This article introduces the concept of derivatrives and explains their utility. It also explains futures and options in detail.

What is a derivative? The textbook definition of a derivative is: A derivative is an instrument whose value depends on an underlying. What does it mean in simple terms? Well, the word is kind of self explanatory – the value of a derivative is derived from the value of something. This something is called the Underlying of the derivative.

So, for stock derivatives, the price of the shares of a particular company is the underlying. For an index derivative, the value of the index is the underlying. And for a crude oil derivative, the price of crude oil is the underlying.

As and when the price of the underlying changes, the value of the derivative based on it also changes. Of course, the price also depends on the demand and supply for that derivative, but the primary driver of the price of a derivative is the price of the underlying.

Various Underlying Assets

Markets are very creative! There are people everywhere who spot opportunity to earn money from innovative sources, and therefore, derivatives are available for almost anything!

The primary focus of this article would be derivatives based on equities and equity indices. But the other derivatives available are: Commodity derivatives (crude oil, cotton, etc), bullion derivatives (gold, silver, etc), weather derivatives, and many more.

Types of Derivatives

There are many types of derivatives, but let me talk about the two basic derivatives traded in India.

Futures

This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon today for a given asset.

At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided quantity of the given asset at the pre-decided price. Similarly, the seller of the futures contract gives the delivery of the pre-decided quantity of the given asset at the pre-decided price.

In a futures contract, both the buyer and seller are bound to honour their commitment – the buyer has to take delivery, and the seller has to make delivery according to the terms of the contract.

Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the pre-decided price. And even if the price goes up, the seller has to give the seller at the pre-decided price.

Cost: There is no upfront cost involved in the purchase of a futures contract, apart from brokerage.

Example: A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry date is 3 months away.

Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of Reliance Industries to B at Rs. 3200.

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