How Derivatives Work

Derivatives are financial securities that don’t possess an independent value and rely on the value of an underlying asset. Futures and options are two popular derivatives in the capital market. A futures contract can be on a stock or an index. In the event that you buy a stock future, it means you have bought the stock with a promise to pay at a future date. If you sell a stock future, it means you have to deliver the stock to the buyer at a future date. On an exchange, these contracts can be settled without actual delivery, by adjusting the funds or cash against the contracts’ value.

An options contract is of two types, call or put. A call option gives the buyer the right to claim a particular stock or index at a predetermined price. A put option gives the buyer the right to sell a particular stock or index at a predetermined price. You have to pay a premium to buy an option, which is market determined and based on: the underlying stock or index, the option time period and the stock’s volatility. You buy a call option if you expect the stock’s price to rise, and a put option if you expect it to fall.

Contracts for futures and options are usually for 1, 2 or 3 months. Unlike options, where a premium is involved, a futures contract is priced as per the underlying stock. For example, a Nifty50 futures contract is valued at 8,530 for a contract ending on 23 October and 8,632 for a contract ending on 26 November. Say, the current value of Nifty 50 is 8,570, the futures reflect a mildly positive sentiment. So, the futures reflects the expectation of where the index will be when the contract ends. This difference in price, between the futures and cash market, is used by speculators and arbitragers. If it works out at expiry, you will gain. If the market moves against your view, you stand to make losses. Gains and losses can be unlimited, depending on how much the index moves against your bet. In futures, both the buyer and seller have an obligation to complete the trade at the end of the contract period.

With options, there is no obligation to fulfil the contract because a premium is paid for buying the option. It gives you a non-binding option to buy or sell the underlying stock or index. Hence, the losses are limited. Butprofits can be unlimited as the contract’s price is fixed. Both securities, however, are risky and require some margin money as collateral against the contract.