Share Market Basics Learning » Derivatives http://www.sharemarketbasics.com/blog Stock Market Basics blog on Investments and Trading Fri, 25 Feb 2011 12:00:47 +0000 en hourly 1 http://wordpress.org/?v=3.3 Futures and Options explained http://www.sharemarketbasics.com/blog/future-and-options-explained/ http://www.sharemarketbasics.com/blog/future-and-options-explained/#comments Wed, 28 Oct 2009 07:26:28 +0000 admin http://www.sharemarketbasics.com/blog/?p=92 Futures and options are the derivative instruments in which the buyer and seller enter into an agreement or transaction which will get settled on a future date. In simple terms it is a promise between buyer and seller to transfer the actual underlying assets (commodities, gold, stock, currency etc) on a specific future date at a specific stipulated price as per the agreement.

To understand this in a better way, let’s have a look at the below comparison chart between futures and option:

Futures
In futures contract the buyer and seller enter into an obligatory agreement to exercise the contract at maturity.

Both the buyer and seller have the obligation to exercise the contract which means on maturity, seller will transfer the underlying securities and buyer will make the cash payment as per agreed price.

The buyer does not have to pay any amount for buying a futures contract because it is an enforceable agreement which will get settled on maturity date.

Example of future trading:

A person bought a futures contract to buy security A at a price of Rs 500 on a specific future date. On the expiry date, the price went up to Rs 600. So the deal is good for buyer who will get the securities at Rs 100 lesser than the actual market price. On other side, it is devastating for the seller who is obliged to sell them at lower price which has been agreed upon.

 Options
In options contract the buyer is given an option to decide whether or not he wants to exercise the contract at maturity.
Buyer of the contract has the option to exercise it anytime on or before expiry but seller has the obligation to exercise it. If buyer demands to buy the asset, seller will have to sell it. Options are of two types:

Call option: It gives the buyer, the right to buy the asset at a strike price.

Put Option: It gives the buyer a right to sell the asset at the ‘strike price’ to the buyer

The buyer has to pay an amount called as “Premium” for acquiring an additional right of having an option to exercise the contract or not.

Example of option trading:

A person bought a call option at a strike price of Rs 100. On maturity the price falls to Rs 80. He will not exercise the contract because he can buy the same asset from the market at Rs 80. However if price rises, he will exercise the contract.

Similarly, a person bought a put option at a strike price of Rs 100. On maturity the price shoots up to Rs 150. He will not exercise the contract because he can sell the same asset in the market at Rs 150, rather than giving it to the seller at agreed upon price of Rs 100.

In both cases, he just lost his premium amount which is marginal.

From the above description, it can be inferred that be it future or an option; these are the ways of hedging the risk of investments. It provides a protection against unexpected rise or fall in the price by entering into an agreement to be executed in future date. The concept is very old when agreement used to be made by negotiating the price for harvest of season having been unaware whether harvest will be meager or plentiful. When harvest time came, demand would rise sharply and ultimately giving the holder of agreement a chance to earn more than what he had expected.

Whatever be the case, playing options and futures has always been a risky. So better  be careful before you enter into the arena!!

Renuka Kinger

(C) Sharemarketbasics.com
Reprint prohibited

P.S. If you want to add your views or want to comment on the article, please use the comments section below

]]> http://www.sharemarketbasics.com/blog/future-and-options-explained/feed/ 34 What are Derivatives ? A Brief Introduction http://www.sharemarketbasics.com/blog/what-are-derivatives-a-brief-introduction/ http://www.sharemarketbasics.com/blog/what-are-derivatives-a-brief-introduction/#comments Mon, 26 Oct 2009 08:06:37 +0000 admin http://www.sharemarketbasics.com/blog/?p=89 Derivatives, as the name indicates are the financial instruments which derive their value from some other asset of monetary value called as “underlying asset”. This underlying asset can be gold, currency, stock or any commodity. In short, derivative is not an asset in itself but an agreement or a contract to transfer the real asset in future whenever exercised!! The date and price of execution is mentioned in the contract as per agreement between the parties. There are varieties of derivatives available at present like futures, options and swaps; futures and options being the most common ones. Before looking into details here are few components of a derivative agreement which need to be introduced first.

Holder: Holder is the buyer of derivative agreement. By buying an agreement, the buyer may agree to buy or sell the underlying asset.

Seller: One who sells the contract to holder.

Expiry date: The date at which agreement will get matured / exercised.

Strike price: The price at which derivative will get exercised and is decided at the time of entering into agreement (between buyer and seller).

Premium: It is the price which buyer pays for buying an option contract. The premium is not to be paid for futures contract.

The reason of its appeal to investors which makes it different than other financial instruments is that it is not an asset in itself but an agreement to convey the transfer of actual assets later in future. The catch here is why to enter an agreement to buy/sell assets in future?? Why not buy the real asset (underlying asset referred here) directly from spot market at current levels??  Why making an agreement to be executed in future date? The answer is; derivates are usually seen as instruments for bringing in protection against unexpected rise or fall in the price of underlying asset. Secondly, derivatives are used to yield better returns with lower capital investment as compared to the amount that will be invested to buy the shares directly form the spot market.

Types of derivative instruments:

Forward Contract: It is an agreement to buy or sell the derivative at a known date in the future at a price decided as per negotiation between the contracting parties. These are not traded in exchanges.

Futures Contract: It is an agreement to buy or sell a financial instrument at a known date in the future at a price as per negotiation between contracting parties. These are traded on stock exchange.

Option Contract: It is a contract that gives holder the right, but not the obligation to exercise it. Call options give holder the right to buy while put option give the holder the right to sell at the strike price at stipulated date as per agreement.

Warrants: These are long term options having 3-7 years of expiration. Warrants are issued by companies for raising finance with no initial servicing costs like divided or interest. It is a type of security issued by corporation usually together with a bond or preferred stock that gives holder the right to buy a certain amount of common stock at a stated price. So it acts as a “sweetener offered along with the fixed-income securities”.

Swap Contract: Swaps are agreements between counterparties to exchange one set of financial obligations for another as per the terms of agreement.

Swaptions: Swaptions are options on swaps. They give holder the right to enter into having calls options and put options.

- Renuka Kinger

]]> http://www.sharemarketbasics.com/blog/what-are-derivatives-a-brief-introduction/feed/ 10