## Derivatives

#### What are Derivatives?

The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else.

In other words, derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act, 1999, derivatives have been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act. The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion etc.

#### What are the different types of Derivatives?

Forwards, Futures and Options are the different types of Derivatives.

#### What is meant by a Forward Contract?

A forward contract is a customized non-standardized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. These are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is a high counterparty risk i.e. a chance that a party may default on its side of the agreement.

#### What is meant by a Futures Contract?

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. **The contract expires on a pre-specified date which is called the expiry date of the contract**. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.

#### What is meant by an Option Contract?

Options Contract in trading is a type of Derivatives Contract which gives Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option purchases the right from the seller/writer for a consideration which is called ‘Premium’. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined.

#### What are the different types of Options?

**Call Option**: When any option contract grants the buyer the right to purchase the underlying asset from the writer or seller, it is called call option or simply "Call"**Put Option**: When the option buyer has the right to sell the underlying asset to the writer, then it is called Put Option or "Put" An option contract can also be categorized on the basis of when the option buyer exercises it, as follows:**American Option**: A contract with American option entitles buyer to exercise it any time up to expiry date**European Option**: When an option can be exercised on only the expiration date, then it is called the European Option**Bermuda Option**: An Option which can be exercised before the expiry date but only on certain specified dates, then that’s called a Bermuda Option

#### What is meant by a Strike Price?

The strike price (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity.

#### What is meant by In-the-money, At-the-money and Out-of-the-money options?

**In-the-money option**is an option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.**At-the-money Option**is an option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.**Out-of-the-money**Option is an option that has no intrinsic value. That is an option which theoretically, it would not be worthwhile to exercise immediately e.g. a call option whose exercise price is above the current underlying share price or a put option whose exercise price is below the current underlying share price.

#### Define Intrinsic Value of an Option?

The amount, if any, by which an option is currently in the money. An option that is not in-the-money has no intrinsic value.

#### Define Time Value of an Option?

The amount, if any, by which an option's premium exceeds its intrinsic value. If an option is not in the money, its premium consists entirely of time value.

#### What is meant by Open Interest?

It is the net long and short amount of outstanding positions in a particular contract.

#### Who is a Writer of Options?

The Writer is the seller of an option contract who is obliged to deliver or take delivery of the underlying instrument upon notification by the buyer (holder).

#### What is meant by a Straddle?

It is the simultaneous purchase (sale) of a call and put option in the same expiry month with the same exercise price.

#### What is meant by a Strangle?

It is the simultaneous purchase (sale) of a call option at one exercise price and a put option at a lower exercise price but with the same expiry date.

#### What are the different options Greeks?

Options traders often refer to the delta, gamma, vega and theta of their option positions. Collectively, these terms are known as the "Greeks" and they provide a way to measure the sensitivity of an option's price to quantifiable factors.

#### What is Delta in options trading?

(Delta) represents the rate of change between the option's price and a $1 change in the underlying asset's price – in other words, price sensitivity. Delta of a call option has a range between zero and one, while the delta of a put option has a range between zero and negative one. For example, assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option's price would theoretically increase by 50 cents, and the opposite is true as well.

#### What is a delta hedge?

Delta hedging is an options strategy that aims to reduce, or hedge, the risk associated with price movements in the underlying asset, by offsetting long and short positions. For example, a long call position may be delta hedged by shorting the underlying stock.

#### What is Gamma in options trading?

(Gamma) represents the rate of change between an option portfolio's delta and the underlying asset's price - in other words, second-order time price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. For example, assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option's delta would increase or decrease by 0.10.

#### What is Theta in options trading?

(Theta) represents the rate of change between an option portfolio and time, or time sensitivity. Theta indicates the amount an option's price would decrease as the time to expiration decreases. For example, assume an investor is long an option with a theta of -0.50. The option's price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option's value would theoretically decrease by $1.50.

#### What is Vega in options trading?

Vega represents the rate of change between an option portfolio's value and the underlying asset's volatility - in other words, sensitivity to volatility. Vega indicates the amount an option's price changes given a 1% change in implied volatility. For example, an option with a Vega of 0.10 indicates the option's value is expected to change by 10 cents if the implied volatility changes by 1%.

#### What is Rho in options trading?

(Rho) represents the rate of change between an option portfolio's value and a 1% change in the interest rate, or sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options.

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