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:
y y

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.

For this privilege.An option is a contract between two parties giving the taker (or buyer) the right. but not the obligation. This contract allows Raj to buy 100 shares of SATCOM at INR 150. to understand the concept. Now. Raj purchases a December Call option at INR 40. that is INR 8. The buyer of a "call" has purchased the right to buy and for that he pays a premium.00 a share for 100 shares.00 + INR 15.00 by the end of December. The names and the prices in the illustrations below are not in real time and have only been used to help explain these options.00 per share at any time between the current date and the end of August.00. You are advised to follow the thought. Illustration 1: Let's say Raj purchases 1 Satyam Computer (SATCOM) AUG 150 Call at a Premium of 8. That is he has purchased the right to buy that underlying share for INR 40. Call Options: The call options give the taker (or buyer) the right. to book this profit he would have to exercise this option on or before the expiry date.00) he will break even and start making a profit. to buy the underlying stocks (or shares) at a predetermined price. Raj pays a fee of INR 800. To acquire this right the buyer pays a premium to the writer (or seller) of the contract. to buy or sell a parcel of stocks (or shares) at a predetermined price. There are two types of options. However. Now.00 (that is INR 40. on or before a determined date. but not the obligation.00 for a premium of INR 15.00. suppose the price of the underlying stock does not rise . possibly on or before a predetermined date. If the price of the underlying stock rises above INR 55. namely: y y Call options Put options We shall discuss both these types of options. let us see how one can profit from buying an option.

Let's say Raj purchases 1 Infosys Technology Aug 3500 Put . then the trader will not exercise his right and would opt to forego the premium of INR 5.00.000. Let's say Nifty is at 1310.INR 1345 = INR 20.00 per contract. but the profit potential is unlimited. as he had bought 10 Call Options contracts his total profit would be INR 4.but falls. He pays a premium for buying these Call Options (that is the right to buy these contract) for INR 500. If.Premium 200. Now the market lot of the Nifty contract is 200.000.00 per share at any time between the current date and the end of August. If the Premium = INR 15. the trader books a profit of INR 20.00.000. This contract allows Raj to sell 100 shares of Infosys Technology at INR 3. So.00 which is INR 35. in case the Nifty falls further below the 1345 level the traders loss is limited to the premium he paid upfront.00. 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.00 less INR 5. then you take a long position by buying the Call Option. When you expect prices to fall.00.00 towards the premium for buying these Call Options. then the Break even point = INR 15. So.00 X 10 = INR 40. Now. You are bearish on the underlying security.500.00 he had paid initially. That is to say that the price of the underlying stock would have to rise to INR 55. You are bullish on the underlying security. but does not want the risk of prices going down.00 and thus limit his loss to this amount only. Call Options: Long and Short Positions: When you expect prices to rise.00 X 200 = INR 4.00 = INR 55. Then Raj would choose not to exercise the option and forgo the premium of INR 15. To have this privilege. he buys 10 Options of January contracts at 1345. Raj pays a . 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.00).00 X 10 = INR 5. the Nifty index goes up to 1365.000. Therefore.00 . In January.000. 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. So he would have earned INR 40. He had paid INR 5. Let us take another example of a Call Option on the Nifty to understand the concept better. on the other had the Nifty had fallen below 1345.00 before Raj would break even in his transaction.000.000.00 when he exercised these Call Option contracts.00 and the Strike price of the Call Option = INR 40.000. then you take a short position by selling the Call Option.000.00 + INR 40.

00 for this contract.00 (that is the premium paid upfront) = INR 20. A trader on 15 December is of the view that Wipro is overpriced and would fall in the future. let's say Raj is of the view that a stock is overpriced and its price would fall in the future.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. he purchases a Put option on Wipro.000.00.00. You are bearish.00. then you take a short position by selling Puts. He pays a Put premium of INR 30. that is INR 30. The quotes are as under: Spot INR 1.00 less INR 15. Jan Spot price of Wipro = 1080 In the first situation. and would start making a profit on this contract when the stock price falls below INR 55. When you expect prices to rise.000. By exercising the Put option he earns INR (1070 . the Spot price of which is INR 1. the trader has the right to sell 1000 Wipro shares at INR 1.00 (that is INR 200.00.00 per share for 100 shares).00 on Stock 'X'. His net income is INR 50. Put Options: Long and Short Positions: When you expect price to fall. By purchasing the put option Raj has the right to sell the stock at INR 70. the price is higher in the Spot market.00 (that is INR but he does not want to take the risk in the event of the price rising.040.000. In this case he would have to let his Put option expire unexercised. His position in the following price points situations is discussed below: 1.070. His loss here would be initial premium paid for the Put option contracts. So. which totals INR 50. So.premium of INR 20. then you take a long position by buying Puts.000.00. The buyer of a put has purchased a right to sell.020.00 . but does not want to take the risk in the event the price rises. You are bullish. Jan Spot price of Wipro = 1020 2. .00 per put. so the trader would not sell at a lower price. but he has to pay a premium of INR 15. he purchases a Put option at INR 70.1020) = INR 50. Let us illustrate this further. In the second price situation. So Raj would breakeven only after the stock falls below INR 55.00 less INR 30. To explain this further.

Don't be scared they are pretty easy to follow. European Option . It is the just the terms used to distinguish between the two different types. Long. In other words. Let us begin with the American option.. where and who you are trading with. They have a simple expiration date and strike price and that is it. At this point in the financial world they become what we know as LEAPS (long-term equity anticipation securities). Options get even more complicated I am afraid. These are either variations on the payoff profiles of the plain vanilla option or are wholly different products with "option-ality" embedded in them. Most exchange traded are of this type. LEAPS aren't available on every stock but are still readily available on the most widely held issues.. They are exactly the same as short-term options except they offer opportunities over a longer time period.can be exercised at anytime between the date of purchase and the expiration date..There are many different types of options when trading depending when. Exotic Options And Plain Vanilla Options OK I hope you are still with me. 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. However to understand the basics and get a real grasp on this type of investing we will keep it simple. Now we need to look at the other types out there starting with long-term options. It is possible to have options that can be held for years for longterm investors.Term Options When people think about options trading they often only consider short-term options of a couple of months or so. . American Option . there exist many types and variations. Because of the versatility of options.The only difference to an the American version is that they can only be exercised at the time of the expiration date. A plain vanilla option is a standard option type. the basic call and puts options are sometimes called "plain vanilla". Non-standard options are called exotic options.. The strange thing is that the American and European moniker have nothing to do with geographical location.

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.Look this is a complex subject at times and it took me time to get to grips with the whole options trading ethos. .

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