per cent of the contract value.

Day	Number of shares that constitute 1 futures contract	Previous closing price per share of the underlying in the futures market	Contract value	Initial margin to be deposited	Closing price per share of the underlying in the futures market	Contract value at the end of the day	Margin to be maintained at the end of the day	Additional margin to be deposited	Marked-to-market the contract	Net Cash Flow on that day
	A	B	C = A x B	D = 10% of C	E	F = A x E	G = 10% of F	H = G-D	I = F-C	J = H - I
1	100 shares	Rs 100 (your purchase price)	Rs 10,000	Rs 1,000	Rs 100	Rs 10,000	Rs 1,000	Not applicable on the day of purchase	No Profit or Loss	A debit of Rs 1,000
2	100 shares	Rs 100	Rs 10,000	Rs 1,000	Rs 105	Rs 10,500	Rs 1,050	Rs 50	Rs 500 profit	A credit of Rs 450
3	100 shares	Rs 105	Rs 10,500	Rs 1,050	Rs 108	Rs 10,800	Rs 1,080	Rs 30	Rs 300 profit	A credit of Rs 270
4	100 shares	Rs 108	Rs 10,800	Rs 1,080	Rs 100	Rs 10,000	Rs 1,000	No additional margin to be deposited. In fact you are entitled to a refund of Rs 80	Rs 800 loss	A debit of Rs 720

This exercise is carried till the contract expires or is squared off.

Settling a futures contract
Futures traded on Indian bourses do not result in actual delivery of the underlying, i.e., if you purchase a futures contract which comprises of 100 shares of Company ABC, then, it does not mean that on expiry of the contract, 100 shares of Company ABC will be transferred to your demat account. In the case of index futures, there is no question of giving or taking delivery.

Before expiry of the contract:
If you wish to close your futures position before expiry, you have the option to sell the future that you have purchased or buy back the futures that you have sold, as the case may be, at the price prevailing in the futures market.

For instance, you have purchased a single future of Company ABC (consisting of 100 shares) which is expiring at the end of next month….

On the date of Purchase
Price per share of Company ABC in the futures market	Rs 1,000
Contract Value	Rs 1,00,000 (100 shares x Rs 1,000)
In mid-month
Price per share of Company ABC in the futures market	Rs 1,100
The Result - Square off, by selling a future
On the date of Sale
Price per share of Company ABC in the futures market	Rs 1,100
Contract Value	Rs 1,10,000 (100 shares x Rs 1,100)
Result…
Gross Profit	Rs 10,000 (Rs 1,10,000 - Rs 1,00,000)

Alternatively,

In mid-month
Price per share of Company ABC in the futures market	Rs 900
On the date of Sale
Price per share of Company ABC in the futures market	Rs 900
Contract Value	Rs 90,000 (100 shares x Rs 900)
Result…
Gross Loss	Rs 10,000 (Rs 1,00,000 - Rs 90,000)

Similarly, if you have sold a contract, you can purchase it at the price prevailing in the market. You will receive the difference between the sale price and the purchase price, if the price has fallen and you will have to pay the difference if the price has risen.

Your net profit/loss will be after factoring the margin deposited and the brokerage charges.

On expiry of the contract:
If, you hold onto your contract until the expiry date, then you settle the contract at the spot price (i.e. the price of underlying asset prevailing in the cash market) on the day of expiry.

For instance, you have purchased a single future of Company ABC (consisting of 100 shares) which is expiring in October.

On the date of Purchase
Price per share of Company ABC in the futures market	Rs 1,000
Contract Value	Rs 1,00,000 (100 shares x Rs 1,000)
On the settlement date
Price per share of Company ABC in the cash market	Rs 1,050
Contract Value	Rs 1,05,000 (100 shares x Rs 1,050)
Result…
Gross Profit	Rs 5,000 (Rs 1,05,000 - Rs 1,00,000)

However, if on the settlement date, the share price of Company ABC in the cash market falls below your purchase price in the futures market…

On the settlement date
Price per share of Company ABC in the cash market	Rs 900
Contract Value	Rs 90,000 (100 shares x Rs 900)
Result…
Gross Loss	Rs 10,000 (Rs 1,00,000 - Rs 90,000)

Your net profit/loss will be after factoring the margin deposited and the brokerage charges.

