FUTURES AND OPTIONS

What is Derivative?

A derivative is a financial contract which has no direct value, but with a value derived from an underlying asset price, based on the expected future price movements of that asset. The derivative instrument can be traded independently.

Derivatives are used as an instrument to hedge risk offering the high returns potential for other party of contract and are available with certain stocks, bonds, commodities, index prices, foreign exchange rates, changes in interest rates etc. Derivatives are traded as a “lot” (bundle) usually.

Exchange traded and over the counter (OTC) types of derivatives are available. Futures and options are exchange traded derivatives that can be bought and sold like stocks through organised exchanges around the world.

Examples for OTC instruments are swaps, swaptions, forwards, etc. Over the counter derivatives are not standardized and with varied features. They are not traded through the authorised exchanges.

Futures and options are two most common forms of derivatives.

Futures

What is meant by Futures Market ?

A 'Future' is a contract to buy / sell the underlying asset at a pre-determined time, and certain price. Buying futures contract means you promise to pay the price of the underlying asset within a specified period of time. On selling a future, one promises to transfer the underlying asset to the buyer of the future contract at a particular time and certain price.

Features of future contracts are Buyer, Seller, Expiry and Price.

Most popular assets having futures contract, are equity stocks, currency, indices, and commodities.

The difference between the price of the underlying asset in the spot market and the futures market is known as 'Basis'.

On holding equity shares, one may get dividends, but for equity futures there is no eligibility to receive dividends.

Usually future price of an asset is more than its spot price. If spot price is greater than future price, the price of the asset is expected to fall. On approaching expiry time of the future contract, the basis becomes nearly zero.

Options

What is meant by Option Trading?

The financial instrument that gives the right to the holder to buy/sell the underlying asset at a predetermined price is named as call/put options respectively. Predetermined price is known as strike price. Seller has no right, but only obligation. The price paid to buy an option contract is called option premium.

An investor would buy a call option of a strike price (levels of index or a security of stock, commodity, currency etc.) if he expects the underlying asset to rise above the strike price before the contract expires.

An investor would purchase a put option of a strike price if he expects the underlying asset to drop below the strike price before the contract expires.

Option has time value also, that decreases on approaching expiry. Risk on options 'shorting' (selling without holding expecting to buy at a lower rate) is unlimited while options 'long' (buying with out a shorting position or fresh buy, not to cover any short position) risk is limited to premium amount.

Call option is denoted by “CE” (Call European style) or “CA” (Call American style). Put option is denoted by “PE” (European) or “PA” (American).

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BINARY OPTIONS