Derivative is a product whose value is derived from the value of a particular underlying asset(s) which could be a commodity, equity, currency or any other actively traded asset. Thus, its value depends directly on the price of the underlying asset and its expected price movement. It can help safeguard the investment portfolio against potential loss resulting from the adverse price movement of assets.

Derivatives are an effective tool used for:

• Undertaking speculation
  Speculation entails betting on the future price movement of a particular asset. Derivatives help speculators book profits if the value of the underlying asset moves as they expected. Through a derivative contract, one can buy an asset in the future at a predetermined price as per the contract, even if the future market price is high, or sell the asset in the future at a predetermined price (as per the contract) even if the future market price is low.
• Undertaking hedging
  Hedging is used to eliminate or reduce risks. Derivatives allow you to hedge your investment portfolio from any adverse future price movement.
  For instance, an investor holds 1000 shares of XYZ Ltd. which he plans to sell after 2 months. To avoid any negative impact on the valuation of these shares, he can invest in futures. Let us assume that a futures contract for XYZ Ltd has a lot size of 500 shares. In such a case he can short two futures with 2 months expiry.

	Spot Price Per Share	Futures Price	Impact on cash position	Impact on future position
Jan 2010	100/-	98/-	--	--
Feb 2010	90/-	88/-	(10,000/-)	10,000/-
Mar 2010	92/-	90/-	2,000/-	(2,000/-)

Note: This example is for illustrative purposes only. In reality, the spot prices of shares and their value in the futures market may not rise and fall by the same amount.

By entering a futures contract, the investor benefits from the fact that the current valuation will remain more or less the same, even if there is a fall in the price of the shares. He can also reap some gain on this hedge position if he books profits on the future position if he sees signs of recovery in the share price, i.e. to settle future position in February 2010 and continue with the cash position.

• Undertaking arbitrage
  Any gap or difference between prices of the same asset in two different markets provides an arbitrage opportunity. It entails buying the asset in one market and simultaneously selling it in the other or vice versa, i.e. taking of equal and opposite positions in related markets, in order to take advantage of the small price differences between the markets. In the derivative market too, arbitrage opportunities may be exploited when the price of the derivative product is different from its underlying asset. So, for instance, the price of a stock futures contract is higher than its price in the cash market, there is an arbitrage opportunity – you could buy the stock in the cash market and sell an equivalent amount of futures.
• Buying on margin
  Derivatives allow you to take huge positions in a particular asset, by paying only a fraction of the value of the transaction. This amount that you pay is called a margin.
  To illustrate, suppose you are bullish on shares of company ABC Ltd., which are currently trading at Rs. 50. You expect at least a 10 per cent upside in one month in the share price. You have a cash balance of Rs. 20,000 from which you can buy 400 shares. In case the prices move as per your expectations, you can make a profit of Rs. 2,000 (Rs. 5 X 400). Now, instead of investing Rs. 20,000 in the cash market, if you are confident about the upside movement in the price, you can buy a futures contract of 500 lot size. Assuming a margin of 20 per cent is payable, you can buy 4 futures lots with Rs. 20,000, which are equivalent to 2,000 shares. (20% of (Rs. 50 x 500) = Rs. 5000 per lot margin).

	Price	Cash position	Future position
Current Price	50/-	Bought 400 shares at 20,000/-.	Bought 4 lots (2,000 shares) by paying margin of Rs. 20,000/-
Price after 1 month	55/-	Sold 400 shares at 22,000/-	Sold 4 lots (2,000 shares) at 55/-
Impact	10% upside	Profit of 2,000/- i.e. 10% of investment	Profit of 10,000/- i.e. 50% on investment

In a nutshell, you can buy 5 times the amount of shares with the same amount of money simply because you have to pay up only 20% (1/5th) of the value of the shares.

Forwards, futures, options, warrants and swaps are the various types of derivatives available. In the Indian market, however, futures and options are the most actively-traded derivatives

All you wanted to know about futures

Futures are exchange-traded standardized derivative products. It is a contract between two parties to buy or sell an asset at a particular price on a particular date.

Stock and index futures

Stock futures are contracts with a particular stock being the underlying asset; whereas index futures are contracts which have the index value as the underlying asset.

