DERIVATIVES

In the equity market, derivatives are financial contracts whose

value is derived from the price movements of underlying equities
or stock indices. They are essentially agreements between two
parties to buy or sell an underlying asset at a predetermined price
on a future date.

Here's a breakdown of the meaning:

Financial contract: Derivatives are not the actual stocks
themselves, but rather agreements about them. They're like bets on
the future price of the underlying asset.
Underlying asset: This could be a single stock, a basket of stocks,
or even a stock index like the S&P 500. The derivative's value
fluctuates based on the price movements of this underlying asset.
Predetermined price: This is the price at which the derivative can
be bought or sold on the expiry date. It's agreed upon by both
parties when the contract is entered into.
Expiry date: This is the date when the derivative contract matures
and ceases to exist. If not exercised before this date, the contract
becomes worthless.

Q. Why are derivatives used in the equity market?

There are several reasons why investors and traders use
derivatives:
Hedging: Derivatives can be used to protect existing holdings from
adverse price movements. For example, if you own a stock you
think might go down, you could buy a put option to lock in a selling
price.
Speculation: Derivatives can be used to make bets on the future
price of an underlying asset, potentially generating significant
profits if the bet pays off.
Leverage: Derivatives often require a smaller initial investment
than buying the underlying asset outright. This can amplify gains
(and losses) for experienced traders.
Income generation: Some derivatives, like options contracts, can
be used to generate income through premiums paid by other
traders.
Types of derivatives in the equity market:
Futures:
✓ A futures contract is a legally binding agreement between two
parties to buy or sell a specific quantity of an underlying asset
(stock, index, commodity, etc.) at a predetermined price on a
future date. Essentially, it's a bet on the future price of the
asset.
✓ Both parties are obligated to complete the transaction,
regardless of the actual market price at the expiry date.
✓ Futures contracts are standardized and traded on exchanges,
requiring a margin deposit for leveraged exposure. Their high
liquidity allows for easy entry and exit.
✓ While offering potential for large gains, futures also carry
significant risk of substantial losses if the price movement
doesn't favor your position.
✓ Understanding these complex instruments is crucial for
anyone participating in the equity market, as they can be
powerful tools for hedging, speculation, gaining leverage, and
even income generation.
Forwards:
 ✓ A forward contract, similar to a futures contract, is a
customized agreement between two parties to buy or sell a
specific asset at a predetermined price on a future date.
✓ However, unlike futures contracts, which are standardized
and traded on exchanges, forward contracts are tailor-made
agreements traded over-the-counter (OTC) between two
parties directly.
✓ They offer more flexibility in terms of quantity, underlying
asset, and settlement date. However, they also lack the
standardized rules and regulations of futures contracts,
making them less transparent and potentially less liquid.
✓ Forward contracts can be useful for hedging specific needs or
speculating on niche assets not covered by standardized
futures contracts but require careful consideration due to the
increased counterparty risk and reduced transparency.
Options:
✓ An option contract grants the holder the right, but not the
obligation, to buy (call option) or sell (put option) an
underlying asset at a predetermined price (strike price) by a
specific date (expiry date).
✓ Unlike futures contracts, which bind both parties to fulfill the
agreement, options offer flexibility. The holder can choose to
exercise the right to buy or sell the asset at the strike price, or
let the option expire worthless. This provides a way to
speculate on the future price of the asset with limited
downside risk.
✓ Call options are used to profit from anticipated price
increases, while put options benefit from price decreases.
✓ Options are also utilized for hedging existing holdings by
locking in a buying or selling price. Understanding their
intricacies and potential benefits is crucial for navigating the
dynamic world of equity markets.
Swaps:
✓ A swap contract is a customized agreement between two
parties to exchange cash flows based on the performance of
different underlying assets.
✓ Imagine two farmers: one with fertile land and the other with
abundant water. They could enter a swap agreement, where
the farmer with fertile land agrees to pay the other farmer a
fixed amount of corn in exchange for a variable amount of
water, based on rainfall levels. This allows each farmer to
manage their risk and ensure their resources are optimized.
✓ Similarly, swap contracts allow investors and businesses to
exchange interest rate payments, currency exchange rates, or
other financial instruments to achieve specific goals, such as
managing interest rate risk, speculating on currency
movements, or gaining exposure to assets without directly
owning them.
✓ The key features include customization, exchange of cash
flows, and underlying asset dependence, making them
versatile tools for risk management and portfolio
diversification.
Long call:
This means you have bought a call option contract, giving you the
right, but not the obligation, to buy a specific underlying asset at a
predetermined price (strike price) by a specific date (expiry date).
You are optimistic about the underlying asset's future price and
hope it will rise above the strike price before expiry.
Short call:
This means you have sold a call option contract, giving another
party the right to buy the underlying asset from you at the strike
price by the expiry date. You are neutral or bearish on the asset's
price and expect it to remain below the strike price or even decline.
Long put:
This means you have bought a put option contract, giving you the
right, but not the obligation, to sell a specific underlying asset at a
predetermined price (strike price) by a specific date (expiry date).
You are pessimistic about the underlying asset's future price and
hope it will fall below the strike price before expiry.
Short put:
This means you have sold a put option contract, giving another
party the right to sell the underlying asset to you at the strike price
by the expiry date. You are neutral or bullish on the asset's price
and expect it to remain above the strike price or even increase.

