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Understanding Derivatives Trading

This episode opens with the basics of Derivatives, with focus on uses and types of Derivatives Contracts.

9329 views  6 Nov 2017

Derivatives Trading

Derivative is a contract or an instrument whose value is derived from one or more other underlying assets. Underlying assets can be:

  • Metals such as Gold, Silver, Aluminum, Copper etc
  • Energy resources such as Oil, Gas & Coal etc
  • Agri Commodities such as Wheat, Sugar, Coffee etc
  • Financial Assets such as Stocks, Bonds and Foreign Exchange
  • Example: Nifty derivative future contract is derived from the underlying Nifty 50

Derivatives instruments are legal contracts. All specifications are pre-defined and binding. Specifications are defined as price, validity, quantity, quality, rights & obligation of participants.

Trading participants:

  • Hedgers: They neutralize perceived risk of stock market, primarily to offset losses in portfolio by taking opposite positions in the Derivative market.
  • Speculators: They buy & sell based on price movement & benefit from either side Market moves.
  • Arbitrageurs: They take advantage of price differential between the cash & the derivative market. The spread between the two markets enables them to make a return with no risk & deploy cash.

Types of Derivatives Contract

  1. Exchange Traded: Traded via specialized derivative exchanges. Derivative exchanges acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee.
  2. Over the counter (OTC): Traded (and privately negotiated) directly between two parties without going through exchange or other intermediary. There is no formal centralized limits on individual positions, margining, no formal mechanisms for ensuring market stability, integrity and safeguarding participant’s interest.

Types of OTC Contract

  1. Forward: Forward is a contract between two parties whereby one agrees to sell the underlying asset to another party at some point in the future for a price agreed upon now. The amount of sale as well as when it occurs is customized at the time of the contract.

Drawbacks of Forwards

  • Lack of centralized trading
  • Poor liquidity
  • Counter Party Risk

It is because of these drawbacks that Exchange traded contracts are more attractive & the OTC market in the Indian context remains extremely dormant.

Types of Exchange Traded Funds

  1. Future: Futures contract is an agreement between two parties to 'buy' or 'sell' an asset on a pre-specified date for a pre-specified price and pre-specified quantity. Future contracts are standardized and are traded on exchange. The exchange specifies certain standard features of the contract to facilitate liquidity in the future contracts.
  2. Options: Gives the holder of contract 'Right but no obligation' to buy or sell the underlying. ‘Right but no obligation' is transferable/tradeable.

Features of Futures

  1. All Future contracts are legally binding contracts.
  2. Daily Mark to Mark (MTM) settlement.
  3. Generally contracts are available up to three months of validity – current month, mid month and far month.
  4. All trades are margined positions, i.e. a small portion of the contract value is paid / blocked initially.
  5. Last Thursday of every month is the expiry day.
  6. All trades are settled in cash.
  7. The derivative contracts traded have no impact on your Demat account.
Underlying Symbol Expiry date Lot Size LTP
RELIANCE FUTSTK 26-Oct-2017 1000 821.8
RELIANCE FUTSTK 30-Nov-2017 1000 826
RELIANCE FUTSTK 28-Dec-2017 1000 831.5

Spot Price [ Reliance ] 820.20

Convergence of Spot and Future

The Terminal value of a Future contract is equal to the spot price of the underlying asset on the day of expiry (Last Thursday of each month)

Practical Application of Futures

Trading in Underlying Trading in Future
Involves providing for all the money Involves providing for Margin Money
Limited Opportunities for short selling (only for intraday ) Can short sell & hold the position for longer duration
Holding of stocks represent ownership in the company Doesn't represent ownership in the company

How Futures work

  • If Nifty is trading @ 10000 & Target is 10300
  • Buy Nifty Futures @ 10000
  • If Nifty Closes @ 10300 then profit = (10300-10000) = 300
  • Rs 300*75*No. of lots purchased

Options

It gives the holder of contract 'Right but no obligation' to buy or sell the underlying. ‘Right but no obligation' is transferable/ tradeable

Terminologies

  1. Premium: The price of an option (price paid for buying an option).
  2. Expiry Date: The date at which right can be exercised.
  3. Strike Price: The rate at which the right can be exercised (also known as Exercise Price).
  4. Spot Price: The price at which the underlying asset trades in the spot market.
  5. Lot Size: Lot size is the number of units of underlying asset in a contract.
Call Option An Options contract which gives the Buyer 'Right but NO obligation' to BUY the underlying share/index by a certain date for a certain price.
Put Option An Options contract which gives the Buyer 'Right but NO obligation' to SELL the underlying share/index by a certain date for a certain price.
Buyer of a Call/ Put Option The Buyer of a Call/Put Option is the one who by paying the option premium buys the right but not the obligation to exercise his option on seller/writer.
Writer of a Call/Put 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/holder exercises on him

Note: The buyer of a call or Put option has limited risk to the amount of premium he pays whereas his profit is unlimited.

The writer of a call or Put has limited profit to the amount of premium he gains by selling the option whereas his loss is unlimited.

Long Call- Pay Off

Lot Size: 75  Strike Price: Rs 10400  Premium : 99  No. Of Lot = 1

Spot @ Expiry P/L Total P/L
10200 -99 -7425
10300 -99 -7425
10400 -99 -7425
10500 1 75
10600 101 7575
10700 201 15075

Call Writing: Pay Off

Lot Size: 75  Strike Price: Rs 10400  Premium : 99  No. Of Lot = 1

Spot @ Expiry P/L Total P/L
10200 99 7425
10300 99 7425
10400 99 7425
10500 1 75
10600 -101 -7575
10700 -201 -15075

Long Put - Pay Off

Lot Size: 75  Strike Price: Rs 10400  Premium : 175  No. Of Lot = 1

Spot @ Expiry P/L Total P/L
10400 -175 -13125
10350 -125 -9375
10300 -75 -5625
10250 -25 -1875
10200 25 1875
10150 75 5625

Put Writing - Pay Off

Lot Size: 75  Strike Price: Rs 10400  Premium : 175  No. Of Lot = 1

Spot @ Expiry P/L Total P/L
10500 175 13125
10400 175 13125
10350 125 9375
10300 75 5625
10250 25 1875
10200 -25 -1875

Market Indicators & Interpretations

  1. Open Interest
  2. Roll Over
  3. Put Call Ratio
  4. Volatility Index