Derivatives

Future and options represent two of the most common form of “derivatives”. The
derivative is a financial instrument whose value is derived from the value of another
asset, which is known as the underlying. Common underlying instruments include the
bond, commodities, currencies, interest rates, market indexes, and stock. The underlying
can be a stock issued by a company, currency and other. The value of the derivative
instrument will change; it was caused by the changes in the value of the underlying.
There are two types of derivatives, exchange traded and over the counter. The exchange-
traded derivatives are traded through organized exchanges around the world. These
instruments can be bought and sold through these exchanges. For the over the counter
(OTC), the derivatives are not through the exchanges. They are not standardized and
have varied features. Derivatives thus have no value of their own but derive it from the
asset that is being dealt with under the derivative contract. The financial manager can
hedge himself from the risk of loss in the price of a commodity or stock by buying a
derivative contract. Thus derivative contracts acquire their value from the spot price of
the asset that is covered by the contract.

The future and option are two popular derivatives in the capital market.
Future contract

A future contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. As the contract is legally binding, the parties
to it must perform it by transferring the stock or cash respectively. A futures contract can
be on a stock or an index. Every futures contract has buyer, seller, price, and expiry these
five features. The items which are traded on the stock in a future contract include
currencies, commodities, stocks and other similar financial assets. In such contract the
buyer expects the asset price to rise while the seller expects it to fall. For additional
explanation, if you buy a stock future, it means that you have bought the stock with a
promise to pay at a future day. On the contrary, if you sell a stock future, this will mean
you have to deliver the stock to the buyer at a future date.

Futures can be used to hedge or speculate on the price movement of the

underlying asset. For example, a producer of oil could use futures to lock in the certain
price and reduce risk could speculate on the price movement of oil by going long or short
using futures. The hedgers were rather sought to stabilize the revenues or costs of their
business operations. They usually do not seek a profit by trading commodities futures.
The gains or losses usually offset to some degree by a corresponding loss or gain in the
market for the underlying physical commodity. Actually, the speculators do not want to
own related assets. They basically are betting on the future prices of certain
commodities. Therefore, if you disagree with the consensus that wheat prices will fall,
you could purchase futures contracts. On the contrary, if your prediction is correct and
the wheat prices increase, then you can make money by selling futures contract before
they expire. This prevented you from having to take delivery of the wheat as well.
Speculators are often blamed for large price fluctuations, but they also provide a lot of
liquidity for the futures market.

A future contract is standardized. This meaning that they specify the quality,
quantity, and delivery of the relevant product, so the price means the same thing for
everyone in the market. For example, each crude oil, such as light sweet crude oil must
meet the same quality standards, so that a light sweet crude oil produced by
manufacturers is indistinguishable from another manufacturer, and the buyer of light
sweet crude oil futures is exact. The ability to trade future contracts depends on the
clearing member, which manages payments between buyers and sellers. They usually are
the large bank and financial services companies. Clearing members provide guarantees
for each transaction and therefore require traders to conduct credit deposits (called
margins) to ensure that traders have sufficient funds to deal with potential losses and will
not default. The risks assumed by clearing members further support the strict quality,
quantity and delivery specifications of futures
Options contract

An options contract is of two types, call or put. A call option gives the buyer the
right to claim a particular stock or index at a predetermined price. The predetermined
price on which trading is concluded is known as the strike price. For the seller, it has the
obligation to sell stock at a certain price. For example, if the buyer wants to buy the
asset, the seller has to sell it. The owner of the option, also known as long a call, it does
not have to exercise the option and buy the stock. If buying the stock at the strike price is
unprofitable, the owner of the call can just let the option expire worthlessly. A call
option is defined by 4 characteristics:

 There is an underlying stock or index.

 There is an expiration date (a certain date) of the option.
 There is a strike price (predetermined price) of the option.
 The option is the right to buy the underlying stock or index. This contrast to a put
option, which is the right to sell the underlying stock.

When to buy a call option, there are three trades that can make to profit from a rising
stock price if you think a stock price is going to go up. There are can buy the stock, can
buy a call option on stock, and can write put options on the stock.

A put option is a security that you buy when you think the price of stock or index
is going to go down. A put option gives the buyer the right, but not the obligation to sell
a given quantity of an underlying asset at a given price on or before a given future date.
For the buyer, it has the right to sell stock at a certain price. For the seller, it has the
obligation to buy the stock at a certain price. Since you can sell your stock at any
particular point in time, if the spot price of the stock falls during the contract period, the
holder will be protected from the fall in this price and will not be affected by the present
price. With this explanation was explained why the put option becomes more valuable
when the price of the underlying stock falls. Similarly, if the price of the stock rises
during the contract period, the seller only loses the premium amount and does not suffer a
loss of the entire price of the asset.
 The other two types of options are European style options and American style
options. The European style options can be exercised only on the maturity date of the
option, also known as the expiry date. For the American style, options can be exercised
at any time before and on the expiry date.
The different and the similarly of future and option.

