MECHANISM OF DERIVATIVES PART-II “OPTIONS” BY MANSUKH JANUARY 2011

Options, the most complicated instrument of the capital market is widely used to trade while investing in mutual funds, stocks and bonds. Options are complex securities and can be extremely risky. This is why, when trading options, you'll see a disclaimer like“Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital”. Basically “An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.


Options can be divided into two parts, call option and put option.
Call Option: A call gives the holder the right to buy (but not the obligation)      an asset at a certain price within a specific period of time. Calls are similar to
having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

Put Option: A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having  a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market 
There are four types of participants in options markets depending on the position they take. These are Buyers of calls, Sellers of calls, Buyers of puts, Sellers of puts. People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions. The main difference between the buyer and seller is that. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. While Call writers and put writers (sellers), however, are obligated to buy or sell.

Use of Options
Options are used generally for two purposes either for speculating or for hedging. The advantage of options is that it is limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the pure form of betting on the movement of the stock in which the big money is made and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement.

Hedging is just like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit.

Types of Options
There are two types of options which are used to trade in different exchanges. American options which can be exercised at any time between the date of purchase and the expiration date. The example about a Reliance Industries is an example of the use of an American option. Most exchange-traded options are of this type. While on the other hand European options are different from American options in that they can only be exercised at the end of their lives.

Conclusion: In this section of the tutorial we hope it has given you some insight into the world of options. Once again, we must emphasize that options aren't for all investors. Options are sophisticated trading tools that can be dangerous if you don't educate yourself before using them. Please use this tutorial as it was intended as a starting point to learning more about options.

MECHANISM OF DERIVATIVES BY MANSUKH DEC 2010

Derivatives, a most influential part of the capital market is considered as a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, an India investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Rupees.

Underlying Assets in Derivatives
Derivatives consists of some underlying instruments like Futures contracts,   
Forward contracts, Options and Swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Future Contracts: Futures contract mean a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. Futures contracts can be used either to hedge or to speculate on the price movement of the underlying asset.

Forward Contracts:  A forward contract is an agreement between two counterparties - a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.

Options Contracts:  An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. One options contract may represents certain number of shares for a particular underlying stock. The quoted price of an option is per share. Option can be used for speculation or Hedging purpose, Speculation is as betting on the movement of a security and on Hedging is used to insure your investments against a downturn.

Futures vs Options
The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short in the same type of contract to offset your position. This serves to exit your position much like selling a stock in the equity markets would close a trade.

Conclusion: Both Futures and Options have been derived from any particular underlying stock and can be used either for raising money or protecting our investment from any probable risks. Hence we should use these instruments according to our need and investment norms. However, speculation is the territory in which the big money is made and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you use an option contract you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. The combinations of these factors means the odds are stacked against you. That's why we need to understand more about options like type and use of it, so we will use our next series of stock market session to explain more about options.