Derivatives Trading

What is meant by Derivative?

In financial market, Derivative refers to an instrument whose value is derived from the underlying asset. The underlying asset could be Equity share, Commodity, Currency, Interest Rate, Debt Instruments (like, Bonds, etc.). Derivatives on stock market indices (like NIFTY, BANKNIFTY) are also widely traded.

Derivatives are basically a bet on future value of the asset underlying derivative contracts. There are two types of Derivative instruments, Futures & Options (F&O). F&O are tools used by investors for speculation or hedging purpose. They offer the potential to earn huge profits besides posing risk of losing large amount.Let’s understand about it in detail.

Futures

It is an agreementbetween two parties to buy or sell the specified quantity of the underlying asset at an agreed price on a predetermined date. Here both the parties to contract are bound to fulfil their obligation, i.e., buyer has to buy the asset & make payment and seller must sell the asset.

Options

Option grants the buyer of it the right but not the obligation. Option seller is bound to fulfil hisobligation if the buyer exercises his right. The price of the option is called “Premium”.Options can be used for hedging, taking a view on the future direction of the market, for arbitrage or for implementing strategies which can help in generating income for investors under various market conditions.There are two types of options. Call and Put.

Call option gives the option buyer the right to buy the specified quantity of the underlying asset at an agreed price on a predetermined date. If Call buyer exercises his right Call seller has to deliver shares at agreed upon price.

Put option gives the option buyer the right to sell the specified quantity of the underlying asset at an agreed price on a predetermined date. If Put buyer exercises his right Put seller has to purchase shares at agreed upon price.

  • Equity Derivative Market TradingHours

 

Option Terminology
  • Stock options – Options on individual stocks are called stock options. A stock option contract gives the holder the right to buy or sell the underlying shares at the specified price
  • Index options – They have stock market index as the underlying. Option contracts on NIFTY & BANKNIFTY index are very popular among traders.
  • Option buyer – 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.
  • Option seller – The seller of an option is the one who receives the option premium and is hence obliged to sell/buy the asset if the buyer exercises his right. Option seller is also referred to as Option writer.
  • Option premium – Option premium is the price of the option which the option buyer pays to the option seller.
  • Expiry – The date specified in the options contract is known as the expiration date, the exercise date, or the maturity. In India options contract on index are issued with monthly as well as weekly expiration date.Monthly F&O contracts expire on last Thursday of the contract month and weekly contracts on every Thursday. If Thursday is the trading holiday, the contracts expire on previous trading day.
  • Strike price – The price specified in the options contract is known as the strike price or the exercise price.
  • American options – options are options that can be exercised at any time up to the expiration date.
  • European options – European options are options that can be exercised only on the expiration date itself.
  • In-The-money (ITM) option – A call option on stock is said to be ITM if the current market price (spot price) of the stock is higher than the strike price. A put option is ITM if the current market price is lower than the strike price.
  • At-The-Money (ATM) option – An option is ATM if the current price of the underlying is equal to the strike of the option.
  • Out-of-The-Money (OTM) option – It is converse to ITM option. A call option is said to be OTM if the spot price of the underlying is lower than the strike price. A put option is OTM if the spot price is higher than the strike price.
Option Strategies

As we have understood earlier that options areused for speculation and as a hedging tool, there is a variety of option trading strategies available to that end. Simple buy and sell of options gives the buyer the right to buy or sell the asset and creates obligation on option seller.

A trader may have bullish, bearish, or neutral view on the market. Accordingly, traders adopt various combinations of buying & selling call and put options to maximize profit in their trades. Such combinations are also used as a protective measure especially where stock prices are highly sensitive to news or events. Several popular option trading strategies are explained below.

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