When to buy and sell a futures contract:
Depending on whether you are bullish or bearish on the underlying asset, you can buy or sell a futures contract respectively.

If you are bearish about the share price of Company ABC and foresee a fall from the present level in a month from today, you could sell a futures contract today and buy it back a month later. 1 futures contract of Company ABC comprises of 100 shares.

On the date of Purchase
Price per share of Company ABC in the cash market	Rs 205
Contract Value	Rs 20,500 (100 shares x Rs 205)
On the date of Expiry
Price per share of Company ABC in the cash market	Rs 150
Your futures contract will be settled at	Rs 15,000 (100 shares x Rs 150)
The Result
Gross Profit	Rs 5,500 (Rs 20,500 - Rs 15,000)

In any case, you will earn profits on the futures contract on Company ABC if the share price of Company ABC in the cash market on the date of expiry is below your futures selling price of Rs 205 per share in the futures market.

However, if the share price of Company ABC in the cash market on the date of expiry of the contract is above your futures selling price of Rs 205 per share in the futures market, you have incurred a loss.

On the date of Expiry
Price per share of Company ABC in the cash market	Rs 250
Your futures contract will be settled at	Rs 25,000 (100 shares x Rs 250)
The Result
Gross Loss	Rs 4,500 (Rs 25,000 - Rs 20,500)

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In any case, you will start incurring a loss on the futures contract on Company ABC if the share price of Company ABC in the cash market on the date of expiry is higher than your futures selling price of Rs 205 per share in the futures market.

Your net profit/loss will be after factoring the margin deposited and the brokerage charges.

If you are bullish about the share price of Company ABC and foresee a rise from the present level in a month from today, you could buy a futures contract today and sell it a month later. 1 futures contract of Company ABC comprises of 100 shares.

On the date of Purchase
Price per share of Company ABC in the cash market	Rs 205
Contract Value	Rs 20,500 (100 shares x Rs 205)
On the date of Expiry
Share price of Company ABC in the cash market	Rs 250
Your futures contract will be settled at	Rs 25,000 (100 shares x Rs 250)
The Result
Gross Profit	Rs 4,500 (Rs 25,000 - Rs 20,500)

In any case, you will earn profits on the futures contract on Company ABC if the share price of Company ABC in the cash market on the date of expiry is higher than your futures buying price of Rs 205 per share in the futures market.

However, if the share price of Company ABC remains below your purchase price until the contract expires and the closing price in the cash market on the date of expiry of the contract is below your futures selling price, you will incur a loss.

In any case, you will start incurring a loss on the futures contract on Company ABC if the share price of Company ABC in the cash market on the date of expiry is lower than your futures selling price of Rs 205 per share in the futures market.

Your net profit/loss will be after factoring the margin deposited and the brokerage charges.

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	Forwards	Futures
Contract details	Negotiable	Standardised
Contract price	Negotiable	Market driven, therefore better price discovery
Liquidity	Low	High
Risk of default	Possible	Absent
Risk due to price movement	Unlimited	Unlimited

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An option is a derivatives contract that gives you the right (but not the obligation or the liability) to buy or sell a specified quantity of the underlying asset at an agreed price (strike/exercise price) on or before the specified future date (expiration date). To acquire this right, you pay a price (option premium) to the seller of the option. In technical parlance, the buyer of the option is known as an ‘option holder’ and the seller of the option ‘option writer’.

The potential loss for the option seller is unlimited, while, his upside or profit is limited to the premium that he receives. On the other hand, the maximum loss that the buyer could face is the option premium that he pays, but his potential profit is unlimited.

Features of Options Some of the salient features of options are:

• Standardised quantity: Each options contract has a ‘market lot’ or a pre-determined number of the underlying asset that constitute one contract.
• Standardised expiry dates and duration: At any point of time, there are three durations of which options are available – 1 month, 2 months and 3 months. The expiry date for all the contracts is the last Thursday of the month in which the contract expires.
• Standard settlement procedures: All options are settled in cash if the option buyer exercises his right to buy or sell the underlying shares.
• No counter party risk or risk of default: Options are guaranteed by the exchange on which they are traded. For instance, if you buy or sell options of Company ABC, then the counter-party to the trade is the exchange. So, in effect, the exchange steps into every trade, between the buyer and the seller and there is a credit guarantee (guarantee of no default on payments) from the exchange behind every trade. In fact, in a futures contract you are unlikely to even know your counter party, just as is the case with buying or selling stocks through a stock exchange.

