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18 December 2017

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Derivatives


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  More About Derivatives

Futures and Options Market Instruments

The F&O segment provides trading facilities for the following derivative instruments:
1. Index based futures
2. Index based options
3. Individual stock options
4. Individual stock futures

At any point of time there will be minimum three months futures & options contracts are available for trading at Indian Exchanges. Currently exchanges are providing index options with a tenure upto 5 years at any given point of time.

The National Stock Exchange and Bombay Stock Exchange have commenced trading in Derivatives Market with Index Futures being the first instrument. Now both the exchanges provide trading in Index Futures and Options and Stock Futures and Options.

Recently MCX SX has started derivatives trading in stock futures and stock options.

The standardized items in a futures contract are:

• Quantity of the underlying
• Quality of the underlying
• The date and the month of delivery
• The units of price quotation and minimum price change
• Location of settlement

Futures Terminology

• Spot price: The price at which an underlying asset trades in the spot market.
• Futures price: The price that is agreed upon at the time of the contract for the delivery of an asset at a specific future date.
• Contract cycle: It is the period over which a contract trades on the Friday following the last Thursday; a new contract having a three-month expiry is introduced for trading.
• Expiry date: is the date on which the final settlement of the contract takes place.
• Contract size: The amount of asset that has to be delivered under one contract. This is also called as the lot size.

Options

Option Terminology

• Index options: Have the index as the underlying. They can be European or American. They are also cash settled.
• Stock options: They are options on individual stocks and give the holder the right to buy or sell shares at the specified price. They can be European or American.
• Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
• Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
There are two basic types of options, call options and put options.
• Call option: It gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.
• Put option: A It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.
• Option price/premium: It is the price which the option buyer pays to the option seller. It is also referred to as the option premium.34
• Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
• Strike price: The price specified in the options contract is known as the strike price or the exercise price.
• American options: These can be exercised at any time upto the expiration date.
• European options: These can be exercised only on the expiration date itself. European options are easier to analyze than American options and properties of an American option are frequently deduced from those of its European counterpart.
• In-the-money option: An in-the-money (ITM) option would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
• At-the-money option: An at-the-money (ATM) option would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).
• Out-of-the-money option: An out-of-the-money (OTM) option would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
• Intrinsic value of an option: The option premium has two components - intrinsic value and time value. Intrinsic value of an option at a given time is the amount the holder of the option will get if he exercises the option at that time
• Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value.

Comparison between Futures and Options

Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses.

Applications of Stock Futures

1.Long security, sell futures
2.Speculation: Bullish security, buy futures
3.Speculation: Bearish security, sell futures
4.Arbitrage: Overpriced futures: buy spot, sell futures
5.Arbitrage: Under priced futures: buy futures, sell spot

Application of Options

1.Hedging: Have underlying buy puts
2.Speculation: Bullish security, buy calls or sell puts
3.Speculation: Bearish security, sell calls or buy puts
4.Bull spreads - Buy a call and sell another
5.Bear spreads - sell a call and buy another
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