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21 August 2017

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Derivatives

Derivatives


Futures


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  More About Derivatives

Frequently Asked Questions

1. What are derivatives?

Derivatives, such as futures or options, are financial contracts which derive their value from a spot price, which is called the “underlying”. The term “contracts” is often applied to denote the specific traded instrument, whether it is a derivative contract in commodities, gold or equity shares. The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange, real estate etc.

2. What is a forward contract?

In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.

3. Why is forward contracting useful?

Forward contracting is very valuable in hedging and speculation. If a speculator has information or analysis which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction making a profit.

4. What are the problems of forward markets?

Forward markets worldwide are afflicted by several problems:
(a) Lack of centralisation of trading,
(b) Illiquidity, and
(c) Counterparty risk.

5. What is a futures contract?

Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardized and trading is centralized (on a stock exchange). There is no counterparty In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter party risk. Futures markets are highly liquid as compared to the forward markets.

6. What are various types of derivative instruments traded at Exchanges?

There are two types of derivatives instruments traded on Exchanges; namely Futures and Options:
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.
Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives
the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types - Calls and Puts options:
“Calls” give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
“Puts” give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. All the options contracts are settled in cash.
Further the Options are classified based on type of exercise. At present the Exercise style can be European or American.
American Option - American options are options contracts that can be exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options.
European Options - European options are options that can be exercised only on the expiration date. All index options traded at NSE are European Options.

7. What are various products available for trading in Futures and Options?

Futures and options contracts are traded on Indices and on Single stocks.

8. Why Should I trade in derivatives?

Futures trading will be of interest to those who wish to:

1) Invest - take a view on the market and buy or sell accordingly.
2) Price Risk Transfer- Hedging - Hedging is buying and selling futures contracts to offset the risks of changing underlying market prices. Thus it helps in reducing the risk associated with
exposures in underlying market by taking a counter- positions in the futures market
3) Leverage- Since the investor is required to pay a small fraction of the value of the total contract as margins, trading in Futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin.
Thus the Leverage enables the traders to make a larger profit (or loss) with a comparatively small amount of capital.

Options trading will be of interest to those who wish to :

1) Participate in the market without trading or holding a large quantity of stock.
2) Protect their portfolio by paying small premium amount.

Benefits of trading in Futures and Options :

1) Able to transfer the risk to the person who is willing to accept them
2) Incentive to make profi ts with minimal amount of risk capital
3) Lower transaction costs
4) Provides liquidity, enables price discovery in underlying market
5) Derivatives market are lead economic indicators.

9. What are the benefits of trading in Index Futures compared to any other security?

An investor can trade the ‘entire stock market’ by buying index futures instead of buying individual securities with the efficiency of a mutual fund.
The advantages of trading in Index Futures are:
• The contracts are highly liquid
• Index Futures provide higher leverage than any other stocks
• It requires low initial capital requirement
• It has lower risk than buying and holding stocks
• It is just as easy to trade the short side as the long side
• Only have to study one index instead of 100s of stocks

10. What is the Expiration Day?

It is the last day on which the contracts expire. Futures and Options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.

11. What is the concept of In the money, At the money and Out of the money in respect of Options?

In- the- money options (ITM) - An in-the-money option is an option that would lead to positive cash fl ow to the holder if it were exercised immediately. A Call option is said to be in-the-money when the current price stands at a level higher than the strike price. If the Spot price is much higher than the strike price, a Call is said to be deep in-the-money option. In the case of a Put, the put is in-the-money if the Spot price is below the strike price.
At-the-money-option (ATM) - An at-the money option is an option that would lead to zero cash fl ow if it were exercised immediately.An option on the index is said to be “at-the-money” when the current price equals the strike price.
Out-of-the-money-option (OTM) - An out-of- the-money Option is an option that would lead to negative cash flow if it were exercised immediately. A Call option is out-of-the-money when the current price stands at a level which is less than the strike price. If the current price is much lower than the strike price the call is said to be deep out-of-the money. In case of a Put, the Put is said to be out-of-money if current price is above the strike price.

12. Is there any Margin payable?

Yes. Margins are computed and collected on-line, real time on a portfolio basis at the client level. Members are required to collect the margin upfront from the client & report the same to the Exchange.

13. What are the Risks associated with trading in Derivatives?

Investors must understand that investment in derivatives has an element of risk and is generally not an appropriate avenue for someone of limited resources/ limited investment and / or trading experience and low risk tolerance. An investor should therefore carefully consider
whether such trading is suitable for him or her in the light of his or her financial condition. An investor must accept that there can be no guarantee of profits or no exception from losses while executing orders for purchase and / or sale of derivative contracts.

14. Importance of Derivatives: Derivatives are very important financial instruments for risk management as they allow risks to be separated and more precisely controlled. Derivatives are used to shift elements of risk and therefore can act as a form of

Opening Purchase Transaction

An opening purchase transaction is one that creates or increases a long position in a given option series.

Opening Sale Transaction

An opening sale transaction is one that creates or increases a short position in a given option series. Such a sale is also referred to as "writing" an option contract.

Closing Purchase Transaction

A closing purchase transaction is one that eliminates or reduces a short position in a given option series. Such a purchase is commonly referred to as "covering" a short option position.

Closing Sale Transaction

A closing sale transaction is one that eliminates or decreases a long position in a given option series.

What is open interest?

Open interest refers to the number of outstanding contracts in the exchange market.

Futures & Options Contracts on Global Indices: NSE had introduced Futures & Options contracts on global indices with effect from August 29,2011 with the introduction of S&P 500 indices & DOW JONES Industrial Average (DJIA) indices. Three serial monthly contracts and following three quarterly expiry contracts in MAR-JUN-SEP-DEC cycle are available for trading in Global Indices. On May 03,2012 Futures & Options contracts of FTSE 100 introduced. Expiry day of Global indices is thhird Friday of the expiry month. In case the third Friday of the expiry month is a holiday, the contract shall expire on the preceding business day of the expiry month. The final Settlement price shall be based on the rates in respective markets.

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