The most commonly used derivatives contracts are forwards, futures and options, which we shall

discuss in detail later. Here we take a brief look at various derivatives contracts that have come
to be used. 

Forwards: A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today's pre-agreed price. 

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts. 

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given
future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date. 

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts. The
two commonly used swaps are:

 Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
 Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those in the
opposite direction.

Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter. 

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of upto three years. 

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is
usually a moving average or a basket of assets. Equity index options are a form of basket
options. 

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry
of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts,
the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive
floating. 
An option is a contract between two parties giving the taker (or buyer) the right, but not the
obligation, to buy or sell a parcel of stocks (or shares) at a predetermined price; possibly on or
before a predetermined date. To acquire this right the buyer pays a premium to the writer (or
seller) of the contract.

There are two types of options; namely:

 Call options
 Put options

We shall discuss both these types of options. You are advised to follow the thought, to
understand the concept. The names and the prices in the illustrations below are not in real time
and have only been used to help explain these options.

Call Options: The call options give the taker (or buyer) the right, but not the obligation, to buy
the underlying stocks (or shares) at a predetermined price, on or before a determined date.

Illustration 1: Let's say Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call at a
Premium of 8.

This contract allows Raj to buy 100 shares of SATCOM at INR 150.00 per share at any time
between the current date and the end of August. For this privilege, Raj pays a fee of INR 800.00;
that is INR 8.00 a share for 100 shares.
The buyer of a "call" has purchased the right to buy and for that he pays a premium.

Now, let us see how one can profit from buying an option.

Raj purchases a December Call option at INR 40.00 for a premium of INR 15.00. That is he has
purchased the right to buy that underlying share for INR 40.00 by the end of December. If the
price of the underlying stock rises above INR 55.00 (that is INR 40.00 + INR 15.00) he will
break even and start making a profit. However, to book this profit he would have to exercise this
option on or before the expiry date. Now, suppose the price of the underlying stock does not rise
but falls. Then Raj would choose not to exercise the option and forgo the premium of INR 15.00
and thus limit his loss to this amount only.

If the Premium = INR 15.00 and the Strike price of the Call Option = INR 40.00, then the Break
even point = INR 15.00 + INR 40.00 = INR 55.00. That is to say that the price of the underlying
stock would have to rise to INR 55.00 before Raj would break even in his transaction.

Let us take another example of a Call Option on the Nifty to understand the concept better.

Let's say Nifty is at 1310. The following Nifty Options are trading at the following quotes:

A trader is of the view that the index or Nifty would go up to 1400 in January, but does not want
the risk of prices going down. Therefore, he buys 10 Options of January contracts at 1345. He
pays a premium for buying these Call Options (that is the right to buy these contract) for INR
500.00 X 10 = INR 5,000.00.

In January, the Nifty index goes up to 1365. He sells the Call Options or exercises the option and
takes the difference between the Nifty Spot and the Strike price of his Call Option contracts (that
is INR 1365.00 - INR 1345 = INR 20.00). Now the market lot of the Nifty contract is 200. So,
the trader books a profit of INR 20.00 X 200 = INR 4,000.00 per contract. Now, as he had
bought 10 Call Options contracts his total profit would be INR 4,000.00 X 10 = INR 40,000.00.

He had paid INR 5,000.00 towards the premium for buying these Call Options. So he would
have earned INR 40,000.00 less INR 5,000.00 which is INR 35,000.00 when he exercised these
Call Option contracts.

If, on the other had the Nifty had fallen below 1345, then the trader will not exercise his right
and would opt to forego the premium of INR 5,000.00 he had paid initially. So, in case the Nifty
falls further below the 1345 level the traders loss is limited to the premium he paid upfront, but
the profit potential is unlimited.

Call Options: Long and Short Positions:

When you expect prices to rise, then you take a long position by buying the Call Option. You are
bullish on the underlying security.
When you expect prices to fall, then you take a short position by selling the Call Option. You are
bearish on the underlying security.