Pricing a futures contract

The future price of any asset should normally be higher than its spot price due to the time value of money, i.e. you need to be compensated for parting with your capital. In theory, the future price is derived by using the formula, F = Se^rT

where,
F = Future Price
S = Spot Price,
r = rate of interest
e = 2.71828 (continuous daily compounding)
T = Time till expiry (in years)

In reality, however, the price of futures are determined by the market as players take into account various factors such as the price of the underlying, the expected price of the futures as time goes by and so on.

Understanding the 'basis'

The difference between the future price and spot price of an asset is termed as 'basis'. In normal market conditions, the basis should be positive. A high positive basis is considered as a bullish signal and whereas a negative basis indicates bearish market conditions.

Contango and Backwardation

Normally, the futures price is expected to be in line with the future spot price of the underlying asset. However, due to market forces, the futures price may be higher than the expected future spot price. This situation is termed as 'Contango'. The price will gradually decline to the spot price before the maturity date of the contract.

On the other hand, when the futures price is lower than the expected future spot price of the asset, it is referred to as 'Backwardation'. As we approach the maturity date, the price will gradually rise to the spot price. This is explained below.

Price movement of a 2 month futures contract

2 month Futures contract	Today	15 days	30 days	45 days	Settlement
Expected Future Price	100	100	100	100	100
Contango situation	140	130	120	110	100
Backwardation situation	60	70	80	90	100

We have assumed that the expected futures price is ` 100/- at all times. The graph below shows how the prices gradually decline or rise to the spot price in contango and backwardation respectively.

Trading in futures

Futures can be bought or sold by merely paying a margin amount, which is specified by the exchange. At any point of time there are futures contracts with three expiry dates being simultaneously traded. Although all three have a duration of 3 months, some are due to mature at the end of the current month, others at the end of the next month and the last lot will mature two months from now (again, at the end of the month). All the open future contracts for the current month are to be settled on the last Thursday of the month. Buyers and sellers in the futures segment are required to comply with the various margin requirements.

• Initial Margin
  This is an initial margin required to be deposited with the broker, before an individual can enter into a futures contract, to guarantee the fulfillment of his/her obligations. This margin is a percentage of the contract size.
• Mark-to-market margins
  Till the time the future contract is open, the daily gain or loss resulting due to changes in price of the futures contract, needs to be credited or debited to trader's account. This is termed as 'mark-to-market margin'.

Settling of a futures contract

Futures transactions on stock exchanges in India are settled in cash on their maturity date. Although the underlying is shares, these are not exchanged on the maturity date, the parties are under obligation to settle the transaction in cash, at the closing price of the share on the expiry date.

Working of a futures contract

When you enter into a futures contract, you need to deposit an initial margin with your broker. Your trading account is then debited or credited on a daily basis. The debit or credit is based on the daily closing price of the underlying till the final settlement of the future contract is made.  On settlement date the trade gets settled at the closing price of the futures contract. This value is the closing price of the shares in the cash market multiplied by the lot size.

For instance, you wish to take a long position in Nifty futures for December 2009 at a future price of 5100 with the lot size of 50 on December 24, 2009. Let us assume that the futures contract is closing on December 31^st and the initial margin is 20% of the contract size.

Date	Nifty Dec Future Price	Amount payable towards mark to market margin	Balance
24-12-09	5100	Initial Margin = -51000	-51000
25-12-09	5140	40*50= +2000	2000
28-12-09	5175	35*50= +1750	3750
29-12-09	5090	-85*50=-4250	-500
30-12-09	5065	-25*50=-1250	-1750
31-12-09	5120	55*50=+2750	1000 - Final Profit, also the initial margin is returned

You have gained ` 1,000 since you had taken a long position at 5100 whereas the final settlement price was 20 points higher.

When to buy and sell a futures contract

When you expect the price of a particular stock to rise, you may buy stock futures. Further, if the overall market is likely to remain bullish in the coming days, one can go for index futures.

Similarly, when the price of a particular stock is expected to fall, futures of such a stock can be sold (short position). Similarly, index futures can be sold (short) when the overall market outlook is bearish.

An option is a contract written between a buyer and a seller, which gives the buyer a right but not an obligation to buy or sell a particular asset at a particular price on or before a specified date.

