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What are derivatives? |
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Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be Equity, Forex, Commodity or any Other Assets. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. |
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| 2. |
What are futures? |
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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. Futures markets were designed to solve the problems that exist in forward markets. The standardized items in a futures contract are: |
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Quantity of the underlying (or lot size) |
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Date and month of delivery (e.g. 31 Dec 2009, 31 Jan 2010 etc) |
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Units of price quotation (Indian Rupees) and minimum price change (tick size) |
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| 3. |
What are the different margins applicable in derivative trading in India? |
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Margin is the deposit money that needs to be paid to buy or sell each contract. The margin required for a futures contract is better described as performance bond or good faith money. The margin levels are set by the exchanges based on volatility (market conditions) and can be changed at any time. The margin requirements for most futures contracts range from 4% to 20% of the value of the contract. In the futures market, there are different types of margins that a trader has to maintain. The following are the types of margins applicable in the Indian context. |
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Initial Margin: The amount that must be deposited by a customer at the time of entering into a contract is called initial margin. This margin is meant to cover the largest potential loss in one day. The margin is a mandatory requirement for parties who are entering into the contract. Take for instance a stock future quoting at Rs 100 that requires 15% margin. It means that in order to take a |
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Maintenance Margin: A trader is entitled to withdraw any balance in the margin account in excess of the initial margin. To ensure that the balance in the margin account never becomes negative, a maintenance margin, which is somewhat lower than the initial margin, is set. If the balance in the margin account falls below the maintenance margin, the trader receives a margin call and is requested to deposit extra funds to bring it to the initial margin level within a very short period of time. The extra funds deposited are known as a variation margin. If the trader does not provide the variation margin, the broker closes out the position by offsetting the contract. |
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Additional Margin: In case of sudden higher than expected volatility, the exchange calls for an additional margin, which is a preemptive move to prevent breakdown? This is imposed when the exchange fears that the markets have become too volatile and may result in some payments crisis. |
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Mark-to-Market Margin (MTM): At the end of each trading day, the margin account is adjusted to reject the trader's gain or loss. This is known as marking to market the account of each trader. All futures contracts are settled daily reducing the credit exposure to one day's movement. Based on the settlement price, the value of all positions is marked to market each day after the official close. i.e. the accounts are either debited or credited based on how well the positions fared in that day's trading sessions If the account falls below the maintenance margin level the trader needs to replenish the account by giving additional funds. On the other hand, if the position generates a gain, the funds can be withdrawn (those funds above the required initial margin) or can be used to fund additional trades. |
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Just as a trader is required to maintain a margin account with a broker, a clearinghouse member is required to maintain a margin account with the clearinghouse. This is known as clearing margin. In the case of clearing house member, there is only an original margin and no maintenance margin. |
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| 4. |
What do you mean by long position or short position in futures trading? |
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Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. |
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The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. |
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The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses. |
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| 5. |
What is an option? How does a Put/Call option are different? |
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Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right but not the obligation to buy or sell. In contrast, in a forward or futures contract, the two parties have committed themselves to buying or selling. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up–front payment of the premium.
There are two basic types of options, call options and put options. |
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Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. |
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Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. |
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How option writing (selling) is different from option buying? |
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Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. |
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