DERIVATIVES BROKING

Derivatives as the name suggests are the financial contracts which derive their value from the underlying. The underlying may be the security or an index. Thus derivative instruments have no independent value.

Frequently Asked questions

What are options?

An option contract is the right to buy or sell a pre-determined number of securities at an agreed price. Thus the buyer of an option contract has a right to buy or sell but not the obligation to do so from the seller or writer of the option at a price which is fixed at the time of trade.

What is option premium?

Option premium is the fee or the price of option. It is payable by the buyer of the option to the seller or writer as the writer is under obligation to honor the terms of option if the buyer insists on the same. Thus buyer of the option has a right to exercise the option while writer of an option has an obligation to fulfill it.

What are different types of options?

Options are of two types. ‘Call option” gives buyer of the option, a right but not the obligation to buy a pre determined number of shares at the agreed price and “Put option” will give buyer of the put option a right but not the obligation to sell a pre determined number of shares at the agreed price.

What is an Index Option Contract?

An Index option contract is where the underlying security is not an individual share but the Index such as Sensex, Nifty, and so on. Thus the buyer of a call option on Nifty has a right to buy the Index at a predetermined price on or before a future date. All future index contracts are cash settled.

What is In the Money Option Contract?

An In the Money Option contract is when in which the strike price of the option is less than the current market price of the underlying security (for a call option) or above the current market price of the underlying security (for a put option). Such an option has intrinsic value.

What is Out of the Money Option Contract?

An Out of the money call option is a call option whose strike price is higher than the market price of the underlying security, or a put option whose strike price is lower than the market price of the underlying security. These contracts would become worthless and would not be exercised by the option holder.

What is at the money Option Contract?

The money contract is when the strike price of an option is equal to or nearly equal to the market price of the underlying security.

What is risk management of derivatives in India?

Stock exchanges follow robust risk management measures for derivative trading. These include, initial base minimum capital requirements, real time and system based monitoring of positions and automatic deactivation of trading terminals in case of exceeding the limits as imposed by exchanges, margins and daily mark to market margin system and initial Value at risk (VAR) based margin system. Apart from that there are various position limits, broker wise limits and scrip wise limits are also there to avoid building up of huge positions.

Who monitors derivative trading in securities market?

Derivative trading in India is very well monitored by the stock exchanges (NSE has a pre dominant position as far as derivative trading is concerned compared to BSE). Besides SEBI also monitors the derivative markets through appropriate policy measures and frequent inspections.

What are the advantages of trading in derivatives?

Derivative contracts are effective tool for hedging and thereby reducing the potential of future risk. They also allow investors to take a leveraged position in the market and thereby increase the possibilities of earning higher returns. Derivative trading is the logical extension of cash market trading and a healthy derivative market is a sign of effective and robust economy.

What are the disadvantages of trading in derivatives?

Because of their ability to provide leveraging, derivative disasters are pretty common in international markets. Just as there is huge potential of earning higher returns, it also exposes individuals and corporations alike to lose money in case the market moves against the positions held by them. Too much leverage has been the cause of worry and pitfalls for many traders and investors alike.

How can I start derivative trading?

For starting a derivative trading, an investor has to register with a stock broker who is registered on the derivative segment of the stock exchange (NSE or BSE). He will also be required to execute the broker client agreement as well as give certain details about himself to the broker as a part of ‘know your client’ guidelines. You are also given a Risk Disclosure Document, specifying the risks of trading in the derivative instruments. As a prudent investor, you should carefully go through these documents carefully.

What is the minimum contract size?

It has been specified that the value of a derivative contract should not be less than Rs. 2 lakh at the time of introducing the contract in the market. The contract size is frequently updated depending upon the current market price of the underlying.

What is the lot size of contract?

Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.100 each and the minimum contract size is Rs.2 lakhs, then the lot size for that particular scrips stands to be 200000/100 = 2000 shares i.e. one contract in XYZ Ltd. would be for 200 shares. Thus lot size of the contract is determined by the market price of underlying security and the minimum contract size at the time of introduction of the derivative contract on that underlying.

What are the securities where derivative trading is allowed?

Stock exchanges have predetermined criteria for selection of securities where derivative trading is allowed. The criteria are generally the market capitalization of the securities, liquidity and the securities are frequently traded on the stock exchange. Apart from individual securities, derivative trading is also allowed on Indices such as Nifty, IT Index and Bank Index. The list of securities on which derivative trading is available is constantly increasing.

What are the derivative products available in securities markets in India?

There are futures as well as option contracts available on individual securities. Apart from that one can also buy or sell options as well as futures on certain indices such as Nifty, IT Index, Bank Index, Sensex etc.

What are the advantages of trading in derivatives?

Derivative contracts are effective tool for hedging and thereby reducing the potential of future risk. They also allow investors to take a leveraged position in the market and thereby increase the possibilities of earning higher returns.

What are the disadvantages of trading in derivatives?

Because of their ability to provide leveraging, derivative disasters are pretty common in international markets. Just as there is huge potential of earning higher returns, it also exposes individuals and corporations alike to lose money in case the market moves against the positions held by them.

What is risk management of derivatives in India?

Stock exchanges follow robust risk management measures for derivative trading. These include, initial base minimum capital requirements, margins and daily mark to market margin system and initial Value at risk (VAR) based margin system. Apart from that there are various position limits, broker wise limits and scrip wise limits also to avoid build up of huge positions.

Who monitors derivative trading in securities market?

Derivative trading in India is very well monitored by the stock exchanges (NSE has a pre dominant position as far as derivative trading is concerned compared to BSE) Besides SEBI also monitors the derivative through appropriate policy measures.

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