What is Derivative?

Derivatives: It is a contract whose value is derived from other assets known as underlying asset. For example: financial instrument-shares, bond, warrant etc., Agriculture products- pulses, sugar etc.

Derivative market products:

Forward Contract: It is a contract between two parties for buying and selling of assets in pre - determine date and price in future. It is also known as Over the Counter (OTC) contract.

Future Contract: It is a contract between two parties for buying and selling of assets in pre determine date and price in future in an organized way it means all transactions are done in a standardized way by regulated exchange only.

Option: It is a contract which gives right but not an obligation to buy and sell the underlying assets in future in pre determine price. Buyer has a right to buy assets and seller has an obligation to sell underlying assets to buyer when buyer uses his rights.

Swap: It is an agreement to exchange cash flows in future between two parties. Parties use swap to prevent themselves from changes in interest rate, exchange rate etc.

Type of option:

Long Call Option:

Let’s understand long call option with an example: ABC company traded their stock in market at Rs.50 and the call option strike price is Rs.50 and to purchase the call option the buyer have to pay a premium of Rs.2. If a person wants to purchase 100 shares of ABS Company and he assumes that the price of a stock will go up in future then he purchases call option for 100 shares of ABC Company at Rs.200 (100*2) and if his assumptions are correct and the prices are gone up to Rs 60. In that case he exercises his right and purchases the 100 shares @ Rs.50 each (100*50) and sell them in market @ Rs. 60 (100*60)and makes a profit of Rs.10 on one share. So, the total profit of call option holder is Rs.800 (6000-(5000+200)). If the assumption of a option holder is wrong and the prices of a stock is decreases up to Rs.40 then in that case he suffers a loss up to the premium paid means only Rs.200.

Short Call Option:

It is just opposite of Long call option. Let’s take above example if a person assumes that the price of ABC Company stock is decreases to Rs.30 in future then he wants to sell all the stock he holds of ABC Company and in that case he become seller and he receives premium of Rs.200 from buyer and the strike price is Rs. 35. If buyer doesn’t exercise his right then the seller earns only Rs.200 as profit. If the prices increases to Rs.40 and at that point if buyer exercise his rights and purchase the stock @ Rs.35 then seller suffer a loss of Rs.5 each on price plus Rs.200 as premium. The maximum loss of Rs.700.

 Long Put Option:

A person purchases the put option if he thinks that the market is bearish. He pay premium of Rs. 200 to seller to purchase put option which gives a right to sell the underlying asset before expiration of date at predetermine price. If the prices fall as per the assumption then the option holder has a right to sell his stock at strike price of Rs.40 (same example) he purchases the stock from market @ Rs.30 and sell it at the strike price of Rs.40. So, the total profit of put option holder is Rs.800 ((4000 -(3000+200)). But if the price increases the option holder doesn’t exercise his right and he incurred a loss of Rs. 200 only.

Short Put Option:

It is just opposite of long put option. The opposite party who sell the put option to buyer is known as short put. He receives premium in exchange of put option he sold to buyer as a profit. Selling a put option means the seller assumes prices will go up in future. The seller doesn’t own the stock but to minimize his losses he purchases future contract. In that case he sell the put option at the strike price of Rs.45 (let’s assume) and the expiration date is one month if the prices increases to Rs.42 then the buyer doesn’t exercises his right then the seller earn only Rs.200 as premium.