A derivative is a financial instrument which has no value of its own and is obtained from another asset’s underlying. The underlying could be stock, commodity, securities, bullion, live stock or market index among others. The derivatives could either be a future contract or an options contract.
The futures contract is a standard, transferable contract by which one commits to buy or sell the underlying securities at a future date. It is a legally binding contract, in case of commodities, in terms of quantity and quality, time and place of delivery but on a future date. There is an expiry date to the contract. In futures contract, there is an obligation to buy. They are like taking an oath to do certain transactions at a future date. The trading is regulated by the Securities and Exchange Board of India [SEBI]. SEBI control the market and ensure that traders dealing do not take control of the market and to prevent fraud.
Future transactions are settled in three ways:
- Squaring off: You take a stand which is just the opposite of your original one. If you have been purchasing gold you square off by selling an identical number.
- Delivery: By physically delivering the underlying asset on the date specified.
- Cash settlement: Settling the whole issue by paying the difference between the futures price and the present rate of the underlying asset.
The options contract gives the buyer or holder the right to buy or sell the underlying asset at the predetermined price at the end of the period, but they are under no obligation to settle the option. The seller/ writer are obligated to accept the terms of the contract. The underlying asset could be securities, stock or index.
The buying option is called the Call option while the selling option is the Put option. When the option is applied on or before the expiry date it is called American option while the option exercised after the expiry date is called European option. The option contracts can also be settled by cash or underlying asset. The price of an option is the option premium. The price at which the underlying security can be bought or sold is called the Strike price. People buying the options have a Right which is known as right to Exercise. Call option holders can buy the stock at the strike price and the Put holders can sell stock at strike price. Neither Call nor the Put is under any obligation to sell or buy though they have a right.
Future contract based on the index where the underlying asset is the index is called the index future contracts i.e. the NIFTY index. Their value is obtained from the value of the underlying index. Similarly, the option contracts are known as index options contract. Here again, the buyer of the index has a right but is not obliged to buy or sell the underlying index. These are generally applicable only after the expiry date like the European style options.
Structure of derivative markets:
Derivative trading in India is usually done in a different segment of the stock exchange. It functions as a self regulatory organisation [SRO] and SEBI regulates it.
Contracts approved by SEBI:
The index future contracts were first introduced in June 2000. Then the index options and the stock options were introduced in June and July 2001 followed by the Stock future in November 2001. Sectoral indices were allowed from December 2002.
The measures taken by SEBI to safeguard investor’s rights include:
- The investor’s money is kept separate and is not available to the trading member and can be used against any liability of the investor
- The investor should be given the risk disclosure statement where the risks involved in derivative trading are mentioned
- The monies paid by the investor in the derivative market is kept with the Clearing house and in case of default the amount paid by the client is segregated but not utilized but if the investor suffers any loss due to the default by a member, he is compensated from the investor protection fund.
- Investors are given the contract notes duly time stamped for receipt and work on the order.
- Stock exchanges are supposed to set up arbitration and investor grievance redressed mechanism throughout the country.