The following table is different between futures and options contract;

Basis for comparison Futures Options

Meaning A futures contract is a Options are the contract in
binding agreement, for which the investor gets the
buying and selling of a right to buy or sell the
financial instrument at a financial instrument at a set
predetermined price at a price, on or before a certain
future specified date. date, however, the investor
is not obligated to do so.
Obligation of buyer Yes, to execute the No, there is no
contract. obligation.
Execution of contract On the agreed date. Any time before the
expiry of the agreed
date.
Risk High Limited
Advance payment No advance payment Paid in the form of
premiums.
The degree of Unlimited Unlimited profit and
profit/loss limited loss

The similarities of futures and options are exchange-traded derivative contracts that are
traded on stock exchanges like Bombay Stock Exchange (BSE) or Nasional Stock
Exchange (NSE) which are subject to daily settlement. The underlying asset covered by
these contracts is the financial products such as commodities, currencies, bonds, stocks
and so on. Moreover, both the contracts require a margin account.
Flowchart for both derivatives.

The step of future contract:

Step 1: Determining Your Outlook

No matter what kind of underlying assets you are trading futures, you need to first
have an outlook. If you expect the price of the underlying asset to rise, you will hold
its futures contract for long-term speculation, or if you expect the price of the
underlying asset to fall, you would go short instead. You also need to determine the
trading futures trading hours so that you can decide which month contracts to trade.

Step 2: Determining Your Risk Tolerance and Position Sizing

This is a step missed by most beginners for futures trading. Futures trading as a
leveraged trading method, losses can increase rapidly and eliminate accounts faster
than most beginners can imagine. A future trading is definitely a type of transaction
that does not tolerate losses because profits and losses are settled at the end of the
daily trading day by the “day-to-day settlement” process.

Step 3: Determining Initial Margin Requirement

Once you have determined the number of futures contracts traded, you now need to
determine which futures contracts to trade and the amount of initial margin required
to trade that many futures contracts. Basically, if you plan to make an aggressive
short-term transaction, you can choose recent futures contracts. If you plan to trade
futures with less volatility or longer duration, you can choose longer-term futures
contracts. This step of selecting a trading futures contract should actually be
completed during the position adjustment phase.
 Step 4: Entry and Stop Loss

Once you have determined the direction of the transaction, the futures contract to
trade, the number of contracts traded, and how much cash to trade for futures
contracts, it is time for you to enter. When trading futures, we must ensure that we
invest in related assets during speculation and reduce basic assets when speculating.
Once your futures position is applied, you also need to set a stop loss order as
planned in the previous steps.

Step 5: Offsetting

Whether you make a profit or stop loss while trading futures, you need to perform an
operation called "offset." Offsetting means taking equal and opposite transactions to
offset your existing position and effectively close it out. The actual process is
invisible to futures traders and is automatically executed by your futures broker. Read
the tutorial on offsetting futures.

The process of option for the call and put.

A call option provides the buyer of a call option with a hedge.

Buying call option is essential to a number of other more advanced strategies. A call
option is a contract that gives the buyer the right to buy 100 shares of an underlying
equity at a predetermined price (the strike A call option is an option is an option contract
in which the holder (buyer) has the right (but not the obligation) to buy a specified
quantity of a security at A. The following diagram is about the call option:

Diagram 1:

Diagram 2:

For the put option, there are two ways to sell options; there are covered calls and
uncovered call. One of the most popular call writing strategies is called an insurance call.
In covered call options, you are selling the right to buy your own stock. If the buyer
decides to exercise his option to purchase the underlying equity, you are obliged to sell it
to him at the strike price - regardless of whether the execution price is higher or lower
than your original cost of equity. Sometimes investors may purchase equity and
simultaneously sell (or write) equity requests. This is called "buy-write." In an
uncovered call, you are selling the right to buy an equity from you which you don’t
actually own at the time. For example, you write a Call for the stock for $2. The current
market price is $20 and the execution price is $25. Once again, you immediately receive
$200 - Premium.

 If the stock price stays below $25, then the buyer's options will lose value, and
you have already received a $200 premium.
 If the stock price rises to $30 and the option is exercised, you will have to buy 100
shares at a market price of $30 to fulfill your obligation to sell for $25. You will
lose $300 - This is the difference between the $3,000 purchase cost of your stock
purchase, minus the $2,500 you received for the sale of the stock and the $200
premium you received for the option sale.