Kind of Derivatives . . .

The kind of Derivatives that have been introduced are

Index Futures Index Options and Stock Options

Stock Futures On 9th November, 2001, the much awaited Stock Futures have been introduced in the line of Derivative Instruments in India. The stock futures are deemed to be the replica of 'Badla System' and would suffice the need of a carry forward system to play in the market. The positive sentiments and acceptance of the Stock Futures is reflected in the zooming volumes of stock futures as well as the upward movement in the cash market.

What are Stock Futures?
The stock futures are the contract between the buyer and seller for purchase and sale of underlying securities (like Satyam, L&T).

At a specified future date
At a specified price

It involves the obligations of both the parties to fulfill the terms of the contract.

Benefits of Stock Futures
Risk management of the portfolio can be done effectively with stock futures to cover the loss due to an erosion in the value of the stock comprising the portfolio.

Stock futures provide the arbitrage opportunities between the Cash Market and the Derivative Market in the real sense of the word.

The intrinsic features of stock futures make it a perfect deferral product like Badla.

Badla V/S Stock Futures
Stock futures are superior to Badla in the following ways.

In Stock futures, the position can be carried forward for a longer period of 1, 2 or 3 months. While in Badla, the settlement was on weekly basis.
In Stock futures, the quantity lot has been defined and the trade is not allowed below a minimum requisite quantity. In Badla, the lot could be of 10 shares also.
In Stock futures, the contracts are cash settled, but in Badla, it was delivery settled.

No intermediatories are there between the parties in stock futures, unlike Badla, where the financiers used to act as intermediatories and in case the seller had no intention to carry on the trade, the financiers used to take the delivery and had badla charges.

Procedure for trading in Stock Future
The Stock futures trading would require the following margins

Initial margin of 25% (Variable) of the contract value
Mark-to-Market margin.
The Brokerage on the contract value of the futures.

An Illustration:

The arbitrage exists due to mis-pricing between the RPL stock and futures as follows

The price differential between the spot price & futures price of RPL is 30 Paise.
If the Buy position in cash market at Rs.33.10 and the sell position in the futures at Rs. 33.40 is taken then by reversing the above positions, the mispricing can be encashed.

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Futures
Futures contract is an agreement between a buyer and a seller for the purchase and sale of a particular asset at a specific future date. The price at which the asset would change hands in the future is agreed upon at the time of entering into the contract. A future contract involves obligation on both the parties to fulfill the terms of the contract.

Index Futures
A Future Contract, in which the underlying asset is an Index (i.e NIFTY) is called an Index Futures contract. Participants in this market take position , buy or sell , after taking a view on the way the Index (NIFTY) will move.

How do you trade in Nifty Futures.
Trading in NIFTY Futures requires initial margin of 12% (variable) on the contract value. The position of buy or sell is taken as per the view on the Index.
The position is marked to market daily to post the profit and loss in your financial ledger due to movement in the Index.


On the Expiry date:

In buying position
If the closing Index value is higher than the value at which you had bought the Index, you make profit and vice versa.

In selling position
If the closing Index value is lower than the value at which you had bought the index, you make a profit and vice versa.


Index Futures Contracts find their use in the following situations
If one is long or short in Stocks, owns a portfolio of stocks and wants protection from unfavorable market movements.

Index Futures allows to take up either a long position or short position on the contact and reverse the position when it nears the target
Index Futures provides a unique way to conduct arbitrage by lending funds, lending stocks.Variant Trading strategies can be formulated to adhere to the needs of the investors

There are three instruments available in the market:
One month contract
Two months contract
Three months contract


Every contract expires on the last Thursday of the respective month.
The minimum number of units which can be traded is 200 and its multiples thereafter (i.e Lot size=200)

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ALTERNATIVES AVAILABLE TO YOU WITH THE FUTURES
You can speculate on the value of the futures, i.e.
If the future index value is 1320, then the value of one lot is 1320*200 = Rs. 2,64,000.

