A derivatives market is a market where derivatives are bought and sold by investors.
A derivative is a financial contract, the value of which, is derived from an underlying asset (share, commodity, currency, security etc.). If the value of underlying asset declines the value of the derivative also decreases and vice versa.
An option is a right, but not an obligation; to buy or sell something on a specified date and at a specified price. In the securities market, It is a contract between two parties, an option buyer and an option seller or writer in which the seller gives the buyer an option to buy or sell a specified number of shares in the future at an agreed price.
An option contract contains:
- The name of the company whose shares are to be bought or sold
- The number of shares to be bought or sold
- The purchase price or striking price at which shares bought, the selling price or the striking price at which shares are sold
- The expiration date of the option/contract
Parties involved in option trading:
- Option Seller or Writer – The one who provides the option to buy or sell something in return for a premium on its price.
- Option Buyer – The one who pays the price for an option.
- Broker/Agent – The one links options buyers with option sellers in return for a fee or commission.
Types of Options:
- Call Option – A contract that gives the owner the right to buy an asset or security.
- Put Option – A contract that gives the owner the right to sell an asset or security.
A future is a financial contract which derives its value from the underlying assets. They may be Commodity Futures or Financial Futures. While the former involves commodities like sugarcane or wheat the latter involves foreign currencies, interest rate and market index futures. Market index futures are directly related to the stock market.
Future markets aim to solve the problems of trading, liquidity and counter party risk which are achieved through standardised contracts, centralized trading and settlement through clearing houses. A forward market lacks these three features.
In a Forward contract, two parties mutually agree to buy or sell a specific quantity of an underlying asset on a future date at a specified price. No monetary transactions are involved at the time of signing of contract. A forward contract safeguards and eliminates the risk of fall in prices in the future. Such a contact is not tradable, there is no centralization of trade and no third party guarantee is involved in the contract. Hence, if a party to contract declares bankruptcy, the other party suffers the loss.