Basics of Derivatives

What is Derivative?
A derivative is a financial security with a value that is reliant upon & derived from an
underlying asset.
A derivative itself is a contract between two parties which derives its value/price from an
underlying asset.

Example;
Milk is an underlying asset.
Paneer,ghee,butter,cheese,curd these all are derived from underlying asset, which is milk.
So, these all are called as derivatives.

Notes: 1- derivatives always derived from its underlying asset.

2-without underlying asset derivatives has no existence.
Stock market examples of derivatives;

• Examples of derivatives are;

1) Futures
2) Forwards
3) Options
For eg. Tcs future is a derivative of tcs stock which is underlying asset
for Tcs future.
TCS oct fut 3547 & TCS cash 3536
• Tcs options is derivative of Tcs stock which is underlying asset for Tcs
options.
• Tcs 3540ce 72.70 & Tcs 3536

• Nifty50 Futures- its, underlying asset is the Nifty50 index itself.

Nifty oct fut 19637 and nifty index 19523

NIfty50 Options- its, underlying asset also is the Nifty50 index itself
Nifty 19650ce 87.10 & Nifty index 19523
What is Underlying Asset?
1-The financial assets upon which a derivative’s Price is based.
2-Represents the assets from which derivatives derive their value.
3- Cash is the main underlying asset.
Note: Cash/equity/cnc are all same with different names.
5- Underlying asset is the main component which is cash/equity/cnc.
What is futures and how it works?

• Futures are a type of derivative

contract agreement to buy or sell
a specific asset or security at a set
future date for a set price.

• The parties involved in the

futures transaction are obligated
to fulfill a commitement to buy or
sell the underlying asset.
for
eg.
• One person buys wipro 26 Oct futures • But what happens when price
at 408 price. goes against ,
• Lot size is 1500 • So consider on 26 Oct this futures
• 26 Oct is the expiry date of contract.. price was trading at 398.
• So, on 26 Oct this futures price was • 408-398=10*1500=15000
trading at 420. • So, loss will be 15000
• 420-408= 12*1500=18000, • Here we can see that futures has
• So here profit will be 18000 rs. linear pay off.
There are two types of futures;
• Stock futures • Index futures
• A stock future is a contract to buy or • A index future is a contract to buy
sell a specific stock for a certain price
on a set future date.
or sell a index for a certain price on
a set future date.
• Contarct value in Lot size.
• Contarct value in Lot size.
• Expiry date- Last thursday of the
month. • Expiry date- Weekly(every Thus)
• Here holding period is just for 3 • Monthly(Last Thus)
months so we can straight away buy a
3-month future.
• Lot sizes;
• 1)Near month- Expires at 26 Oct 1) Nifty50- 50
• 2)Next month- Expires at 30 Nov 2) Bank NIfty- 15
• 3)Far month - Expires at 28 Dec 3) Sensex- 10
What is Futures Margin?
• Here in futures you will get 15% margin of total investment according
to sebi.
• Eg.The price of Wipro 26 Oct Fut is 408 & lot size is 1500. so
realistically you have to pay amount which is equal to
1500*408=612000
• But as we know, we get margin in futures which is mostly 15%,
• So we will pay only the amount which is 612000*15%100=91800.
• Basically initial margin reduce our cost to buy or sell specific cost.
Q- Sunpharma 26 Oct fut price is 1164 & lot size is 700.
Initial margin is 10%.
What will be the initial margin required to buy or sell this future ?
Examples of Stock future & Index future
• Buy M&M 26 Oct fut (1 lot) • Buy Nifty50 26 Oct fut (1 lot)
• Lot size is 700 • Lot size is 50
• Current Market Price- 1564 • CMP- 19714
• Investment- 1094800 • Investment- 985700
• Margin(13%)- 142324 • Margin(12%)- 118284
• Selling Price- 1570 • Selling Price- 19800
• Profit- 1570-1564=6*700=4200 • Profit-19800-19714=86*50=4300
• Selling Price- 1554 • Selling Price- 19650
• Loss- 1564-1554=10*700=7000 • Loss- 19714-19650=64*50=3200
What is Forwards?
• Forwards are similar to futures,but do not trade on an exchange, only
trades on Over The Counter (OTC).
• A forward contract is a customizable derivative contract between two
parties to buy or sell an asset at a specified price on a future date.
• Forward contracts carry a greater degree of counterparty risk for both
buyers & sellers.
• Counterparty risks are a kind of credit risk in that the buyer or seller
may not be able to live up to the commited outlined in the contract.If
any one party of the contract becomes defaulter, the other party have
no recourse and could lose the value of its position.
• Because of their potential for default risk and lack of a centralized
clearinghouse, forward contracts are not as easily available to retail
investors as futures contracts.
Where to trade OTC contracts;

• As we know Forward contracts are risky, but still someone wants to

trade in OTC contracts; so we will see here where to trade them;
• Since OTC stocks are not listed on the stock market, i.e., the NSE and the
BSE, they have a separate stock exchange dedicated to them. Such
stocks are traded on the OTC Exchange of India, which is a stock
exchange designed solely for over-the-counter stocks.
• So, if you want to trade in over-the-counter stocks, you need to trade on
the OTC exchange.
• Like with stock exchanges, trading on the OTC exchange is not directly
possible. You need to buy or sell OTC stocks through registered brokers
who deal in such stocks.
• If you want to invest in OTC stocks, contact your broker and check if they
provide OTC trading facility since not all brokers have access.
 Difference between Futures & Forwards

• Futures • Forwards
1) Futures has fixed Lot size. 1) Lot size is not fixed.
2) Futures are SEBI regulated. 2) Forwards are not regulated.
3) Futures are standardised. 3) Forwards are customizable.
What is Options?
• An agreement between two parties
to buy or sell an asset at a
predetermined future date for a
specific price.
• The prime difference between
options and futures is that futures
need the contract holder to purchase
the underlying assets on a respective
date in the near future. Options, on
the other hand, offer the contract
holder the choice or option of
executing the contract.
• In simple language, options contracts
offer the buyer the right,but not the
compulsory to buy or sell the
underlying asset.
• Option is like an insurance.
• Here risk is limited & profit is
unlimited.
Types of options;
There are two types of option 1) Call option 2) Put option
• Some basic knowledge about options.

