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A derivative is a financial instrument that derives its value from the value of an underlying asset. The underlying asset can be equity, commodities or any other asset. For the purpose of this chapter, we would restrict the scope to Equity derivatives only. Derivatives were introduced in the Indian stock market to enable investors to hedge their investments against adverse volatile price movements. However they are now commonly being used for taking speculative positions.
Broadly,
Futures and
Options are the derivative instruments that are traded on the two main exchanges, BSE and the NSE.
Futures: - To understand the term better, let’s take an example. Nifty is trading at the level of 4000. You can buy or sell a lot of Nifty Fututres. The lot size of Nifty futures is 100. You would be required to pay a margin of 10% of the contract value.
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The margin money would work out as follows: -
Transaction value: 4000 × 100 (lot size) = Rs. 4,00,000
Margin Amount: 10% of 4,00,000 = Rs.40,000
The lot size and margin money percentage vary for different scrips and contracts. We took the example of Nifty, which is an index. You can take positions in various stocks which are listed for Futures trade. On NSE, the last Thursday of every month is the expiry date. In our example, if the Nifty is trading at 4300 on the last Thursday of the month and the position is not squared off then the purchaser of the Nifty futures contract at 4000 would be a gainer by Rs.20,000 (200 × lot size100). Similarly seller of Nifty futures contract would stand to lose Rs. 20,000.
Options: Options are hedging/investment instruments, which allow the buyer the right but not the obligation to buy/sell the underlying stock/ index. The buyer of the option incurs a charge for this right, which is referred to as the “premium”. The option writer or seller is the other party to such a contract who earns the premium.
Call Option - Option to buy the stock at a specific price
e.g. Mr. A buys a Nifty Call option with a strike price of 4100 at a premium of Rs.100. Mr. B, the seller of the option earns this premium of Rs.100 taking unlimited risk whereas Mr. A’s risk is limited to the premium amount of Rs.100. If at the expiry date, Nifty is trading at 4350, then Mr. A would exercise his option and earn a net amount of Rs.150. The strike price of the contract is 4100 and at the expiry, the Nifty is at 4350. So he stands gainer by Rs.250 (4350 – 4100). He however has incurred a premium of Rs.100, so his net earnings would be Rs.150 (Rs.250 – Rs.100).
Now, had the Nifty fallen to 3950, then Mr.A would be a loser by only Rs.100, which is the premium amount. His Call option would not exercise and Mr.B would be a gainer by Rs.100.
Put Option - Option to sell the stock at a specified price
e.g. Mr. A buys a Nifty Put option with a strike price of 4100 at a premium of Rs.100. Mr. B, the seller/writer of the option earns this premium of Rs.100 taking unlimited risk whereas Mr. A’s risk is limited to Rs.100. If at the expiry date, Nifty is trading at 3850, then Mr. A would exercise his option and earn a net amount of Rs.150. The strike price of the contract is 4100 and at the expiry, the Nifty is at 3850. So he stands gainer by Rs.250 (4100 - 3850). He however has incurred a premium of Rs.100, so his net earnings would be Rs.150 (Rs.250 – Rs.100).
Now, had the Nifty risen to 4250, then Mr.A would be a loser by only Rs.100, which is the premium amount. His Put option would not exercise and Mr.B would be a gainer by Rs.100.
Spot Mkt Price – It is the price at which the stock is trading in the cash markets.
Strike Price - Specified Price at which the underlying may be purchased or sold when the option is exercised.
Expiry Date - Last date for exercising the option by buyer--- Last Thursday of the relevant month on NSE.
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