Introduction[/b]
Derivatives are the contracts which derive their values from the value of one or more of other assets, known as underlying assets. For eg. Futures, Options, etc.
Future Trading –Mechanism[/b]
A future contract is an arrangement by which a buyer/seller agrees to take/give delivery of the securities on a specified future date at a fixed price and make payment on the delivery date. Such contracts are zero-sum games where the gain equals loss.
The clearing house is the counterparty in such contracts. A buyer is called the ‘long’ and the seller ‘short’. A margin is deposited at the clearing house for futures.
Options Trading-Mechanism[/b]
An option is a contract between two parties in which the maker of the option (option writer) agrees to buy or sell a specified number of shares at later date for an agreed price (strike price) to the holder of the option (option buyer) on a due date and time, when and if the latter so desires, in consideration of a sum of money(premium). The premium is the site price which is required to be paid for purchase of right to buy or sell.
The terms of contract allow the holder, not the maker, to cancel the option.
Types of option[/b]
Options are two types: Call option and Put option
In call option, an investor has a right to buy. An investor takes a call option, if he expects that the market price will be higher than the strike price to earn the difference as his profit.
In put option, an investor has a right to sell. An investor takes a put option if he expects that the market price will be lower than the strike price. The lower the market price than the strike price, the higher will be the profit the investor.
An investor can simultaneously buy as well as put option, if he is uncertain about the market conditions.
Investment Strategies[/b]
Straddle[/b]: combination of one put and one call option is known as straddle. Here, the investor is against any movement on either side and has opportunity to gain from upmove and downmove.
Strap[/b]: Combination of one put and two calls option is known as strap. Here, the investor is confident that scrip price will change, but it is more likely to go up than go down.
Strip:[/b] Combination of two puts and one call option is known as strip. Here, the investor is confident that scrip price will change, but it is more likely to go down than go up.
Index Futures[/b]
Futures based on an index, the underlying asset being the index, are known as Index Futures. A futures contract is a standardized contract to buy or sell a specific security at a future date at an agreed price. An index future is a future on the index i.e. the underlying is the index itself. There is no underlying security or a stock, which is to be delivered to fulfill the obligations as index futures are cash settled. As other derivatives, the contract derives its value from the underlying index. The underlying indices in this case will be the various eligible indices as permitted by the Regulator from time to time.
Significance or Importance of Derivatives Trading[/b]
Risk management, an important tool of scientific management, is basically concerned with rationally handling of a situation. The derivatives are as tools of investment risk management. The futures and trading not only provide a way to hedge against the market risk of a large stock portfolio, but also enable investors to hedge their position in the market.
In the case of options, losses to the buyer are limited to the amount paid for purchase of option, but there always remains scope off earning unlimited profits. The amount of premium is relive small and possibility of making is higher, it is the buyer who has the option and flexibility to take the risk to the extent he likes and pass on the rest to the option writer, who is fully exposed to the risk to the extent he likes and pass on the rest to the option writer, who is fully exposed to the risk of price fluctuations and has to exercise due care and diligence. As such, the system can fail if adequate precaution is not taken in advance to ensure the risk of the option writer. The stock exchange authorities have to on sure the performance of the contract in the event of the failure of the option writer. In USA, stock exchanges of the contract in the in case the option writer fails to meet his liability.
Derivatives are the contracts which derive their values from the value of one or more of other assets, known as underlying assets. For eg. Futures, Options, etc.
Future Trading –Mechanism[/b]
A future contract is an arrangement by which a buyer/seller agrees to take/give delivery of the securities on a specified future date at a fixed price and make payment on the delivery date. Such contracts are zero-sum games where the gain equals loss.
The clearing house is the counterparty in such contracts. A buyer is called the ‘long’ and the seller ‘short’. A margin is deposited at the clearing house for futures.
Options Trading-Mechanism[/b]
An option is a contract between two parties in which the maker of the option (option writer) agrees to buy or sell a specified number of shares at later date for an agreed price (strike price) to the holder of the option (option buyer) on a due date and time, when and if the latter so desires, in consideration of a sum of money(premium). The premium is the site price which is required to be paid for purchase of right to buy or sell.
The terms of contract allow the holder, not the maker, to cancel the option.
Types of option[/b]
Options are two types: Call option and Put option
In call option, an investor has a right to buy. An investor takes a call option, if he expects that the market price will be higher than the strike price to earn the difference as his profit.
In put option, an investor has a right to sell. An investor takes a put option if he expects that the market price will be lower than the strike price. The lower the market price than the strike price, the higher will be the profit the investor.
An investor can simultaneously buy as well as put option, if he is uncertain about the market conditions.
Investment Strategies[/b]
Straddle[/b]: combination of one put and one call option is known as straddle. Here, the investor is against any movement on either side and has opportunity to gain from upmove and downmove.
Strap[/b]: Combination of one put and two calls option is known as strap. Here, the investor is confident that scrip price will change, but it is more likely to go up than go down.
Strip:[/b] Combination of two puts and one call option is known as strip. Here, the investor is confident that scrip price will change, but it is more likely to go down than go up.
Index Futures[/b]
Futures based on an index, the underlying asset being the index, are known as Index Futures. A futures contract is a standardized contract to buy or sell a specific security at a future date at an agreed price. An index future is a future on the index i.e. the underlying is the index itself. There is no underlying security or a stock, which is to be delivered to fulfill the obligations as index futures are cash settled. As other derivatives, the contract derives its value from the underlying index. The underlying indices in this case will be the various eligible indices as permitted by the Regulator from time to time.
Significance or Importance of Derivatives Trading[/b]
Risk management, an important tool of scientific management, is basically concerned with rationally handling of a situation. The derivatives are as tools of investment risk management. The futures and trading not only provide a way to hedge against the market risk of a large stock portfolio, but also enable investors to hedge their position in the market.
In the case of options, losses to the buyer are limited to the amount paid for purchase of option, but there always remains scope off earning unlimited profits. The amount of premium is relive small and possibility of making is higher, it is the buyer who has the option and flexibility to take the risk to the extent he likes and pass on the rest to the option writer, who is fully exposed to the risk to the extent he likes and pass on the rest to the option writer, who is fully exposed to the risk of price fluctuations and has to exercise due care and diligence. As such, the system can fail if adequate precaution is not taken in advance to ensure the risk of the option writer. The stock exchange authorities have to on sure the performance of the contract in the event of the failure of the option writer. In USA, stock exchanges of the contract in the in case the option writer fails to meet his liability.