Here's a table summarizing the key differences:

Option Type Long Short
Call Right to buy Obligation to sell
Put Right to sell Obligation to buy
Position Optimistic Neutral/Bearish
Position Pessimistic Neutral/Bullish

It's important to remember that derivatives can be complex and

carry significant risks. They're not suitable for all investors and
require thorough research and understanding before diving in.

ATM (At the Money):

An option is considered ATM when its strike price is equal to the
current market price of the underlying asset. In this case, the option
has no intrinsic value but still has time value, as there is still a
chance it will become profitable before expiration.
ITM (In the Money):
An option is considered ITM when its strike price is lower than the
current market price for a call option, or higher than the current
market price for a put option. In this case, the option has both
intrinsic and time value.

OTM (Out of the Money):

An option is considered OTM when its strike price is higher than
the current market price for a call option, or lower than the current
market price for a put option. In this case, the option only has time
value, as it is currently unprofitable to exercise.

Implied Volatility (IV):

IV is a market-derived estimate of the future volatility of an
underlying asset. It is calculated using the Black-Scholes options
pricing model and is a key determinant of option prices. Higher IV
leads to higher option prices, and vice versa.

Open Interest (OI):

OI represents the total number of open contracts for a particular
option at a specific strike price and expiration date. It measures the
level of market activity for that specific option. High OI indicates a
liquid option with readily available buyers and sellers, while low OI
indicates less liquidity and potentially wider bid-ask spreads.
Put-Call Ratio (PCR):
The Put-Call Ratio (PCR) is a technical indicator used to gauge the
sentiment of the options market and its potential direction. It is
calculated by dividing two values:
Put Volume: The total number of put options traded during a
specific period (e.g., day, week).
Call Volume: The total number of call options traded during the
same period.
Interpreting the PCR:
PCR > 1: This indicates a higher volume of puts being traded than
calls, suggesting a bearish sentiment in the market. Traders are
more interested in protecting themselves from potential downside
risk than profiting from an upward move.
PCR < 1: This indicates a higher volume of calls being traded than
puts, suggesting a bullish sentiment in the market. Traders are
more optimistic about the future price of the underlying asset and
are looking to profit from potential upside moves.
PCR ≈ 1: This indicates a neutral sentiment, with roughly the same
number of puts and calls being traded. This suggests that the
market is unsure of the future direction and there is no clear bias
to either the upside or downside.
While the PCR can provide valuable insights into market sentiment,
it is important to note that it should not be considered the sole
factor in making trading decisions. Other technical and
fundamental factors should also be analyzed to gain a more
comprehensive view of the market.
Additional points:
✓ The PCR can be calculated for individual stocks, indices, or the
entire market.
✓ The interpretation of the PCR may vary depending on the
underlying asset and the current market conditions.
✓ High PCR values can sometimes signal potential market tops,
while low PCR values can signal potential market bottoms.
✓ The PCR can be combined with other technical indicators to
develop more complex trading strategies.