Types Of Options

• Index and stock options
  Index options are options whose underlying asset is a particular index. Likewise, stock options are options with the underlying asset being a particular stock.
• American and European options
  American options can be exercised at any time before the expiry date of the option. European options, on the other hand, can be exercised only on the expiry date. In the Indian context, stock options are American options and index options are European options.
• Call and put options
  A call option gives the buyer the right to buy a certain quantity of a particular asset at a specified price (strike price) on or before the expiry date of the contract.

Put option gives the buyer the right to sell a certain quantity of a particular asset at a specified price (strike price) on or before the expiry date of the contract.

Buying a call option

Buyer of a call option can enter into an options contract by paying a premium (at a price determined by market forces) and take a long (bullish) position on a particular asset. If the price of the underlying rises, the buyer can exercise his option to record gains. If the price falls, the loss borne by the buyer is limited to premium paid for entering into an options contract.

Let us consider a situation where you and your friend are bullish on the price of a particular stock since you expect the company to announce its third quarter result on Jan 27, 2010 with a huge upside in profits. On Jan 21, 2010, you decide to invest ` 2 lakh and buy 200 shares at ` 1,000 per share. Your friend on other hand buys a call option of the same strike price, which is quoted at Rs 40 for a lot size of 200 shares and pays ` 8,000 towards premium.

While you will start gaining immediately on increase in share price of the company beyond purchase price of ` 1,000, your friend will profit only once the price crosses ` 1,040 since he has paid premium of ` 40 per share. Now let us look at two scenarios where the company's result is as per expectation and against expectation, assuming both of you close / sell shares on Jan 27, 2010 after results are announced.

Price movement	Price moves as per expectation			Price moves against expectation
	Price / Share	You (Cash)	Your friend (Call)	Price / Share	You (Cash)	Your friend (Call)
21-01-10 (Investment)	1000	(2 lakh)	(8,000)	1,000	(2 lakh)	(8,000)
27-01-10 (Profit)	1120	24,000	16,000	900	(20,000)	(8,000)

 

• Buying a put option
  Here, the buyer of the put option has a bearish view of the price of the underlying. He can enter into the option contract by paying a premium amount, and can gain by exercising his option in case there is a fall in the price of the asset. The maximum loss for the buyer of the put option is restricted to the premium amount paid for entering into the put option contract.

To exemplify, suppose you are holding 100 shares of a telecom company ABC Ltd. which are currently trading at ` 400 a share. The company is going to announce its third quarter result which you feel will be disastrous due to overall industry scenario. Since you have invested with a long term view, you don't want to sell your shares and are also not ready to see the value of your portfolio going down due to bad results. You decide to buy a put option with a strike price of ` 400 (same as the current spot price). This is available at a premium of ` 10 per share.

Price Movement	Price moves as per expectation				Price moves against expectation
	Price / Share	Portfolio value of Mr. X	Impact on Put option transaction	Net impact	Price / Share	Portfolio value of Mr. X	Impact on Put option transaction	Net impact
21-01-10	400	40,000	(1,000)	39,000	400	40,000	1,000)	39,000
27-01-10	330	33,000	` 6,000(Profit of ` 7000 less the premium paid of ` 1000)	39,000	415	41,500	(1,000)(Loss due to premium paid of ` 1,000)	40,500

By taking a put option, you have restricted the fall in your portfolio value in both the scenarios by paying small premium amount of ` 1,000.

• Selling call and put options
  The option seller takes a call on the price movement. He is exposed to an unlimited risk of losses if the price behavior is against his expectations. His gain is, however, restricted to the premium amount received on selling an option (which is paid by the buyer). The seller of a call option actually bets on the limited or no rise in the price of an asset. If the price rise is more than his expectation, he is exposed to an unlimited risk. Selling a put option is exactly the reverse – while the gain of a put option seller is restricted to the premium amount received for selling an option, his losses are unlimited if there is fall in price of an asset beyond his expectations.

When to use call and put options

If you feel that the price of a particular asset will rise in the near future, buy a call option. Put options can be bought, if you hold a bearish view on the asset’s price.

