Derivatives Basics

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Derivatives Basics

  1. 1. Derivatives in finance<br />Futures and options<br />
  2. 2. Derivatives<br />A conditional contract used in the financial market is called as a derivative.<br />Derivatives are contracts whose value is "derived" from the price of something else, typically, ‘cash market investments’ such as stocks, bonds, money market instruments or commodities.<br />Derivatives may be used for trading or for protection of value of assets (hedging).<br />
  3. 3. Types of derivatives <br />The most common type of derivatives used in the financial markets are<br />Futures<br />Options<br />Forwards<br />Swaps<br />
  4. 4. Futures and options<br />Futures<br />A futures is an contract in which buyer and seller agree to a deal in a future date at a pre decided price<br />Options<br />Options is a contract where the seller is obligated to sell at a future date at a pre decided price but the buyer has a option not to buy. <br />Hence since the seller is obligated the buyer pays an options premium to the seller.<br />
  5. 5. Derivatives in Indian Stock Market<br />Futures and options are the only derivatives in use in the Indian stock market.<br />NSE and BSE offer these options.<br />The market where derivatives are traded are called as derivatives market.<br />
  6. 6. How do derivatives work?<br />Let us take a stock of ABC company. It is trading currently at Rs 300 per share.<br />If I buy the share, then I have to sell it when the price is higher to make a profit.<br />
  7. 7. How do derivatives work?<br />What is the other option I have?<br />I feel the price will rise, and Mr. X agrees.<br />So I make a contract with Mr. X saying that I will sell the stock at RS 320 in 3 months time.<br />So in 3 months time I have to sell and Mr. X has to buy.<br />Both me and Mr. X are obligated to fulfill the contract.<br />This is FUTURES contract.<br />
  8. 8. How do derivatives work?<br />If I say that I will sell at Rs 320.<br />But Mr. X has the option of not buying the stock.<br />So I must sell and he may buy.<br />Thus he holds an option and I am obligated.<br />
  9. 9. How do derivatives work?<br />So he pays me a premium (a small cost) of 2 percent (i.e. Rs 6.4) for the option.<br />This is called as OPTIONS contract.<br />The maximum profit I may make is Rs 6.40 and the maximum loss that Mr. X can make is Rs 6.4.<br />But there is no limit to the amount of profits that Mr. X can make. That is another reason why he pays the option premium.<br />
  10. 10. Making Profits from derivatives(Rising price expectation)<br />I have 100 shares of ABC company. The price of each share is Rs 100 today.<br />I feel that the price will go up in the future.<br />So how can I make a profit using derivatives on a rising price expectation?<br />I will take a futures for buying 100 shares of ABC at Rs 100, but 60 days from today.<br />
  11. 11. Making Profits from derivatives(Rising price expectation)<br />If the price is say, Rs 110 on the 60th day then I get to buy that stock at Rs 100.<br />Thus I made a profit of Rs 10 per share i.e. a total profit of Rs 10 x 100 = 1000.<br />What would happen if the price was down to Rs 90?<br />I will make a loss of Rs 10 per share as I will be obligated to buy at Rs 100.<br />Both parties will pay the witness of the contract (usually the stock exchange) a small fee for facilitating the contract.<br />
  12. 12. Making Profits from derivatives(falling price expectation)<br />I have 100 shares of ABC company. The price of each share is Rs 100 today.<br />I feel that the price will go up in the future.<br />So how can I make a profit using derivatives on a falling price expectation?<br />I will take a futures for selling my stock at Rs 100, 60 days from today.<br />
  13. 13. Making Profits from derivatives(Falling price expectation)<br />If the price is say, Rs 90 on the 60th day then I get to sell that stock at Rs 100.<br />Thus I made a profit of Rs 10 per share i.e. a total profit of Rs 10 x 100 = 1000.<br />What would happen if the price was up to Rs 100?<br />I will make a loss of Rs 10 per share as I will be obligated to sell at Rs 110.<br />Both parties will pay the witness of the contract (usually the stock exchange) a small fee for facilitating the contract.<br />
  14. 14. Using options to restrict losses.The CALL option<br />Options can be used to restrict our losses to a fixed amount.<br />I have 100 shares of ABC company. The price of each share is Rs 100 today.<br />I feel that the price will go up in the future, but I don’t want to make a big loss.<br />So I write as options contract for buying the shares of ABC at Rs 100, 60 days from now. I pay Rs 2 per share, as options premium because I am not obligated to buy but the seller is obligated to sell at Rs 100.<br />
  15. 15. Using options to restrict losses.The CALL option<br />If the price is say, Rs 110 on the 60th day then I get to buy that stock at Rs 100.<br />Thus I made a surplus of Rs 10 per share. My options premium was Rs 2 per share. profit of Rs 8 per share which means a total profit or 8 x 100 = 800 <br />What would happen if the price was down to Rs 90?<br />I will not exercise my option and my loss will be restricted to Rs 2 which I paid as options premium.<br />This option to buy is called as call option.<br />
  16. 16. Using options to restrict losses.The PUT option<br />Options can be used to restrict our losses to a fixed amount.<br />I have 100 shares of ABC company. The price of each share is Rs 100 today.<br />I feel that the price will go down in the future, but I don’t want to make a big loss.<br />So I write as options contract for selling the shares of ABC at Rs 100, 60 days from now. I pay Rs 2 per share, as options premium because I am not obligated to sell but the seller is obligated to buy at Rs 100.<br />
  17. 17. Using options to restrict losses.The PUT option<br />If the price is say, Rs 90 on the 60th day then I get to sell that stock at Rs 100.<br />Thus I made a surplus of Rs 10 per share. My options premium was Rs 2 per share. profit of Rs 8 per share which means a total profit or 8 x 100 = 800 <br />What would happen if the price was up to Rs 110?<br />I will not exercise my option and my loss will be restricted to Rs 2 which I paid as options premium.<br />This option to sell is called as PUT option.<br />
  18. 18. Difference between futures and options<br />
  19. 19. Thank You<br />

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