Derivatives Basics
- 1. Derivatives in financeFutures and options
- 2. DerivativesA conditional contract used in the financial market is called as a derivative.Derivatives are contracts whose value is "derived" from the price of something else, typically, ‘cash market investments’ such as stocks, bonds, money market instruments or commodities.Derivatives may be used for trading or for protection of value of assets (hedging).
- 3. Types of derivatives The most common type of derivatives used in the financial markets areFuturesOptionsForwardsSwaps
- 4. Futures and optionsFuturesA futures is an contract in which buyer and seller agree to a deal in a future date at a pre decided priceOptionsOptions is a contract where the seller is obligated to sell at a future date at a pre decided price but the buyer has a option not to buy. Hence since the seller is obligated the buyer pays an options premium to the seller.
- 5. Derivatives in Indian Stock MarketFutures and options are the only derivatives in use in the Indian stock market.NSE and BSE offer these options.The market where derivatives are traded are called as derivatives market.
- 6. How do derivatives work?Let us take a stock of ABC company. It is trading currently at Rs 300 per share.If I buy the share, then I have to sell it when the price is higher to make a profit.
- 7. How do derivatives work?What is the other option I have?I feel the price will rise, and Mr. X agrees.So I make a contract with Mr. X saying that I will sell the stock at RS 320 in 3 months time.So in 3 months time I have to sell and Mr. X has to buy.Both me and Mr. X are obligated to fulfill the contract.This is FUTURES contract.
- 8. How do derivatives work?If I say that I will sell at Rs 320.But Mr. X has the option of not buying the stock.So I must sell and he may buy.Thus he holds an option and I am obligated.
- 9. How do derivatives work?So he pays me a premium (a small cost) of 2 percent (i.e. Rs 6.4) for the option.This is called as OPTIONS contract.The maximum profit I may make is Rs 6.40 and the maximum loss that Mr. X can make is Rs 6.4.But there is no limit to the amount of profits that Mr. X can make. That is another reason why he pays the option premium.
- 10. Making Profits from derivatives(Rising price expectation)I have 100 shares of ABC company. The price of each share is Rs 100 today.I feel that the price will go up in the future.So how can I make a profit using derivatives on a rising price expectation?I will take a futures for buying 100 shares of ABC at Rs 100, but 60 days from today.
- 11. Making Profits from derivatives(Rising price expectation)If the price is say, Rs 110 on the 60th day then I get to buy that stock at Rs 100.Thus I made a profit of Rs 10 per share i.e. a total profit of Rs 10 x 100 = 1000.What would happen if the price was down to Rs 90?I will make a loss of Rs 10 per share as I will be obligated to buy at Rs 100.Both parties will pay the witness of the contract (usually the stock exchange) a small fee for facilitating the contract.
- 12. Making Profits from derivatives(falling price expectation)I have 100 shares of ABC company. The price of each share is Rs 100 today.I feel that the price will go up in the future.So how can I make a profit using derivatives on a falling price expectation?I will take a futures for selling my stock at Rs 100, 60 days from today.
- 13. Making Profits from derivatives(Falling price expectation)If the price is say, Rs 90 on the 60th day then I get to sell that stock at Rs 100.Thus I made a profit of Rs 10 per share i.e. a total profit of Rs 10 x 100 = 1000.What would happen if the price was up to Rs 100?I will make a loss of Rs 10 per share as I will be obligated to sell at Rs 110.Both parties will pay the witness of the contract (usually the stock exchange) a small fee for facilitating the contract.
- 14. Using options to restrict losses.The CALL optionOptions can be used to restrict our losses to a fixed amount.I have 100 shares of ABC company. The price of each share is Rs 100 today.I feel that the price will go up in the future, but I don’t want to make a big loss.So I write as options contract for buying the shares of ABC at Rs 100, 60 days from now. I pay Rs 2 per share, as options premium because I am not obligated to buy but the seller is obligated to sell at Rs 100.
- 15. Using options to restrict losses.The CALL optionIf the price is say, Rs 110 on the 60th day then I get to buy that stock at Rs 100.Thus I made a surplus of Rs 10 per share. My options premium was Rs 2 per share. profit of Rs 8 per share which means a total profit or 8 x 100 = 800 What would happen if the price was down to Rs 90?I will not exercise my option and my loss will be restricted to Rs 2 which I paid as options premium.This option to buy is called as call option.
- 16. Using options to restrict losses.The PUT optionOptions can be used to restrict our losses to a fixed amount.I have 100 shares of ABC company. The price of each share is Rs 100 today.I feel that the price will go down in the future, but I don’t want to make a big loss.So I write as options contract for selling the shares of ABC at Rs 100, 60 days from now. I pay Rs 2 per share, as options premium because I am not obligated to sell but the seller is obligated to buy at Rs 100.
- 17. Using options to restrict losses.The PUT optionIf the price is say, Rs 90 on the 60th day then I get to sell that stock at Rs 100.Thus I made a surplus of Rs 10 per share. My options premium was Rs 2 per share. profit of Rs 8 per share which means a total profit or 8 x 100 = 800 What would happen if the price was up to Rs 110?I will not exercise my option and my loss will be restricted to Rs 2 which I paid as options premium.This option to sell is called as PUT option.
- 18. Difference between futures and options
- 19. Thank You