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You Need to Know About Derivatives Trading

Investing in the stock markets is the best hope of enhancing


one’s wealth. If you’ve tinkered around in the share markets or
tried your hand at investing, you’ve most likely come across the
term “derivatives”. In simple terms a derivative is a financial
instrument whose value depends upon the characteristics and
value of an underlying asset such as a commodity, bond, equity
or currency. Since the time the derivatives were introduced in
the year 2000, its popularity among the Indian investors.

Why invest in derivatives?


Derivatives are a good alternative to trade if you want to trade
outside of the traditional stocks and bonds. Derivatives allow
you to make profits by betting on the future value of the
underlying assets. Derivatives prove to be exceedingly beneficial
because they help you to make additional profits by accurately
guessing the future price as well as act as a buffer in case of
losses while trading. They typically pay off over a period of time
based on the performance of assets, interest rates, exchange
rates, or indices. Apart from stock markets, derivatives can also
be traded in the money market and foreign exchange.

Types Of Derivatives

What are the types of derivatives?


Derivatives can be classified into two broad categories: futures
and options. An option derivative gives the buyer the right to
buy (or sell) a certain asset at a specific price at any time during
the life of the contract. A futures contract gives the buyer the
obligation to purchase a specific asset, and the seller to sell and
deliver that asset at a specific future date.

How derivatives trading works?


Derivatives trading involves a simple buying and selling process.
The only difference being payment of a marginal sum as
opposed to the entire amount. For instance, if you want to buy
100 contracts of Nifty 50 October futures with a value of 5000,
with the margin of 5%, you do not have to pay the entire Rs 5,
00,000, but only Rs 25,000.

How to start investing in derivatives?


Derivative instruments can be availed through registered
trading members of stock exchanges such as brokerage firms. If
you are a first time investor, you need to fill up a KYC (Know
Your Client) Form. After the form is processed, you will be
allotted with a client identification number proceeding which
you need to deposit cash to initiate trade

Derivative
REVIEWED BY JAMES CHEN

Updated Mar 13, 2019


What is a Derivative
A derivative is a financial security with a value that is reliant upon, or derived
from, an underlying asset or group of assets. The derivative itself is a contract
between two or more parties, and its price is determined by fluctuations in the
underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates and market
indexes.

Melissa Ling {Copyright} Investopedia, 2019.


These assets are commonly purchased through a variety of brokerages. You
can check out Investopedia's list of the best online brokers to see some of the
top places to start investing.
Derivatives can either be traded over-the-counter (OTC) or on an exchange.
OTC derivatives constitute the greater proportion of derivatives and are not
standardized. Meanwhile, derivatives traded on exchanges are standardized
and more heavily regulated. OTC derivatives generally have greater
counterparty risk than standardized derivatives.

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Derivative: My Favorite Financial Term

BREAKING DOWN Derivative


Originally, derivatives were used to ensure balanced exchange rates for
goods traded internationally. With differing values of national currencies,
international traders needed a system to account for these differences. Today,
derivatives are based upon a wide variety of transactions and have many
more uses. There are even derivatives based on weather data, such as the
amount of rain or the number of sunny days in a region.

There are many different types of derivatives that can be used for risk
management or for speculation. For example, imagine a European investor
who purchases shares of a U.S. company through a U.S. exchange using
U.S. dollars. This investor is exposed to exchange-rate risk while holding that
stock. If the value of the euro rises relative to the dollar, the investor's profits in
dollar terms are less valuable when those profits are converted back into euro
once the stock is sold. To hedge this risk, the investor could purchase a
currency derivative to lock in a specific exchange rate. Derivatives that could
be used to hedge this kind of risk include futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could
profit by using a derivative that rises in value with the euro. When using
derivatives to speculate on the price movement of an underlying asset, the
investor does not need to have an interest in the underlying asset.

Many derivative instruments are leveraged. That means a small amount


of capitalis required to have an interest in a large amount of value in the
underlying asset. For example, an investor who expects the S&P 500 stock
index to rise in value could buy a futures contract based on that asset.
The notional value of a futures contract on the S&P 500 is $250,000, but
the Chicago Mercantile Exchange (CME) only required $30,000 in
a margin balance to maintain a long position in the derivative in 2018. This
gives the futures investor a leverage ratio greater than 8:1. The required
margin to hold a futures or derivative position changes depending on market
conditions and broker requirements.

Common Forms of 'Derivative' Futures


Futures contracts are one of the most common types of derivatives. A futures
contract (or simply, futures) is an agreement between two parties for the
purchase and delivery of an asset at an agreed upon price at a future date.
Futures are exchange-traded, and the contracts are standardized. Traders will
use a futures contract to hedge their risk or speculate on the price of an
underlying asset.