IV. Covered and naked options

If an investor owns a particular stock and is moderately bearish on the stock price, but does not wish to sell it, he can sell a call option. If there is a sudden, huge rise in stock price, as against his expectations, though he will be losing on the options contract, he can still make money on his cash position. Hence, he is covered against the losses. Entering an option contract, having a cash position simultaneously is therefore a 'covered option'.

When the investor sells an option contract (call or put) without having a corresponding long or short position on the underlying stock, the position is termed as ‘naked option’. For example, an investor selling a call option for a stock without owning the shares of that stock. Under naked option, there is a huge amount of risk involved since this is an unlimited loss and limited gain situation.

Trading an option in the market

Trading in the option segment of the market requires the buyer of the contract to pay a premium to the seller. The buyer then acquires the right to exercise an option to buy or sell within the specified contract tenure. Options are available for the current month, next month and for duration of 3 months. Buyers of the current month options can exercise their right by the last Thursday of the month.

Valuing an option

Since options are settled at a future date, in theory the valuation of an option includes the time value of money, volatility impact and general bullish/bearish view on the asset price. Suppose a stock is currently trading at Rs 100 and the call option of stock with strike price of Rs 90 is traded at Rs 14, the the value of the call option is ` 4(Strike price + premium price – current stock price).

Pricing of options

The Black-Scholes equation is widely used for the pricing of options. The equation considers various aspects of pricing an option such as continuous compounding, delta (a measure of change in the option price on a change in the price of the underlying) and a measure of volatility.

Call option price = C = SN (d1) – (Xe)-rt N(d2)
Put option price = P = (Xe)-rt N(-d2) – SN(-d1),

where,
S = the price of the underlying stock
X = Strike price
r = continuously compounded risk-free interest rate
t = Time until expiry of the option (in years)
N = Standard normal cumulative distribution function

• In-the-money (ITM)
  An option which results in a positive cash flow, if exercised immediately, is called in-the-money option. For example, when the spot price (current market price) of a scrip is more than the call option strike price, the call option is said to be in-the-money. Similarly, in the case of an in-the-money put option, the spot price will be less than the strike price.
• At-the-money (ATM)
  When the strike price is equal to the spot price, an option is said to be at-the-money option. An at-the-money option leaves no gains, if exercised immediately.
• Out-of-the-money (OTM)
  When the spot price of a call option is less than its strike price, the call option is called an out-of-money option. These options leave negative cash flows, if exercised immediately. The spot price of an out-of-money put option will, however, be more than the strike price.

Spot Price	Call Strike Price	Put Strike Price	Option Type
5000	4900	5100	In the money option
5000	5000	5000	At the money option
5000	5100	4900	Out of money option

Market view	Strategy
Highly bullish	a. Buy Call b. Sell Put c. Long Combo (Buy Call and Sell Put)
Sluggishness or a possible fall in price	a. Buy Call b. Sell Put c. Synthetic Long Put (Sell Stock and Buy Call option)
Possible sharp fall in the price of a stock or index	Buy Put
Sluggishness or a possible rise	Buy Call and Buy Put
Moderate bullishness	a. Synthetic Long Call (Buy Stock and Buy Put) b. Covered Call (Buy Stock and Sell Call Option)
Moderate bearishness	Covered Put (Short Stock and Sell Put option)
Uncertainty in price movements and expected movement in either direction will be large	a. Long Straddle – Buy Call and Put as same strike price b. Long Strangle – Buy Call and Put at different strike prices
Large price changes are unlikely	a. Short Straddle – Sell Call and Sell Put at same strike price b. Short Strangle – Sell Call and Sell Put at different strike prices
Large price changes may take place with more likelihood of decrease in price rather than increase	Bear Call Spread – Sell ITM Call and Buy OTM Call
Large price changes may take place with more likelihood of increase in stock price than decrease	Bull Call Spread – Buy ITM Put and Sell OTM Put

As per Section 43(5) of the Income Tax Act, 1956, income or losses on derivative transactions, carried out on recognized stock exchanges, can be set off against any other income during the year (except under the head 'salaries'. The income is treated as a business income and is taxable under the prevalent tax rates. In case of losses, if the set-off is not possible, then such losses can be carried forward up to next 8 years and set-off only against income from business and profession.