Futures faq, Options faq, frequently asked questions on futures & options

- Learn more about futures & options.
- 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, live stock 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.
  
  Derivative includes: -
  1. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
  2. a contract which derives its value from the prices, or index of prices, of underlying securities;
  
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  What is 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.
  
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  What is an Option contract?
  
  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 the 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.
  
  Under Securities Contracts (Regulations) Act,1956 options on securities has been defined as "option in securities" meaning a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities.
  
  An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.
  
  Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame.
  
  As in the case of futures contracts, option contracts can be also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract.
  
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  What are Index Futures and Index Option Contracts?
  
  Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index.
  
  Similarly, the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.
  
  An index, in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectoral indices.
  
  In the beginning futures and options were permitted only on S&P; Nifty and BSE Sensex. Subsequently, sectoral indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the index has begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be discontinued.
  
  By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry.
  
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  Why mini derivative contract?
  
  The minimum contract size for the mini derivative contract on Index (Sensex and Nifty) is Rs. 1 lakh at the time of its introduction in the market. The lower minimum contract size means that smaller investors are able to hedge their portfolio using these contracts with a lower capital outlay. This means a better hedge for portfolio, and also results in more liquidity in the market.
  
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  Why longer dated index options?
  
  Longer dated derivatives products are useful for those investors who want to have a long term hedge or long term exposure in derivative market. The premiums for longer term derivatives products are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. Presently, longer dated options on Sensex and Nifty with tenure of upto 3 years are available for the investors.
  
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  What is Bond Index?
  
  A bond index is used to measure the performance of bond markets. The index is used as a benchmark against which investment managers measure their performance. It is also used as a measure to compare the performance of different asset classes. The government bond market is the most liquid segment of the bond market.
  
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  What is Volatility Index?
  
  Volatility Index is a measure of expected stock market volatility, over a specified time period, conveyed by the prices of stock / index options. It depicts the collective sentiment of the market on the implied future volatility.
  
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  What is the structure of Derivative Markets in India?
  
  Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organisation (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.
  
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  Which derivative contracts are permitted by SEBI?
  
  Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced in June 2003 and exchange traded interest rate futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004. During December 2007 SEBI permitted mini derivative (F&O;) contract on Index (Sensex and Nifty). Further, in January 2008, longer tenure Index options contracts and Volatility Index and in April 2008, Bond Index was introduced. In addition to the above, during August 2008, SEBI permitted Exchange traded Currency Derivatives.
  
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  What is the eligibility criteria for stocks on which derivatives trading may be permitted?
  
  A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria:-
  
  a) The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis.
  
  b) The stock’s median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock’s quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.
  
  c) The market wide position limit in the stock shall not be less than Rs.50 crores.
  
  A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued.
  
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  What is the lot size of contract in the equity derivatives market?
  
  Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying.
  
  For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
  
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  What is corporate adjustment?
  
  The basis for any adjustment for corporate action is such that the value of the position of the market participant on cum and ex-date for corporate action continues to remain the same as far as possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-the-money and out-of-the-money. Any adjustment for corporate actions is carried out on the last day on which a security is traded on a cum basis in the underlying cash market. Adjustments mean modifications to positions and/or contract specifications as listed below:
  
  a) Strike price
  b) Position
  c) Market/Lot/ Multiplier
  
  The adjustments are carried out on any or all of the above based on the nature of the corporate action. The adjustments for corporate action are carried out on all open, exercised as well as assigned positions. The corporate actions are broadly classified under stock benefits and cash benefits. The various stock benefits declared by the issuer of capital are:
  
  1) Bonus
  2) Rights
  3) Merger/ demerger
  4) Amalgamation
  5) Splits
  6) Consolidations
  7) Hive-off
  8) Warrants, and
  9) Secured Premium Notes (SPNs) among others
  
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  What is the margining system in the equity derivatives market?
  
  Two type of margins have been specified -
  
  a) Initial Margin - is adjusted from the available Liquid Networth of the Clearing Member on an online real time basis.
  b) Mark to Market Margins-
  
  Futures contracts: The open positions (gross against clients and net of proprietary / self trading) in the futures contracts for each member are marked to market to the daily settlement price of the Futures contracts at the end of each trading day. The daily settlement price at the end of each day is the weighted average price of the last half an hour of the futures contract. The profits / losses arising from the difference between the trading price and the settlement price are collected / given to all the clearing members.
  
  Option Contracts: The marked to market for Option contracts is computed and collected as part of the SPAN Margin in the form of Net Option Value. The SPAN Margin is collected on an online real time basis based on the data feeds given to the system at discrete time intervals.
  
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  What are the exposure limits in equity derivatives market?
  
  It has been prescribed that the notional value of gross open positions at any point in time in the case of Index Futures and all Short Index Option Contracts shall not exceed 33 1/3 (thirty three one by three) times the available liquid networth of a member, and in the case of Stock Option and Stock Futures Contracts, the exposure limit shall be higher of 5% or 1.5 sigma of the notional value of gross open position.
  
  In the case of interest rate futures, the following exposure limit is specified:
  a) The notional value of gross open positions at any point in time in futures contracts on the notional 10 year bond should not exceed 100 times the available liquid networth of a member.
  b) The notional value of gross open positions at any point in time in futures contracts on the notional T-Bill should not exceed 1000 times the available liquid networth of a member.
  
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  What are Currency Futures?
  
  Currency futures are contracts to buy or sell a specific underlying currency at a specific time in the future, for a specific price. Currency futures are exchange-traded contracts and they are standardized in terms of delivery date, amount and contract terms.
  
  Currency future contracts allow investors to hedge against foreign exchange risk. Since these contracts are marked-to-market daily, investors can--by closing out their position--exit from their obligation to buy or sell the currency prior to the contract's delivery date.
  
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  What are the eligibility criteria for members of the currency futures segment?
  
  The trading member is subject to a balance sheet networth requirement of Rs. 1 crore while the clearing member is subject to a balance sheet networth requirement of Rs. 10 crores. The clearing member is subject to a liquid networth requirement of Rs. 50 lakhs.
  
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  What measures have been specified by SEBI to protect the rights of investor in Derivatives Market?
  
  The measures specified by SEBI include:
  
  a) Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor.
  
  b) The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
  
  c) Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member.
  
  d) In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.
  
  e) The Exchanges are required to set up arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.
  
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Frequently Asked Questions