For example, on Nov. 6, Company-A buys a futures contract for oil at a price
of $62.22 per barrel that expires on Dec. 19, 2018. The company wants to do
this because it needs oil in December and is concerned that the price will rise
before the company actually needs to make the purchase. Buying an oil
futures contract hedges the company's risk because the seller on the other
side of the contract is obligated to deliver oil to Company-A for $62.22 per
barrel once the contract has expired. Assume oil prices rise to $80 per barrel
by Dec. 19, 2018. Company-A can accept delivery of the oil from the seller of
the futures contract, but if it no longer needs the oil, it can also sell the
contract before expiration and keep the profits.

In this example, it is possible that both the futures buyer and seller were
hedging risk. Company-A needed oil in the future and wanted to offset the risk
that the price may rise in December with a long position in an oil futures
contract. The seller could be an oil company that was concerned about falling
oil prices and wanted to eliminate that risk by selling or "shorting" a futures
contract that fixed the price it would get in December.

It is also possible that the seller or buyer (or both) of the oil futures contract
were speculators with the opposite opinion about the direction of oil in
November and December. If the parties involved in the futures contract were
speculators, it is unlikely that either of them would want to make arrangements
for delivery or shipment of crude oil. Speculators can end their obligation to
purchase or deliver the underlying commodity by closing their contract before
expiration.

The futures contract for West Texas Intermediate (WTI) oil that trades on the
CME represents 1,000 barrels of oil. In this example, if the price of oil rose
from $62.22 to $80 per barrel, the trader with the long position (buyer) in the
futures contract would have profited $17,780 [($80 - $62.22) X 1,000 =
$17,780], and the trader with the short position (seller) in the contract would
have lost $17,780.

Not all futures contracts are settled at expiration by delivering the underlying
asset. Many derivatives are cash-settled, which means that the gain or loss in
the trade is a positive or negative cash flow to the trader. Futures contracts
that are cash settled include many interest rate futures, stock index futures,
and more unusual instruments like volatility futures or weather futures.

Forwards
Forward contracts are an important kind of derivative similar to futures. Unlike
futures, forward contracts (or "forwards") are not traded on an exchange, only
over-the-counter. When a forward contract is created, the buyer and seller
may have customized the terms, size and settlement process for the
derivative. The buyers and sellers of forward contracts also have counterparty
risks.

Counterparty risks are a kind of credit risk in that the buyer or seller may not
be able to live up to the obligations outlined in the contract. If one party of the
contract becomes insolvent, the other party may have no recourse and could
lose the value of its position. Once created, the parties in a forward contract
can offset their position with other counterparties, which can increase the
potential for counterparty risks as more traders become involved in the same
contract.

Swap
Swaps are another common type of derivative that is often used to swap one
kind of cash flow with another. For example, one might use an interest rate
swap to switch from a variable interest rate loan to a fixed interest rate loan, or
vice versa.

Imagine that InvestCo, Inc. has borrowed $1,000,000 and pays a variable
rate of interest on the loan that is currently 6%. InvestCo may be concerned
about rising interest rates that will increase the costs of this loan or encounter
a lender that is reluctant to extend more credit while InvestCo has this variable
rate risk.

Assume that InvestCo creates a swap with FixedCo, Inc., which is willing to
exchange the payments owed on the variable rate loan for the payments owed
on a fixed rate loan of 7%. That means that InvestCo will pay 7% to FixedCo
on $1,000,000 principal, and FixedCo will pay InvestCo 6% interest on the
same principal. At the beginning of the swap, InvestCo will just pay FixedCo
the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%,
InvestCo will have to pay FixedCo the 2% difference on the loan. If interest
rates rose to 8%, then FixedCo would have to pay InvestCo the 1% difference
between the two swap rates. Regardless of how interest rates change, the
swap has achieved InvestCo's original objective of turning a variable rate loan
into a fixed rate loan.

Swaps can also be constructed to exchange the risk of default on a loan or


cash flows from other business activities. Swaps related to the cash flows and
potential defaults of mortgage bonds are an extremely popular kind of
derivative. The counterparty risk of swaps like this eventually spiraled into the
credit crisis of 2008.
Options
Options are another common form of derivative. An option is similar to a
futures contract in that it is an agreement between two parties to buy or sell an
asset at a predetermined future date for a specific price. The key difference
between options and futures is that, with an option, the buyer is not obligated
to "exercise" the option, while the option seller is obligated to either buy or sell
the underlying asset if the buyer chooses to exercise the contract. As with
futures, options may be used to hedge or speculate on the price of the
underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share that she
believes will rise in value in the future. However, this investor is concerned
about potential risks and decides to hedge her position with an option. The
investor could buy a put option that gives her the right to sell 100 shares of
stock for $50 per share (strike price) until a specific day in the future
(expiration date).