Put Options: A Put Option gives the holder the right to sell a specified number of shares of an
underlying security at a fixed price for a period of time.

Let's say Raj purchases 1 Infosys Technology Aug 3500 Put - Premium 200.

This contract allows Raj to sell 100 shares of Infosys Technology at INR 3,500.00 per share at
any time between the current date and the end of August. To have this privilege, Raj pays a
premium of INR 20,000.00 (that is INR 200.00 per share for 100 shares). The buyer of a put has
purchased a right to sell.

To explain this further, let's say Raj is of the view that a stock is overpriced and its price would
fall in the future, but he does not want to take the risk in the event of the price rising. So, he
purchases a Put option at INR 70.00 on Stock 'X'. By purchasing the put option Raj has the right
to sell the stock at INR 70.00, but he has to pay a premium of INR 15.00 for this contract.

So Raj would breakeven only after the stock falls below INR 55.00 (that is INR 70.00 less INR
15.00) and would start making a profit on this contract when the stock price falls below INR
55.00.

Let us illustrate this further. A trader on 15 December is of the view that Wipro is overpriced and
would fall in the future, but does not want to take the risk in the event the price rises. So, he
purchases a Put option on Wipro. The quotes are as under:

Spot INR 1,040.00

Jan Put 1050 INR 10.00
Jan Put 1070 INR 30.00

The trader purchases 1000 Wipro Put at Strike price 1070 at Put price of INR 30.00. He pays a
Put premium of INR 30,000.00. His position in the following price points situations is discussed
below:

1. Jan Spot price of Wipro = 1020

2. Jan Spot price of Wipro = 1080

In the first situation, the trader has the right to sell 1000 Wipro shares at INR 1,070.00 , the Spot
price of which is INR 1,020.00. By exercising the Put option he earns INR (1070 - 1020) = INR
50.00 per put, which totals INR 50,000.00. His net income is INR 50,000.00 less INR 30,000.00
(that is the premium paid upfront) = INR 20,000.00.

In the second price situation, the price is higher in the Spot market, so the trader would not sell at
a lower price. In this case he would have to let his Put option expire unexercised. His loss here
would be initial premium paid for the Put option contracts, that is INR 30,000.00.

Put Options: Long and Short Positions:

When you expect price to fall, then you take a long position by buying Puts. You are bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are bullish.
There are many different types of options when trading depending when, where and who
you are trading with. However to understand the basics and get a real grasp on this type of
investing we will keep it simple.

Let us begin with the American option.

American Option - can be exercised at anytime between the date of purchase and the
expiration date. Most exchange traded are of this type.

European Option - The only difference to an the American version is that they can only be
exercised at the time of the expiration date.

The strange thing is that the American and European moniker have nothing to do with
geographical location. It is the just the terms used to distinguish between the two different
types.

Options get even more complicated I am afraid. Now we need to look at the other types out
there starting with long-term options.

Long- Term Options

When people think about options trading they often only consider short-term options of a
couple of months or so. It is possible to have options that can be held for years for long-
term investors.

At this point in the financial world they become what we know as LEAPS (long-term equity
anticipation securities). They are exactly the same as short-term options except they offer
opportunities over a longer time period. LEAPS aren't available on every stock but are still
readily available on the most widely held issues.

Exotic Options And Plain Vanilla Options

OK I hope you are still with me... the basic call and puts options are sometimes called "plain
vanilla". Don't be scared they are pretty easy to follow.

A plain vanilla option is a standard option type. They have a simple expiration date and
strike price and that is it. With an exotic option there may be other contingencies such as a
knock-on options that becomes active when the stock hits a pre-determined price point. In
other words...

Because of the versatility of options; there exist many types and variations. Non-standard
options are called exotic options. These are either variations on the payoff profiles of the
plain vanilla option or are wholly different products with "option-ality" embedded in them.
Look this is a complex subject at times and it took me time to get to grips with the whole
options trading ethos. All I can stress is till you are completely certain that you understand
the intricacies of options trading don't invest as you could lose a lot of money.