he term ‘Derivative’ stands for contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity.
Derivative trading in India comprises of 4 basic contracts namely Forwards, Futures, Swaps and Options.
A forward contract is an agreement between parties to buy or sell an underlying asset on a specified date for a specified price. One of the parties of the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the 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. But unlike forward contracts, future contracts are standardized and exchange traded. To facilitate liquidity in future contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with:
- Standard underlying asset,
- Standard quantity and quality of the underlying asset that can be delivered, and
- Standard timing of such settlement (date and month of delivery)
- The units of price quotation and minimum price change
- Location of settlement
A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. In future contracts, the losses as well as profits for the buyer and the seller are unlimited.
Payoff for buyer of future contract: Long futures
Suppose a trader buys a two-month Nifty index future contract when the Nifty trades at 5700 (spot price). The underlying asset in this case is the Nifty index. When the Nifty moves up, the future contract position on Nifty starts making profits, and when the Nifty moves down it starts making losses.
Payoff for seller of future contract: Short futures
Suppose a trader sells a two-month Nifty index future contract when the Nifty trades at 5700 (spot price). The underlying asset in this case is the Nifty index. When the Nifty moves down, the future contract position on Nifty starts making profits, and when the Nifty moves up it starts making losses.
Note: It is important to note that in future contracts, the buyer could suffer very large losses as his margin account is marked to market at the end of each trading session.
In contrast an option buyer pays the option premium at the time of purchasing the option. This is the maximum loss which he could suffer. In other words, he only stands to gain if the price of the underlying rises above the strike price and can suffer no more loss than the option premium paid.
Margin Account – In a margin account, some initial amount of money must be deposited at the time of entering in the future contract. This margin money need to be maintained in the account, at the end of each trading day so if the balance falls below the initial margin, it is required to deposit more cash to bring the account to the initial margin level before trading commences on the next day.