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Derivatives, such as futures or options, are financial contracts which derive their value from a spot price, which is called the “underlying”. The term “contracts” is often applied to denote the specific traded instrument, whether it is a derivative contract in commodities, gold or equity shares. The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange, real estate etc.

There are two types of derivatives instruments traded on Exchanges; namely Futures and Options: 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.

Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives

the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him. Options are of two types – Calls and Puts options:

“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 underlying asset at a given price on or before a given future date. All the options contracts are settled in cash.

Further the Options are classified based on type of exercise. At present the Exercise style can be European or American.

American Option – American options are options contracts that can be exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options.

European Options – European options are options that can be exercised only on the expiration date. All index options traded at NSE are European Options.

Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardized and trading is centralized (on a stock exchange). There is no counterparty In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter party risk. Futures markets are highly liquid as compared to the forward markets.

Futures and options contracts are traded on Indices and on Single stocks.

An investor can trade the ‘entire stock market’ by buying index futures instead of buying individual securities with the efficiency of a mutual fund. The advantages of trading in Index Futures are:

In- the- money options (ITM) – An in-the-money option is an option that would lead to positive cash flow to the holder if it were exercised immediately. A Call option is said to be in-the-money when the current price stands at a level higher than the strike price. If the Spot price is much higher than the strike price, a Call is said to be deep in-the-money option. In the case of a Put, the put is in-the-money if the Spot price is below the strike price.

Investors must understand that investment in derivatives has an element of risk and is generally not an appropriate avenue for someone of limited resources/ limited investment and / or trading experience and low risk tolerance. An investor should therefore carefully consider whether such trading is suitable for him or her in the light of his or her financial condition. An investor must accept that there can be no guarantee of profits or no exception from losses while executing orders for purchase and / or sale of derivative contracts.