The Initial Margin chargeable at the moment is say 12% (variable) of the contract value (12% of 2,64,000 = Rs. 31,680).

Suppose the Spot NIFTY Index value is 1315

If you expect the Index to move up, you can buy Futures Contract ruling at 1320

If Index Futures close at 1340 same day then the difference (1340-1320=20) is your notional gain but would be paid to you next day.

Similarly, if the Index closes at 1330 then the difference (1330 -1340=-10) is your notional loss and would be taken from you.
The notional profits and loss would be settled on daily basis until you square off your position.
In case you don't square off your position by Expiration date, it will be settled at the closed price of the underlying.

You have a portfolio and you want to protect yourself against the market fluctuations. What do you do?
FUTURES give you a solution:
Suppose you have a portfolio of Rs. 10 lacs
If the portfolio consists of any five shares (say Reliance, Infosys, SBI, HLL, ACC) First we find the Beta of the portfolio (Beta of Reliance* weight of Reliance + Beta of Infosys * weight of Infosys +…………………… ).
Let the Beta of the portfolio comes out to be 1.2
You are required to sell 1.2 * Rs. 10 lacs = Rs. 12 lacs worth of Futures Contract in order to hedge your portfolio.
Now suppose on a particular date the spot NIFTY value is 1369, and the futures are traded at 1372
You sell futures i.e. 1200000/1372 * 200 = 4.37 approx. or 5 lots. (1 lot = 200 units)
On some future date if the spot market crashes to 1300 i.e. 5% and the Futures are traded at 1303
If Nifty is down by 5% then your portfolio is down by 5% * 1.2 = 6% i.e. Rs. 60,000/- Your sell position on NIFTY Futures gain (1372-1303) * 200 * 5 = Rs. 69,000/- You make a profit of Rs.(69000-60000) for Rs. 9,000/-
Brokerage charged for your position is 0.05% of (13,72,000 + 13,03,000) = Rs.1,337.50
In other words you are able to save a loss of Rs. 60,000/- at a small cost of Rs. 1,337.50.

Options
An Option is a contract that goes a step further and the terms of the contracts are standardized and give the buyer the right, not the obligation, to buy or sell the particular asset (which is also known as the underlying for eg. stock or index) at a fixed price (known as strike price) for a specific period of time (until date of Expiration).

To the buyer, an equity Call option normally represents the right to buy shares of underlying stock ,whereas an Equity Put Option represents the right to sell shares of underlying Stock. The seller of an Option (called the Writer of the Option) is obligated to perform according to the terms of the Options Contract-Selling the Stock at the Contracted price ( the strike price) for a call seller, or purchasing it for a Put seller- if the Option is exercised by the buyer.

The price of an option is called its "Premium". This is the consideration paid by the buyer to the Seller and it remains with the seller whether Option is exercised or not. The potential loss to the buyer of an Option can be no greater than the initial premium paid for the contract.

An Illustration of Options
If 'A' Buys a Call Option on 100 Reliance at Rs.10 premium with a strike price of 190 and if the price of Reliance goes up to 230 after he has bought the Call, he can do one of the following things

Sit tight.
Close out the position by reversing the trade.
Exercise it, as it is an American Option. Here one would have to pay for the asset.

If he decides to sit tight till the expiry date, several things could happen. One, the price of Reliance could go down below 190. To say, 180. In such a case, the Option expires worthless. There is no point in buying the Stock at 190 when it is now available at 180. In this case, the premium paid (Rs.10*100shares = Rs.1000) for the Option will be loss.

In second case, If the prices, instead remains at 230, then he can exercise the Call at 190 and Sell it in the market at 230 and a net profit of 40 points less the premium of Rs.10, i.e., 30 points for a net profit of Rs.3000.

In the third case, the prices of the stock could come down to 190. Here again, exercising the Option is meaningless and it is allowed to expire worthless and a loss of Rs.1000 (the Premium) is suffered.

It should be noted that Options are excellent Hedging and Speculative tools.

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