High risk, high returns:

18 Nov, 2007,

Vikas Agarwal

Derivates were introduced in domestic markets a few years ago. Derivatives are market-created financial products. A derivate is a contract between two parties (individuals or institutions) with respect to a certain underlying security. For example, a stock or stock index. Derivatives derive their value from the underlying asset. Futures and options are the two most popular derivate products. Commonly-traded derivates available in the market includes stock futures, stock options, stock index (NIFTY) futures and options, commodity futures (gold, crude oil, wheat, sugar etc), currency options, interest rate futures and options etc.

The most common basic derivatives are of two types -futures and options. Future is an agreement to buy or sell a certain underlying asset at a fixed price and future date. The seller of a future has an obligation to deliver the underlying asset to the buyer of the future, and the buyer has an obligation to pay the agreed price to the seller at a future date. A transaction involving the sale of stock futures is called short future position and a transaction involving the purchase of stock futures is called long future position.

Option is a special type of future contract where the buyer has an option to buy or not buy the underlying asset from the seller at a fixed price. However, the option seller (writer) has an obligation to deliver the underlying asset to the buyer. The buyer of the option pays an upfront fee/premium to the seller of the option. If the buyer does not exercise the option within fixed future period, the option gets expired and has no value.

Call and put options Options are of two types -call option and put option. In a call option the buyer has an option to buy an underlying asset at a predetermined price and in a put option the buyer has an option to sell an underlying asset to the seller of put option at a pre-determined price. A seller of call/put option has an obligation to sell/buy the underlying asset.

Trading cycles There are three trading cycles for derivatives trading on Nifty - current month, next month and the month after next. Therefore, investment/trading in derivatives are of short term horizon. Immediate month derivatives are the most traded in the market. It is advisable for investors to trade in current month derivatives only because most of the time the premium quoted on far month derivatives is quite high due to low trading volume. Derivative settlement (commonly called F&O settlement) in Indian stock markets happens on the last Thursday of every month. Markets remain quite volatile near the F&O expiry date. Small investors in derivatives should take extra care while investing near the expiry date.

Brokers offer a variety of plans for trading in derivatives (reduced brokerage if monthly volume crosses a certain limit or zero brokerage on intra-day settlement etc). Investors should carefully choose their brokerage plan based on their trading quantum and profile. Investors can also look for arbitrage opportunities in derivatives trading but usually it is very difficult to execute an arbitrage opportunity for small investors because transaction cost for small investors is quite high and arbitrage opportunity lasts for very small durations. The core value of derivative products is to manage risk (hedging).

It is important for investors to understand that derivatives are highly leveraged transactions. Traders and investors can assume large positions with very little upfront investments. Derivatives magnify the risk and return of the investors to a large extent. Investors should understand the technicalities of derivatives before getting into the derivatives market.

Note: The Special Packages for the Premium Membership and also Quickie Serives expires on 30th November, 2007. After that the above mentioned instruments will be offered at a revised price, with a moderate price hike.