Faqs

What are derivatives instruments?
Derivative instruments derive their value from another asset - called the 'underlying asset'. The underlying asset can be anything - a precious metal, commodity, financial instrument like stocks, bonds indices etc. which has its independent value. These instruments are not assets by themselves and do not posses their own value. The price movement of the derivative product is directly related to that of underlying product. Some of the common forms of derivatives instruments that are traded are forwards, futures, swaps and options.

What is the purpose of using derivatives?
Two significant benefits are related with the use of derivatives. First, they are used for managing and transferring price risk (the "hedging" function of the market). Second, they provide a forum in which all those with an interest in, and view on, the future outlook for the price of a commodity or financial asset can express that view by taking a market position at low transaction cost (the "price discovery" function of the market)

Who uses derivatives products and why?
Broadly speaking there are two classes of traders in derivatives markets. First are "hedgers" who have existing risks in the market for the underlying commodity or financial asset, such as producers, processors, merchants, banks, mutual funds and insurance companies. They can use a derivative product by taking an opposite derivatives position to that which they hold, or expect to hold, in the underlying market, thereby reducing their exposure to the risk of adverse price movement in the underlying asset. Second are "investors" who are prepared to bear the price risk that hedgers are seeking to avoid and to profit by correctly anticipating the nature of future price movement.

What are Futures?
Futures are exchange traded forward contracts. A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of an asset at a certain time in the future at a price agreed upon at the time of entering into the contract on the futures exchange. The exchange sets the terms and conditions (specifications) relating to each type futures contract that is traded on that exchange.
Some of the standard terms in Future contract include:Quantity of the underlying asset Quality of an underlying asset Expiration Date The Unit of Price Quotation (Not the Price) Minimum Fluctuation in Price (Tick Size)

What is the difference between Forward contracts and futures contarcts?

Futures is a form of forward contract

Standardized Vs Customized Contract- Forward Contracts is customised while the future is standardised. The terms of a Forward Contracts are individually agreed between two counter-parties, while Futures being traded on exchanges haver terms standardised by the exchange.

Counter party risk - In case of Futures, after a trade takes place with in two members of exchange, the exchange / clearing house itself becomes the

Counter Party to every trade. It acts as a performance guarantor. The credit risk, which in case of farward contracts was on the counter party, gets transferred to exchange / clearing house, reducing the risk to almost nil.

Leverage - When a trader takes a futures position (long or short) he is required to deposit with his broker an initial margin set by the exchange, which depends on the price volatility at the time but is typically around 5% of the value of the contract.

Liquidity - Being exchange traded Futures contracts very liquid and their price is much more transparent due to standardization and constant price dissemination by the exchange.

Squaring off - A Forward contract can be reversed only with the same counter-party with whom it was entered into. A Futures contract can be reversed at any time and with any member of the exchange.

Mark to Market - Futures contract are marked to market every day to reflect the gains or losses made by the members of the exchange on the open positions held by them. The daily closing prices is used as a benchmark for calculating the margin. The exchange credits or debits the accounts of the broker members accordingly.

What is margin money?
Buyers and sellers in the futures market have to deposit margin money with their brokers at the time of entering into trades. The margin money is like a security deposit that acts as a performance bond for the contracting parties. The exchange members collect margins from their clients and deposit it with the clearing corporation / exchange clearing house. The prompt collection of margin by the exchange helps in avoiding the risk of default by its members or their clients in fulfilling their obligations that arise or may arise out of trades done on the exchange.
Are there different types of Margin?
Yes, there are different types of margin like Initial Margin, Variation margin (Mark to Market or MTM) Exposure Margin and Addittional Margin etc.

What is Initial Margin?
All clients are required to deposit an initial margin with their broker. Both - the buyer as well as the seller have to deposit this margin. Initial margin is paid to cover the largest possible loss in one day.

When to pay initial margin?
The initial margin needs to be paid up front before taking a buy or sell position.

What is Mark-to-Market (MTM) Margin?
Mark to market margin is also known as variation margin. It amounts to the daily profit or loss that may arise to the members on their outstanding position (held at the end of the trading day) when compared (marked) to closing price of the day.

What are the benefits of using commodity Futures?
Commodity futures offer a variety of benefits to its users. Some of these are:
Investors can take long-term view on the underlying commodity and trade accordingly using commodity futures.
Commodity futures offer high leverage. It means that one can control a large position with less amount of capital.

For example buying 100 oz. of gold at $ 42510z will require a cash outfiow of 425 . 100 = $ 42,5001-. But to take controls of the same quantity of gold on a futures exchange one requires an initial margin of 5% only. A 100 oz. gold futures contract will require an initial margin of only $ 2,1251(5% of 42,500) and yet control underlying asset worth $ 42,500.

Investors can use futures contracts for hedging the price risk associated with the assets held by them. Hedging involves in the transfer of price-risk associated with the ownership of an asset by taking an equally opposite position in the futures market. For example: X holds 1000 kilos of silver and feels that its price may fall in the short-term. He sells futures contract for equivalent quantity to hedge his position.
As a result of hedging, X has locked-in the price of his silver. Any loss resulting from fall in the spot prices will be compensated by an equivalent gain in the futures. Similarly any profit which might result from the rise in spot prices will be set off by the loss that will be incurred on the sale position in the futures market.

Futures often provide opportunity to arbitrage or earn risk-free profit. This phenomenon usually occurs due to temporary distortions in the price relationship between the futures and spot prices.

