Derivatives are a category of financial instruments that have their price based on or derived from a different asset.

Here, the financial instrument is the underlying asset (such as stock issued by a company or a commodity, or a currency or an index), on which the price of the derivative is based. The value of the derivative instrument also changes, when the value of an underlying asset changes. The trading of a derivative instrument is independent of the underlying asset.

Derivatives are of two types -- exchange-traded derivatives and over the counter derivatives.

Exchange-traded derivatives are those traded through organized exchanges the world over. Derivative instruments can be traded on these exchanges, just like the stocks of a company. Futures and Options are among the commonly traded derivative instruments on the exchange.

Over the counter or OTC derivatives are not standardized and they are not traded on exchanges. Forwards, Swaps, Swaptions, etc. are some of the popular OTC instruments.

Basis.

The difference in price between the spot price of an underlying asset with the futures market is termed 'Basis'. ('spot market' is for immediate delivery) When the basis is negative, it means that the price of the asset in the futures market is more than its price in the spot market. The higher price is due to the cost of interest, storage, insurance premium, etc. When an asset is bought at the current price all these expenses incur, and this can be avoided if a futures contract is bought. This negative condition of basis is called as 'Contango'.

At times it may be more profitable to hold the asset in the physical form, than in the form of a futures contract. To give an example, you will receive dividends for the equity shares held in your account, but if hold it as equity futures, you are not eligible.

The basis becomes positive (the price of the asset in the spot market is more than in the futures market) when the benefits exceed the expenses associated with the holding of the asset. Such a condition is termed as 'Backwardation'. This usually happens if the asset price is expected to fall. The 'futures' and 'spot' price tend to close their gap as the futures contract approaches its maturity, and the basis eventually becomes zero.

Futures.

'Futures' is a contract to buy or sell an underlying asset for a specified price at a pre-determined time. When a futures contract is bought, the buyer promises to pay the price of the asset at a specified time. The seller of a futures contract effectively makes a promise to transfer the asset to the buyer at a specified price and time. All futures contracts have the following features:

• Buyer
• Seller
• Price
• Expiry

Equity Stocks, Indices, Commodities, and Currency are examples of the assets on which futures contracts are made.

Options.

Options contracts give the holder of the instrument the right to buy or sell the underlying asset at a pre-decided price. In an options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has the obligation but no right. As the seller of the contract has the obligation, he is paid a 'premium' which is the price of the options contract.

The option could either be a 'call' option or a 'put' option.

Through a ‘Call’ option, the buyer gets the right to buy the asset, at a given price which is also called the 'strike price'. The holder of the call option has the right to demand the sale of an asset from the seller, the seller has the obligation to sell and not the right. In other words, if the buyer wants to buy the asset, the seller has to sell it. He does not have a right.

Similarly, the buyer of a 'Put' option gets the right to sell the asset at the 'strike price' to the option seller. Here the option buyer has the right to sell and the option seller has the obligation to buy.

If the person who buys a Call option finds the spot price of the asset to be less than the strike price, then he will not choose to exercise his option to buy. For example, let us say ‘A’ bought a Call at a strike price of Rs 500. Now let us say that on the expiry date the price of the asset is Rupees 450. Then, 'A' will not exercise his option to buy simply because the same asset can be bought from the market at Rs 450 instead of purchasing it at Rupees 500 from the seller of the option.

As in the case of the above example, the buyer of a Put option will forego his option (to sell) if, on expiry, the spot price of the asset is more than the strike price of the call. Let us say that ‘B’ bought a Put at a strike price of Rupees 600, and on expiry, the price of the asset is Rupees 619. Then in this case, ‘B’ will not exercise his option to sell simply because he can sell the same asset in the market at Rs 619, rather than selling it at Rupees 600 to the seller of the option.