Introduction to Futures and Options

Futures and options are derivative instruments that have brought a radical change in the way a financial market works. They are one of the highly complex financial instruments that normally require basic training in understanding their concept, technical analysis, and buying-selling mechanism. They are considered to provide greater liquidity and improve risk management compared to traditional instruments. However, it is only since last decade that derivatives have become popular in India.

‘Derivative’ is derived from the word ‘derive’ that means ‘to originate or arise from something else.’ Therefore, a derivative instrument is one whose value is derived from the value of other underlying assets like stocks, debentures, and even commodities (wheat, rice, gold, etc.). The market performance of these assets affects the value of its corresponding derivative.

Derivatives can be broadly classified into two categories, options and futures. Under an option, the trader can opt for either call option or put option. A call option is a contractual arrangement that gives a trader the right to buy a specified asset within a stipulate time period. However, he is under no obligation to take the actual delivery of the asset. After the expiry of the time period, the contact automatically dissolves. Similarly, a put option gives the trader to sell the asset. The buying and the selling price are known as the strike price.

Futures are slightly different from the options. They carry greater risk because the buyer and the seller have to fulfill their obligation of giving and taking the actual delivery of the asset. In other words, a future is a typical contract with standard features. The settlement mechanism can take place in three ways: cash settlement, actual delivery, or squaring off the transaction.

In a futures contract, the settlement takes place at an agreed price on an agreed date. Any delay is considered to be a default situation on the concerned party. Futures and options can either be traded on the dedicated derivative exchange or can be settled ‘over the counter (OTC).’ The former are known as exchange traded derivatives whereas the latter are OTC derivatives.

The major stock exchanges of India, the Bombay Stock Exchange and the National Stock Exchange have set up an in-house section for derivatives trading instead of opting for a separate exchange. Moreover, if you are interested in derivatives trading, you need to first register yourself as a legible trader on both the exchanges.

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