Tuesday , October 24 2017

DERIVATIVES

Future and Options are part of Derivatives. So, let us first understand derivatives.

DERIVATIVES

Derivatives are considered as instruments whose value is derived from an underlying security that could be any of the following: debt instrument, shares, commodity and currency.

  • In a normal scenario, Suppose SBI share is of INR 250/share. Then,to buy 1000 shares you will have to pay INR 250000. And you will get the benefit only if the share price will go up.
  • On the other hand, in derivatives you can get the position for INR 250000 by paying almost 20% or more of the amount (called as margin money) varying stock to stock. Future & Option are two types of Derivatives which provides you flexibility to earn on the same stock on downside or upside movement.
  • Before moving to Future and Option one should have an understanding of the following common terms used in Future and Option.

FUTURE

As discussed above it is a part of derivative where a buyer and seller agreed on a particular underlying asset like the stock, commodity, currency etc.

  • A future contract buyer is bullish (expecting to go up) on the market and future contract seller is bearish (expecting to go downwards) on market.
  • Hence, the buyer makes money on the upside movement of the price and loss of the downside movement of the price. On the other hand, seller makes money on the downside movement of the price and loss on the upside movement of price. Here, Profit & Losses are unlimited.
  • This means by paying a certain percentage (at times only 20%) of the stock value you can take advantage of complete stock value.
  • Every future contract has an Expiry on last Thursday of every month. So you can buy “future contract” of the current month, next month and next to next month. The more the expiry date is far the premium is charged over and above on the current price of an asset.


  • For a buyer of “future contract”, he has to pay the premium on underlying asset of the stock price. And, for the seller of “future contract” that premium is gain (if the stock does not move till expiry)
  • Future buyer or seller can book their profit or losses before expiry otherwise it will get booked automatically on expiry. If you have chosen the expiry of current month you can roll over it to next month by paying an extra premium in case your target has not been achieved.
  • Hence, it is a kind of leverage you are taking which can work well if the direction is on your side. Otherwise, the adverse impact of future is sometimes unmanageable. Thus, you have to manage the trade with stop loss. Some smart traders also use Options strategies with future to minimise the risk.

OPTIONS

“Option” is the second type of derivative which has more choices than futures. But, it is also more complicated than futures. Options are kind of contract where buyer and seller make an agreement by paying the premium.

But, here Options are divided into two categories:

  • Call Option
  • Put Option

Call Option

These are contracts where a buyer of “call option” is bullish (expecting to rise) on market and seller of “call option” is bearish (expecting to go downwards) on the market.

Put option

These are contracts where buyer of “put option” is bearish on market and seller of “put option” is bullish on the market

Unlike Future contract for a buyer of Call & Put Option loss is limited to the premium whereas chances of making profit are unlimited

But, for a seller of Call and Put Option, profit making is limited to premium whereas chances of making loss are unlimited.

Option contract

It expires on the last Thursday of the month chosen. Like futures the more time is left in expiry of contract more premium will be required to pay.

You also have the choice to book the profit or loss from these contracts at any time.

Option Pricing

Here option pricing or premium for buyer or seller of contract is below-mentioned factors:

Strike Price

It is a price which has been decided by exchange in advance to trade. Example: In the case of SBI share trading at INR 248/share Strike price are on a difference of INR 5. Like INR 230, 235, 240, 245, 250 and so on.

To understand this better we have also have to understand following terms:

  • In the money
  • At the Money
  • Out of the Money

In the money

It is the position where the current price is higher than strike price that means you have already achieved that strike price. Example: Current price of SBI is INR 248 and strike price chosen is INR 240. It means the premium of this option will be expensive.

At the money

It is a position where the current price is equal to strike price. Example: Current price of SBI is INR 240 and strike price chosen is INR 240. It means the premium of this option will be cheaper than the money option.

Out of the money

It is the position where the current price is lower than strike price Example: Current price of SBI is INR 230 and strike price chosen is INR 240. It means the premium of this option will be cheapest.

Hence, for a buyer of Call & Put Option he has to pay less in out of money and at the money option but profits is unlimited. For a seller of Call & Put option in the money, option is more profitable if the direction is as per the investor.



Options can also be used with Future & stocks to minimise the risk in a bigger portfolio which are meant for a longer duration. It can give you a recurring income where you are holding a future and stock for the long term but you want to earn on both side of the portfolio.

There are various Option strategies available in the market which can be tweaked to make profits with minimum risk. Strategies are as follows:

  • Long call
  • Short
  • Synthetic long
  • Long put
  • Short put
  • Covered call
  • Long combo
  • Protective call
  • Covered put
  • Long straddle
  • Short straddle
  • Long strangle
  • Short strangle
  • Collar
  • Bull call spread strategy
  • Bull put spread strategy
  • Bear call spread
  • Bear put spread strategy
  • Long call butterfly
  • Short call butterfly
  • Long call condor
  • Short call condor

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