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Types of Options

I. Index and stock options
If you wish to trade in options, the underlying asset can either be shares of companies that are traded on the bourses or stock indices. The former is termed as ‘stock options’ and the latter ‘index options’. However, remember, that you can undertake option trading in only those companies that are listed and meet certain criteria as defined by Securities Exchange Board of India (SEBI). In the case of index options, you can undertake option trading in the S&P Nifty CNX 50 index, CNX IT index and the Bank Nifty index on the NSE and the Sensex on the BSE.

II. American and European options
Options can also be classified on the basis of their validity period as ‘American’ and ‘European’.

American style options – This type of an option can be exercised anytime by the option buyer during the validity period of the contract. Stock options traded in India are of this type.
European style options - This type of an option can be exercised only on the expiry date of the contract by the option buyer. Index options traded in India are of this type.

III. Call and Put Options

Call Option: When you buy a call option, you hold the right to buy a specified quantity of the underlying asset at the strike price on or before the expiry date.

Put Option: When you buy a put option, you hold the right to sell a specified quantity of the underlying asset at the strike price on or before the expiry date.

Buying a call option: If you are bullish about a stock, you could purchase a call option at a pre-determined price (the strike price). You will benefit if the price moves beyond the strike price and results in an appreciation.

If all goes well and the stock price in the cash market does rise beyond the strike price plus the premium you have paid, on or before the expiry date of the contract, you can exercise your option. Your profit would be the difference between the strike price and the spot price after deducting the premium and the brokerage paid by you.

If, on the other hand, the price of the stock in the cash market does not rise beyond the strike price plus the premium you have paid, you can let the option contract lapse. Your loss in such a case would be limited to the premium and the brokerage that you have paid.

Buying a put option: If you are bearish about a stock, you could purchase a put option at a pre-determined price (the strike price). Here, you will benefit if the price moves below the strike price.

If all goes well and the stock price in the cash market does fall beyond the strike price plus the premium you have paid, on or before the expiry date of the contract, you can exercise your put option. Your profit will be the difference between the strike price and the spot price after deducting the premium and the brokerage paid by you.

If, on the other hand, the price of the stock in the cash market does not fall below the strike price, you can let the option contract lapse. Your loss in such a case would be limited to the premium and the brokerage that you have paid.

Selling Call and Put options: You buy options from the seller i.e. the option writer. The option writer is obliged to comply with your decision for which he receives a fee (i.e. the premium you pay to buy an option).

A put option seller begins to make losses when the spot price of the underlying stock in the cash market falls below the strike price, unlike a call option seller who begins to make losses once the spot price of the underlying stock in the cash market rises above the strike price.

If you exercise your option (call or put), the option writer bears a loss. The loss would be the difference between the spot price prevailing of the underlying asset in the cash market and the strike price. The loss stands reduced by the premium that he has received at the time of selling the option. In case you let the option lapse, i.e. you do not exercise the option, then, the premium received is the profit earned by the option writer. In other words, the option writer’s return is limited and risk is unlimited.

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IV. Covered and Naked Options
Depending on whether or not the option seller holds the underlying stock at the time of selling the call option, the option can be categorised as ‘covered’ and ‘naked’

Covered Options: These are options wherein the option writer holds the underlying asset at the time of selling the call option to the option buyer.

Covered options allow you to mitigate the loss in case the call option buyer exercises his option. Since, the option will be exercised only if the spot price of the underlying asset rises beyond the strike price plus the premium paid by the option buyer, if you already hold the underlying shares wherein the cost price is higher than the current spot price, your loss will be less. This is because you will not have to buy the underlying asset from the cash market to fulfil the contract.

Naked Options: These are options wherein the option writer does not hold the underlying asset at the time of selling the call option to the option buyer.

Options can get traded
It is not mandatory that if you have purchased/sold options you need to hold onto this position till the expiry date. You can settle off your position in the market at the then prevailing premium.

This premium is not a static figure and changes from moment to moment. Factors which have an impact on its movement include the demand/supply for the option, the current market price of the underlying stock and the time left to expiry of the option (with decrease in time, the premium falls).

