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Derivative-An Introduction to Future Contract,Call Option,Put Option




Derivative means derived from something.In equity market the derivative means future contract of a share/index and its value is derived from the orginal equity price and the movement of this future contract is based on the movement of underlying equity price.The derivative(future) may trade at par,slight up or slight down with Base equity.When it is trading up than base it is on premium ie more accumulation and when on down it is on discount ie more selling on future.Derivative are traded on lots.The Underlying not only be shares it can be Index,volatality,commodity,currency,interest rate,agricultural commodity and more that is measurable.In India Nifty future is the most traded derivative instrument. Derivative are only contract and is not real equity share/index even though the price movement will be similar to base equity/share and do not have any right like dividend,voting etc.So dividend amount will be discounted from this derivative price hope every one have noticed that some time huge discount of derivative contracts with respect to equity shares due to dividend. The main characterize of derivative is their leverage These contract can be bought/sold by giving a little margin(depends on the volatality of share/index) Even though derivative is having same risk as underlying these overutilization of this leverage is making them high risk product.for ex 2 lakh worth share can be hold by paying a small margin es 50000 Rs So the profit potential for this 50000 Rs is for 2 lakh worth share and viceversa.Second main characterize for the Derivative is that Investor/trader can take long(bull) and short(bear) view on stock positionally.Derivatives are used as an instrument to hedge future risk and derivative hedging is not complete without option(explained below), It can also be used for speculative purposes which make them riskier when more leveraging is used.. 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.There are two type of option Call option and Put option. A call gives the holder the right to buy 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. Confuse about call option??? Suppose you want to invest in a property what would you do? You will first watch and visit the property and make some analysis and decide to buy after analysis.Next you would negotiate with property owner and make a deal with a specified price and will make an written contract with property owner to buy the property at specified rate at specified time and will give an small amount as advance.Later on you find that a garbage plat is coming near to that property so that propery is not worth at current price you offered you would simply forgot the advance and cancel the deal because you have no obligation to buy the property.But on another scenario after making the deal some big project comes to the area and price of property had rise to five times the orginal amount.The property owner cannot do any thing simply to give you the property at agreed price because you have the right to buy the property.Similarly in equity market suppose tatasteel is trading at 500 Rs and its lot is 500 share The tatasteel 520 CA at 10 Rs expiry dated 25 jan 2010 call option means you have the right to buy tatasteel at 520 rs before 25 jan 2010 and you have paid 10 Rs (10*500) as advance.So even if tata steel rise to 600 rs at expiry date you have the right to buy it at 520 So what is your profit ((600-520)-10)*500 so net profit 35000 Rs by investing 5000 rs but even if tatasteel is below 520 you will lose only 5000 Rs you paid..Then what is Put option In call option you have the right to buy similarly in put option you have the right to sell the asset at fixed price. Suppose you buy a car at 5 lakh and you wil take an insurance by paying a small premium ex 10000 Rs for protection and nothing adverse has happened to your car simply you will losse only what you have paid as insurance.But if some thing unexpected has happend and if your car has stolen .You can claim the insurance and insurance company will give you full amount of car after depreciation.So in stock market scenario in the place of car you have some share s of a company worth 5 lakh for ex tata steel 500 shares and the current price is at 500 Rs and you have 480 PA at 10 Rs expiry 25 jan 2010 So in an unexpected market crash make your stock price on 350 Rs you can still have the right to sell the stock at 480 and if any market crash had been take place and tata steel goes up simply forgot about put premium. There call and Put are classified into three In the money call-put,At the money call-put,Out of the money call-put.In the money means Strike rate(rate at which offered to Buy) is less than Equity price At the money means strike rate similar to Equity price and out of the money means Strike rate far away from Equity price in case of call option.In put option In the money means Strike price higher than equity price and out of money means Strike less than Equity price because put is selling right.For Ex if tata steel Equity is trading at 500[(CALL)- 480 call or below is in the money 500 at the money and 510 or above is out of money(PUT)-480 Put is out of money 500 at the money and 520 In the money].The So a call option buyer will be bullish and put buyer is bearish and call seller is bearish and put seller is bullish.Except in the money (call and put) Full value of call and put is premium ie Time Value and in case of In the moneyvalue excess of Equity-Strike in case of call and Strike-Eqity in case put is Time value and this premium will come to zero on expiry date and premium will higher in out of money call and put.So if there is no movement in stock price simply the option price will come down as days advances. So for buying call and put you have to give only the buy amount but for selling the option you have to give margin.So by combining derivative(future),Call option,Put option you can make simple to complex stratergies to make the risk very low compared to equity or maximise the return by the power of leveraging that derivative and option offer to you.In in one word our tradig stratergies are making the derivative and option High risk to low risk product You can play very low risk than equity market by reducing the return and also you can also make very risky by maximising the return.

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