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DERIVATIVE
A derivative is a financial instrument that derives its value from an underlying asset. The underlying asset can be equity , forex commodity or any other asset.
• A security derived from a debt instrument ,share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
• A contract which derives its value from the prices, or index of prices, of underlying securities.
TYPES OF DERIVATIVES
 Forwards
A forward contract is customized contract between two entities, where settlement
takes place on a specific date in the future at today’s pre-agreed price.
 Futures
A future is a contract to buy or sell an asset at a specified future date at a
specified price. These contracts are traded on the stock exchanges and it can
change many hands before final settlement is made.
Futures contacts are special types of forward contracts in the contracts in the sense that the former are standardized exchange-traded contracts.
The advantage of a future is that it eliminates counterparty risk. Since there is an
exchange involved in between, and the exchange guarantees each trade, the
buyer or seller does not get affected with the opposite party defaulting
Options
This option is given to only one party in the transaction while the other party has an obligation to take or make delivery. The asset can be a stock, bond, index, currency or a commodity.
But since the other party has an obligation and a risk associated with making good the obligation, he receives a payment for that. This payment is called as premium
Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
a. Option holder : The buyer of the option who gets the right
b. Option writer : The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option : The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the expiration date
j. European option: These are options that can be exercised only on the expiration date
k. Covered option: An option that an option writer sells when he has the underlying shares with him. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the option was exercised immediately
Futures
Futures are traded on a stock exchange
Futures are contracts having standard terms and conditions
No default risk as the exchange provides a counter guarantee
Highly regulated with strong margining and surveillance systems
Forwards
Forwards are non tradable, negotiated instruments
Forwards are contracts customized by the buyer and seller
High risk of default by either party
No such systems are present in a forward market.
Risk Reward Scenario
Maximum Loss = Limited (Premium Paid)
Maximum Profit = Unlimited
Profit at expiration = Stock Price at expiration – Strike Price –
Premium paid
Break even point at Expiration = Strike Price + Premium paid
BULL PUT SPREAD
For Investors who are bullish but at the same time conservative
Write a PUT Option with a higher Strike Price and Buy a Put Option with a lower Strike Price
CESE Spot Price = Rs.270
Premium on Rs. 270 PA = Rs.12
Premium on Rs. 250 PA = Rs. 3
Sell Rs.270 PA and Buy Rs.250 PA
Net Inflow = Rs. 9
COVERED CALL
Neutral to Bullish
Buy The Stock & Write A Call
Perception – Bullish on the Stock in the long term but expecting little
variation during the lifetime of Call Contract
Income received from the premium on Call
CESE Spot Price = Rs.270
Premium on Rs. 270 CA = Rs. 12
Buy CESE @ Rs.270 and sell Rs. 270 CA @ Rs.12.
Stock Price at Expiration Net Profit/Loss
230 - 28 (- 40 + 12)
250 - 8 ( -20+12)
270 + 12 ( + 12)
300 + 12 (-30+30+12)
350 + 12 (-80 +80+12)
Profits are limited . Losses can be unlimited