Example: X holds 500 oz. of gold. The spot price is 430 per oz. Three month future price is at $ 433 per oz. and the cost of carry for 3 months is $ 5 per oz. Now, as the future price of gold must theoretically be equal to spot price plus cost of carry the fair price of the 3 month futures contract should have been 430+5 = $ 435 per oz. Instead, it is available at 433 thereby providing an arbitrage opportunity. X sells spot gold at 430 per oz. and buys 3 month futures at 433 per oz. He makes a risk free arbitrage income of (435 - 433) $ 2 per oz.

The leverage available using futures contracts appears to be a great opportunity. Should the entire investible funds be used for leveraging?
Never! Leverage is like a double edged sword. Yes, the user can benefit immensely in terms of the return on capital employed if used properly.
Leverage can burn its user equally severely if it is not used judiciously. The amount to be used for leveraged trades should form a part of the risk capital. One should always try to look for a balanced and well diversified portfolio for efficient risk management

What are Options?
Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying asset at a specified price on or before a specified date. On the other hand seller is under the obligation to perform the contract (buy or sell the underlying).

What is European & American style of Options?
American Option: One which can be exercised by the buyer at any time, till the expiration date, i.e. anytime between the day of purchase of the option and the day of expiry.
European Option: One which can be exercised by the buyer only on the expiration day and not any time before that.

What is a Call Option?
A call option gives the holder (buyer / one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date in case of American option. The sellecer (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

What is important terminology connected with Options?
Option Premium - Premium is the price paid by the buyer of the option to the seller of that option to acquire the right to buy or sell
Strike Price or Exercise Price - The Strike Price or Exercise price of an option is the specified / predetermined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy / sell on or before the expiration date.
Expiration Date - The date on which the option is actually exercised is called as Exercise Date. In case of European Options the exervise date is same as the Expriy date whereas in case of American Options, the options contract may be exercised any day between the purchase of the contract and its Expiration Date.
Open Interest - The total number of options contracts outstanding (Open Positions) in the market at any given point of time.
Option Buyer / Holder - is one who buys an option. It can be a call or a put option. The holder / buyer of an option enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His profit potential is unlimited while the loss is limited to the premium paid by him to the option writer.
Option Seller / Writer - is the one who sells or writes an option in consideration of premium. He is obligated to buy (In case of put option) or sell (In case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profit potential is limited to the premium received from the buyer where as loss can be unlimited.
Option Class - Options of the same type relating to the same underlying instrument are options of the same class.
Option Series - An option series consists of all the options of a given class with the same expiration date and strike price.
Option Assignment - When holder of an option exercises his right to buy / sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment.

What is a Put Option?
A Put option gives the holder (buyer / one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before a expiry date in case of American option. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

What are Option Greeks?
The options Greeks measure the sensitivity of the option price with respect to a change in the basic factors that affect the price of options. They are often used by professional traders for trading & managing the risk of large positions in options & stocks. These Option Greeks are:
Delta: measures the amount of change in option premium / price in relation to a change in the price of the underlying.
Gamma: measures the estimated change in the Delta of an option due to a change in the price of the underlying Vega: measures the change in the option price that is caused by a change in the volatility of the underlying.
Theta: measures the change in the option price that is caused by a change in the time to option expiry.
Rho: measures the estimated change in the option price that is due to a change in the risk free interest rates.

Who can participate in Options Market?
Options markets provide a lot of opportunities to a large variety of people with different financial objectives such as hedging, arbitrage and investment. Developmental institutions, Mutual Funds, Domestic & Foreign Institutional Investors, Traders, Growers, Manufactures, Brokers, Retail investors are some of the important participants in the Options Market. One can trade in options on a futures exchange only through a broker member of that exchange.

What are the main benefits of using options?
Some of the main benefits of using options are:
- They can be used as instruments for hedging
- Help in diversification of portfolio
- Allow a high degree of leverage to the user.
- They can be used to generate additional streams of income from ideal assets
- Allow the user a great degree of flexibility - can be combined and structured to typically suit the user's requirements.
- Can be used in all market conditions - up, down or sideways.
- Buyers can precisely define and fix their risk levels.

How can I use options?
One can use options according to one's investment / risk management needs. A wide variety of option strategies ranging from plain vanilla options to complex combinations are used by the option traders. The strategy to be used at a given point in time usually depend on factors like investment objective, perception of the future market moves, volatility expectation, time frame within which the perceived move is expected and the expected risk / reward ratio.

Some of the simple strategies that are used by market players are:
- Buy Call Option / Sell Put Option - In case the view is Bullish.
- Sell Call Option / Buy Put Option - In case the view is Bearish.
- Buy Put Option - For hedging long futures position.
- Buy Call Option - For hedging short furtures position.

How does Option get Option settled?

Option is a contract, which has a market value like any other tradable commodity. Once an option is bought there are following alternatives:-
- Sell an option of the same series as bought and close out / square off position in that option at any time on or before its expiration date.
- Exercise the option on the expiration day in case of European Option or before the expiration day in case of an American Option.
- Positions that are 'out of the money' at the time of expiry, will not be exercised for the obvious reason that they are not profitable. Therefore such options will automatically lapse or expire worthless.

What is clearing Corporation? What role does it play in a futures exchange?
Clearing Corporations help in smooth and secure clearance and settlement of trades taking place in the exchange. It acts as a counterparty to each trade and thus provides a performance guarantee to the buyer / seller. In turn they also impose, monitor, and collect margins from members on regular basis to keep the market financially secure and orderly.