• Expiry of options;
1) stocks options- monthly expiry i.e. last thursday of the month
2) index options- weekly expiry i.e. on every thursday.

There are two styles of option;

1) European style option
2) American style option
India follows European style option
Notes: Option is standardized & organized by SEBI.
 What is Call option?

• A call option is a contract that gives the

option buyer the right, but not the
obligation to buy an underlying asset at a
specified price within a specific time
period.
• Call option sellers (writers) have an
obligation to sell the underlying stock at
the strike price and have a “short call
position.” The call seller must have one of
these three things: the stock, enough cash
to buy the stock, or the margin capacity to
deliver the stock to the call buyer.
• If you assume that market is moving upside
then buy call option.
Example of Call option
• NIfty 26 Oct 10500 CE 125
• Here,Nifty50 = Index name
• 26 Oct= Expiry Date
• 10500= Strike price
• CE= Call European option
• 125= Premium
• Lot size= 50
• Spot price(current market price)or ATM=
10400
• ITM= Spot Price is greater than Strike Price
• OTM= Spot price is lesser than Strike price
What is Put Option?
• A Put option is a contract that gives
the option buyer the right, but not
the obligation to Sell an underlying
asset at a specified price within a
specific time period.
• Put option sellers (writers) have an
obligation to Buy the underlying
stock at the strike price and have a
“Short put position.” The put seller
must have one of these three things:
the stock, enough cash to sell the
stock, or the margin capacity to
deliver the stock to the put buyer.
• If you assume that market is moving
downside then buy put option.
Examples of Put option
• NIfty 26 Oct 10500 PE 125
• Here,Nifty50 = Index name
• 26 Oct= Expiry Date
• 10500= Strike price
• PE= Put European option
• 125= Premium
• Lot size= 50
• Spot price(current market price)or ATM=
10400
• ITM= Spot Price is lesser than Strike Price
• OTM= Spot price is greater than Strike
price
Some imp notes about options;
• ITM options are always expensive.
• ATM & OTM options are less expensive.

Q- Why ITM expensive than ATM or OTM?

A- ITM is expensive because ITM Options has more open interest &
open interest generates volume & volatility and volume & volatility
generates demand, thats why ITM is expensive than OTM.

Q- Why no dividend, No bonus in options?

A- Because options has expiry.
Rules of option Market;
• Buying & selling of stocks or indices are in lot size.
• Lot size are different for particular stock & indices.
• Lot size depend on the price, volatility and volume of the stock.
• We can buy maximum contracts upto 3 months.
• NO dividend, No bonus
• Options income areTaxable
• Option market is depend on equity market.
• Option is cost friendly than futures.
Advantages of option market;
• Cost efficiency
• It has less risk
• Higher potential risk
• More strategic alternatives
• Option has unique selling point(USP)
What is Option Premium?
• An upfront payment made by the buyer to the seller to enjoy
the privileges of an option contract.
Option Trading Strategies;
Straddle- there are two types of straddle;
1) Long Straddle 2) Short Straddle
• Long Straddle Conditions
• Market has some big news &
because of that news market will
have big movement either upside or
downside, so we dont know market
direction, thats why we chose this
strategy.
• Shoud have same strike price
• Should have same lot size
• Should have same expiry
• Buy both CE & PE
Short Straddle conditions
• Market should be flat or rangebound.
• No big news in market, you think
market will be flat or in rangebound,
then chose this strategy.
• Shoud have same strike price
• Should have same lot size
• Should have same expiry
• Sell both CE & PE
• At expiry ATM, OTM guaranteed
becomes zero because there IV is
zero.only time value exist and at expiry
time has expired.
Long strangle conditions
• Market has some big news &
because of that news market will
have big movement either upside
or downside, so we dont know
market direction, thats why we
chose this strategy.
• Shoud have Different strike price
• Should have same lot size
• Should have same expiry
• Buy both CE & PE at different strike
price
Short strangle conditions
• Market should be flat or rangebound.
• No big news in market, you think market
will be flat or in rangebound, then chose
this strategy.
• Shoud have Different strike price
• Should have same lot size
• Should have same expiry
• Sell both CE & PE at Different strike price
• At expiry ATM, OTM guaranteed
becomes zero because there IV is
zero.only time value exist and at expiry
time has expired.
Bull call spread conditions
• Market outlook should be
bullish.
• A bull call spread consists of one
long (buy) call with a lower strike
price & one short (sell) call with
a higher strike price.
• Both calls have same underlying
stock & same expiry date.
• In this strategy we get limited
loss & limited profit.
Bear put spread conditions

• Market outlook should be

bearish.
• A bear put spread consists of
one long (buy) put with a higher
strike price & one short (sell) put
with a lower strike price.
• Both puts have same underlying
stock & same expiry date.
• In this strategy we get limited
loss & limited profit.
Advantages of options spread strategies;

• Basically these all strategies are

hegding strategies.
• Here we limit our profit as well
as loss also.
• By doing this strategies we also
require less margin.