Assume that the stock falls in value to $40 per share by expiration and the put
option buyer decides to exercise her option and sell the stock for the original
strike price of $50 per share. If the put option cost the investor $200 to
purchase, then she has only lost the cost of the option ($200) because the
strike price was equal to the price of the stock when she originally bought the
put option. A strategy like this is called a "protective put" because it hedges
the stock's downside risk.

Alternatively, assume an investor does not own the stock that is currently
worth $50 per share; however, he believes that the stock will rise in value over
the next month. This investor could buy a call option that gives him the right to
buy the stock for $50 before or at expiration. Assume that this call option cost
$200 and the stock rose to $60 before expiration. The call buyer can now
exercise his option and buy a stock worth $60 per share for the $50 strike
price, which is an initial profit of $10 per share. A call option represents 100
shares, so the real profit is $1,000 less the cost of the option for a net profit of
$800.

In both examples, the put and call sellers are obligated to fulfill their side of the
contract if the call or put option buyer chooses to exercise the contract.
However, if a stock's price is above the strike price at expiration, the put will
be worthless and the seller gets to keep the premium as the option expires. If
the stock's price is below the strike price at expiration, the call will be
worthless and the call seller will keep the premium. Some options can be
exercised before expiration (so-called "American-style" options), but early
exercise is rare.

Limitations of Derivatives
Derivatives are difficult to value because they are based on the price of
another asset. The risks for OTC derivatives include counterparty risks that
are difficult to predict or value as well. Most derivatives are also sensitive to
changes in the amount of time to expiration, the cost of holding the underlying
asset and interest rates. These variables make it difficult to perfectly match
the value of a derivative with the underlying asset. For example, it is possible
for the supply and demand of a derivative to cause it to rise and fall in value
regardless of what is happening with the price of the underlying asset.

Derivatives Summary
Derivatives are a security that derive their value from an underlying asset or
benchmark. Common derivatives include futures contracts, options and
swaps. Most derivatives are not traded on exchanges and are used by
institutions to hedge risk or speculate on price changes in the underlying
asset. Exchange-traded derivatives like futures and stock options are
standardized and eliminate or reduce many of the risks of over-the-counter
derivatives like counterparty and liquidityrisks. Derivatives are usually
leveraged instruments, which increases the potential risks and rewards of
these securities
Derivatives are tradable products that are based upon another market. This
other market is known as the underlying market. Derivatives markets can be
based upon almost any underlying market, including individual stocks (such as
Apple Inc.), stock indexes (such as the S&P 500 stock index) and currency
markets (such as the EUR/USD forex pair)

Types of Derivatives Markets

There are several general derivatives markets, each containing thousands of


individual derivatives which can be traded. Here are the main ones day
traders use:

 Futures Markets
 Options Markets
 Contract For Difference (CFD) Markets

Futures

May day traders trade the futures market. This is because there are many
different types of futures contracts to trade; many of them with
significant volume and daily price fluctuations, which is how day traders make
money. A futures contract is an agreement between a buyer to exchange
money for the underlying, at some future date.

For example, if you buy/sell a crude oil futures contract, you are agreeing to
buy/sell a set amount of crude oil at a specific price (the price you place an
order at) at some future date. You don't actually need to take delivery of the
crude oil, rather you make or lose money based on whether the contract you
bought/sold goes up or down in value relative to where you bought/sold it. You
can then close out the trade at any time before it expires to lock in your profit
or loss.

Options

Options are another popular derivatives market. Options can be very complex
or simple, depending on how you choose to trade them. The simplest way to
trade options is through buying puts or calls. When you buy a put you are
expecting the price of the underlying to fall below the strike price of the
option before the option expires. If it does, you make money, if doesn't, then
you will lose the value (or some of it) that you paid for the option.

For example, if XYZ stock is trading at $63, but you believe it fall below $60,
then you can buy a $60 put option. The put will cost you a specific dollar
amount, called the premium. If the stock goes up, you only lose the premium
you paid for the put. If the stock price goes down though then your option will
increase in value, and you can sell it for more than what you paid for it
(premium).
A call options works the same way, except when you buy a call you are
expecting the price of the underlying to rise. For example, if you think ZYZY
stock, currently trading at $58 will rally above $60, you can buy a call option
with a strike price of $60. If the stock price rises, your option will increase in
value and you stand to make more than you paid (premium). If the stock drops
instead, you only lose the premium you paid for the call option.

