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Nifty-Futures & Options

Nifty-Futures & Options

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Published by Akhil Gupta

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Published by: Akhil Gupta on Aug 28, 2009
Copyright:Attribution Non-commercial


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erivatives are among the most complex financial instruments and also one of themost controversial. While they are as old as commerce itself, they have becomeprominent only in the last few decades.Their critics claim that they make markets less transparent and more prone toinstability and speculation. Their supporters say that derivatives improve riskmanagement and increase liquidity.Both sides would agree that derivatives are extremely important and have a bigimpact on other financial markets and the economy. So even if the average investordoesn't invest directly in derivatives it's important that he or she knows what theyare.
What is a derivative instrument?
A derivative, as the name suggests, is a financial instrument whose value is derivedfrom another asset (known as the underlying). The underlying can be a stock, acommodity, and a market index among other things. The two main types of derivatives are options and futures.
An option gives you the right to buy or sell the underlying asset but not anyobligation.A call option gives you right to buy the underlying asset while a put option gives youthe right to sell.An option contract specifies the strike price, that is, the price at which you can buyor sell the underlying and the expiry date after which the option is no longer valid. Inother words, the expiry is the last day on which a contract expires or ends. In Inidanmarkets, expiry is the last Thursday of every month.
A mutual fund with a differenceOptions are also classified into American, which can be exercised at any time prior tothe expiry date and European which can only be exercised at the expiry date.In India options on individual stocks are American-style while options on indices likethe Nifty are European.So in the newspaper if you read, say, a Ranbaxy [Get Quote] option contract: CA-330-Mar, it means that this is an American-style call option which gives you the rightto buy Ranbaxy shares at Rs 330 and which expires in March (the last Thursday).Similarly a PE-4300-April Nifty contract is a European-style put option, which givesyou the right to sell at Rs 4,300 and expires in April.
A futures contract is a standardised, tradable contract, which requires the delivery of the underlying asset (commodity, stock etc.) at a specified price and specified futuredate.Unlike options, buying a futures contract gives you the obligation to buy theunderlying and thus involves greater risk. Another difference is that commodities likegold, cotton, crude oil etc are especially prominent in futures markets.Futures transactions can be settled in three ways: squaring off, delivery and cashsettlement.
How to trade in futuresSquaring off means taking a position opposite your initial one. For example, yousquare off the purchase of a gold futures contract by selling the identical contract.Delivery means physically delivering the underlying asset on the agreed date. If yousell a gold futures contract of say 1 kilogram then you will have to give real gold tothe buyer on the mutually agreed date.Cash settlement involves paying the difference between the futures price and thespot price of the underlying asset.For example, if you sell a gold futures contract worth one kilogram for say Rs 1.2lakh and the price of the contract on expiry day is Rs 1.3 lakh then you will have topay the buyer the difference of Rs 10,000.
Speculation and hedging
So what are derivatives actually used for?At the simplest level both options and futures can be used to speculate on pricemovements. For example you can obtain a profit if you purchase Nifty futures at3700 and the Nifty goes up to 4000. In this case your profit is 300.Similarly let us say you purchase a call option with a strike price of 3000. The optionitself will have a cost of, say, 100 rupees. If the price goes above 3000 the option issaid to be "in the money" which means that you can exercise the option, buy theunderlying share for 3000 and make a profit. However that won't cover the cost of the option.For that the share price will have to rise above 3100 after which you can make profitnet of the cost of the option. In practice you will usually be able to book a profit bysquaring off your position without having to exercise the option. (In a real situationyou will also have to consider trading costs and taxes but the general idea stillapplies).
Use options to make moneyIt's also possible to make money in a falling share by buying a put option. Let's saythat for 100 you buy a put option with a strike price of 2000. Now if the price fallsbelow 1900, the option gives you the right to sell at 2000 even though the marketprice is below that. Once again you will make a profit even after considering the costof the option.

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