Illustration
If you have purchased/sold a call option of Company ABC (lot size = 100 shares), for a premium of Rs 20 per share (the total premium payable on the contract would be Rs 2,000 (100 shares x Rs 20 premium per share) you can sell this option in the market any time before the expiry date.

• If the premium per share has fallen to Rs 18, you will receive Rs 1,800 (100 shares x Rs 18 premium per share) on sale of your option.
• If the premium per share has risen to Rs 22, you will receive Rs 2,200 (100 shares x Rs 22 premium per share) on sale of your option.

In the case of the former, you will incur a loss of Rs 200 (premium paid to buy the call option Rs 2,000 – prevailing premium at the time of selling the option Rs 1,800. In the case of the latter, you will book a profit of Rs 200 (prevailing premium at the time of selling the option Rs 2,200 - premium paid to buy the call option Rs 2,000).

Additionally, if you have deposited any margins with the exchange, then, they will be credited back to you.

Valuing an Option
The market value of an option is a function of its ‘intrinsic’ value and its ‘time’ value.

Intrinsic value is the difference between the spot price of the underlying shares in the cash market and the strike price of the option. Where the difference yields,

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	Futures	Options
Rights and obligations	Both the buyer and the seller of futures are bound by the contract.	The option buyer has the right but no obligation to comply with the contract. The option writer is obligated to comply with the wishes of the buyer.
Payout	Both the buyer and the seller of futures have to deposit and maintain the requisite margin amounts with the broker.	The buyer pays ‘premium’ to the option writer, but does not have to deposit any margin with the broker. The option writer receives the ‘premium’ and has to deposit and maintain the requisite margin amounts with the broker.
Payoff	Both the buyer and the seller of futures face the possibility of booking unlimited profits and incurring unlimited losses.	The option buyer could benefit from the possibility of booking unlimited profit. His loss is however limited to the premium paid by him to the option writer. The option writer’s benefit is limited to the extent of the premium received by him. He faces the risk of incurring unlimited losses.

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Offline
Step 1: You will have to register with a broker who is a member of the exchange on which you wish to trade.

Step 2: You will be required to fill in a “client registration form” in which you must provide details such as your name, address, approximate income level, etc. As proof of identity and residence, you will be required to submit copies of your passport, driver’s licence or ration card. In addition, you are required to submit a copy of your Permanent Account Number (PAN) card and details of your bank account.

Step 3: Your broker will guide you about the amount of margin that you must deposit with him after understanding your trading needs. This margin can be in the form of cash or stocks from the approved securities list. In case the margin is in the form of stocks, you will have to pledge the shares to the broker or transfer the shares to his collateral account. The value of shares available for margin will be the value as reduced by the “haircut”. The “haircut” is a fixed percentage, determined by the exchange and is equivalent to the normal margin of safety. For instance, for every share of Company ABC (which is presently traded at Rs 1,000 per share on the bourses) pledged as collateral, the margin available could be 85 per cent of Rs 1000 i.e. Rs 850.

Step 4: Then, just like you would buy and sell equity shares, you can place an order with your broker who, in turn, forwards your orders to the stock exchange. The exchange will monitor your trade and debit or credit your broker’s margin account depending on your trade.

Step 5: Your account is debited/credited daily, based on price movements. At the time of expiry/squaring off of the contract, you will actually have to make good all losses or book profits, as the case may be. These profits/losses are settled by the exchange, through your broker.

Online
Take steps from IDBI cap.

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Myth 1: Derivative trading is only for those who have an appetite for risk. Trading in derivatives holds scope for both the risk-averse and for those who have an appetite for risk. In fact, it provides risk averse investors with products which help them to transfer their risks to those who are more amenable to risks and therefore, it provides them a means of protecting the value of their portfolio.

Myth 2:Futures and options culminate in transfer of shares. In India, both futures and options are settled in cash.

Myth 3: In the case of options, the risks involved are limited. While buying options results in limiting your risks, selling options leaves you open to unlimited risks.

Myth 4: In case you purchase an option contract, you break even when the spot price in the cash market of the underlying asset crosses the strike price. You break even only when the spot price of the underlying asset in the cash market exceeds the sum total of the strike price and the premium per share that you have paid to purchase the contract.

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