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All You Must Know About Derivative trading – Futures and options

In the realm of advanced investing, derivatives are secondary securities whose value is solely based (derived) on the value of the primary security that they are linked to. A derivative is otherwise worthless in and of itself. Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.

What is Derivative trading?

Derivative is a financial product whose value hails from the underlying assets. The underlying assets can be equity, index, commodities, currencies, bonds etc. Derivative products were developed initially as hedging instruments against fluctuations in commodity prices.

The financial derivatives or derivative trading arrived in online trading post 1970, as a result of growing instability in financial markets and since that time, financial derivatives have became highly popular and they accounts for two-thirds of total transactions. Investors of financial markets are broadly categorized on the foundation of time horizon of their investment.

Derivative trading is simply hedging and trading instrument. Being truly a margin based trading instrument, it offers good leverage opportunity which ultimately provides rise of speculations.

Futures trading as a part of Derivative trading

A futures contract gives the right to buy or sell a given amount of underlying at specified price and on or before specified date. Both parties of futures contract must exercise the contract unless they are deliverable on or before the settlement date.

Features of Futures Trading:

Initial margin amount of contract value is required for taking positions which is determined by exchange on the basis of SPAN plus exposure margin. Use of buy sell signal software is very common in derivative trading for analyzing plenty of data and activities.

Mark-to-market profit/loss will be adjusted on daily basis.

Positions need to be squared off by last trading day of the contract failing which exchange will square off those positions.

Index futures have indices as underlying.

 

Contracts of different maturities available for trading are called current month (1 month), near month (2 months) and far month (3 months) contracts. The month in which a contract expires is called the contract month.

Options trading as a part of Derivative trading

It offers the buyer the best to get or sell the underlying without any obligation. While buyer of an option pays the premium and thereby acquires the best to exercise his option, the seller or writer of an option receives the possibility premium and thus become obliged to sell/buy the asset if the buyer exercises his rights.

While the ”Call Option” gives the buyer the best however, not the obligation to get the underlying asset at certain price before given future date, ”Put Option” gives the buyer the best however, not the obligation to market the underlying asset at certain price in future.

Buying of Call and Put options require premium to be paid and expose traders to risk limited by to the size of premium paid while selling/writing of options require margin to be paid and expose to risk just like futures market.

Style of options

European Options can only be exercised i.e., delivery can be taken by buyer of options on expiry date of contract.

American Options can be exercised i.e., delivery can be taken by the buyer any time on or before the expiration date.

Contract Cycle: Contract Cycle is the period over which a contract trades. The index futures contracts on the NSE have one-month, two- months and three- month’s expiry cycles.

Option Strategies

A trader can buy a Call option or write /short Put option if he is having long/bullish directional view on the underlying. Similarly, a trader can sort/write Call option or long/buy Put option if having short/bearish directional view on the underlying.

 

Besides, there are combination strategies which are sufficiently useful when market view is moderately bearish/ bullish, range bound or uncertain and the objective is to reduce overall payout of option premium. Instruments include Strangle, Straddle, Bull & Bear Call-Put Spread, Covered, Butterfly, and Protective Call and Put etc.

Benefits of Derivatives:

Hedging: It helps to safeguard the traders against future price uncertainties. This can be beneficial for traders investing in foreign firms.

Leverage: it allows the traders higher trading exposure due to the fact that the margins required in this derivative trading are very low.

Potential Return: It implies that one can earn money irrespective of market conditions.

Longer position taking: In contrast to the 1-3 days offered in other margin products, this derivative trading gives you time leverage of up to 3 months.

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