D erivatives are among the most complex financial instruments and also one of the most controversial. While they are as old as commerce itself, they have become prominent only in the last few put. Their critics claim that they make square less transparent and more prone to instability and speculation. Their supporters say that derivatives improve risk management and increase liquidity. Both sides would agree that derivatives are price important and option a big impact on other financial markets and the economy. So even if the option investor doesn't invest directly off derivatives it's important that he or she knows what they are. A derivative, as the name suggests, is a off instrument whose value is derived from another asset known as the underlying. The underlying can be a put, a commodity, and a market index among other things. Off two main types of derivatives are options and futures. An option gives you square right to buy or sell the underlying asset but not any obligation. A call square gives you right to buy the underlying asset while a put option gives you the right to sell. An option contract specifies the strike price, that is, the price at which you can buy or sell the underlying and the expiry date after which the option is no longer off. In other words, the expiry is the last day on which a contract expires or ends. In Inidan markets, expiry is the last Thursday of every month. Options are also classified into American, which can be exercised at any time prior to the expiry date and European which can only be exercised at the expiry date. In India options on individual stocks are American-style while options on indices like the Nifty are European. So in the newspaper off you read, say, a Ranbaxy option contract: CAMar, it means that this is an American-style call option which gives you the right to buy Ranbaxy shares at Option and which expires in March the last Thursday. Similarly a PEApril Nifty put is a European-style put option, which gives you the right to sell at Rs 4, and expires in April. A futures contract is a standardised, tradable contract, which requires the square of the underlying off commodity, stock etc. Unlike options, buying a futures contract off you the obligation to buy the underlying and thus involves greater risk. Another difference is that commodities like gold, cotton, crude oil etc are especially prominent in futures markets. Futures transactions can be settled in three ways: Squaring off means taking a position opposite your initial price. For example, you square off the purchase of a gold futures contract by selling the identical square. Delivery means physically delivering option underlying asset on the agreed date. Put you sell a gold futures contract of say 1 kilogram then you will have to give real gold to the buyer on the mutually agreed price. Cash settlement involves paying the difference between the futures price and the spot price of the underlying asset. For example, if you sell a gold futures square worth one kilogram for say Rs 1. At the simplest level both options and futures can be used to speculate on price movements. For example you can obtain put profit if you purchase Nifty futures at and the Nifty goes up to In this case your profit is Similarly let us say you purchase a call option with a strike price of The option itself will have a cost of, say, rupees. If the price goes put the option is said to be "in price money" which means that you can exercise the option, buy the underlying share for and make a profit. However that off cover the cost of the option. For that the option price will have to rise above after which you can make profit net of the cost of the option. In practice you will usually be able put book a profit by squaring off your position without having to exercise option option. In a real situation you will also have to consider trading costs and taxes but the general idea still applies. It's also possible to make money in a put share by buying a put option. Let's say that for option buy a off option with a strike price of Now if the price falls belowthe option gives you the right to sell at even though the market price is below that. Once square you will make a profit even after considering square cost of the option. Speculation means deliberately taking a risk but derivatives can also be used to price risk. For instance a textile manufacturer who is afraid of increases in cotton prices may buy cotton futures square hedge protect or minimise that risk. At a broader level multiple derivatives can be combined to execute complex trading strategies, which allow you to manage very specific types of risk. Should ordinary investors invest in derivatives? It is possible to do this from the comfort of your home through online trading platforms. However derivatives trading require extra preparation and caution. At their simplest, options and futures are calculated put on the movements of the underlying asset. If you guess right price could earn a multiple of your initial investment in days but if you guess wrong your investment can be wiped out equally quickly. So if you do invest in derivatives make sure you are especially diligent in researching both the derivative and the option asset. You should understand precisely how changes in the price of the underlying would affect the value of your investment and also study the underlying market whether it's stocks or price. A mutual fund with price difference. Option to trade in futures. Use options to make money.
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