Contract for Difference (CFD)

Contract for difference (CFD) markets are offered by various brokers, and
therefore may differ from one broker to another. Typically they are simple
instruments though, labeled with a similar name to the underlying. For
example, if you buy a crude oil CFD, you are not actually buying into an
agreement to buy crude oil (like with a futures contract) rather you are just
entering into an agreement with your broker that if the price goes up, you
make money, and if the price goes down you lose money.

A CFD is like a "side bet" on another market.

With most CFD markets (check with your broker), if you believe the underlying
asset will rise, you buy the CFD. If you believe the underlying asset will
decline in value, then you sell or short the CFD. Your profit or loss is the
difference between the prices you enter and exit the trade at.

Final Word on Derivatives Markets

Depending on a trader's trading style, and their capital requirements, one


market may suit one trader more than another. Although one derivative market
isn't necessarily better than another. Each market requires different capital
amounts to trade, base on the margin requirement of that market.

Futures are very popular with day traders--day traders only trade within the
day and don't hold positions overnight. Options and CFDs are more popular
among swing traders--swing traders take trades that last a couple days to a
couple weeks.
Derivatives trading in India – examples, strategies and risks
Published : July 11, 2018

You can do derivatives trading in India through National stocks Exchange (the NSE), Bombay Stocks
Exchange (the BSE) in stocks. Similarly, if your interest is to trade in commodities, MCX and NCDEX are
there. The MCX stands for the Multi Commodity Exchange. While NCDEX stands for the National
Commodity and Derivatives Exchange. However, if you are willing to trade in currency, you can do it over
NSE-SX, MCX-SX. If your interest is to trade in bonds again it’s also possible through NSE platform.

In derivatives trading, you are eligible to trade in derivatives instruments through the above-mentioned
platforms. The most common type of derivatives that you can trade in India is future and
options or f&o in short. Further, the important underlying markets for stocks, commodities, treasury bills,
foreign exchange and real estate.

Before proceeding further let us understand the risks involved in derivatives trading in India.

The risk associated with derivatives trading in India

You should understand that derivatives trading carries an element of risk in it. The following points are
self-explanatory.

 Derivatives product requires a large number of funds. So it is not for you if you have limited resources.
Limited resources mean limited funds and low-risk appetite.
 Trading derivatives need expert knowledge. A high trading expertise and experience is mandatory with high-risk
tolerance.

 As a derivatives trader, you must therefore carefully consider its suitability depending upon your financial
position.

 You should accept the fact that you can lose profits. Even you can incur the loss with the execution of
derivatives trade.

 It is invariably desirable to refer carefully Model Risk Disclosure Document before beginning the derivative
trade. You can ask for this document from your broker. Also, before signing it you should read and understand
its implications. This document clearly mentions all risk associated with derivatives trading.

 Read the sample SEBI Model Risk Document and also the same document for NSE derivatives trading for
having an understanding of risk.

An understanding of derivatives trading risk with examples

Situation 1 – Derivatives trading risk with the future index

Suppose you purchased 100 Nifty 50 futures @ Rs. 10724 on May 10. The expiry date is May 28. Your
total Investment was INR 10,72,400. You paid the initial margin of INR 1,07,240. On May 28, Nifty 50
index future closes at 10678.

Your loss is (1072400 – 1067800) X 100 = INR 4,60,000. In this situation your entire initial investment
(i.e. INR 1,07,240) is lost. Additionally you need to pay INR 3,52,760 (4,60,000 – 1,07,240).

Situation 2 – Derivatives trading risk with stocks future

Now suppose you purchased 100 TCS futures @ INR 1740 on May 15. The expiry date is May 28. Your
total Investment is INR 1,74,000. You paid an initial margin of INR 17,400. On May 28, the price per
shares of TCS was INR 1800.

You gain (1800 – 1740) X 100 = INR 6000.

Situation 3 – Derivatives trading risk with index options

Suppose you buy 100 Nifty 50 call options at a strike price of INR 10,7000 on May 10. Nifty 50 index was
at 10724. Suppose you paid the premium of INR 10,000 (@INR 100 per call X 100 calls). The expiry date
of the contract is May 28. On May 28, the Nifty index closes at 10678. The call expires worthless.

You possess the entire INR 10,000 paid as premium.


Situation 4 – Derivatives trading risk with stocks option

Let us not assume that you buy 100 TCS put options at a strike price of INR 1750 on May 10. TCS share
price is at 1740. You paid the premium of INR 5,000 (@ INR 50 per put X 100 calls). The expiry date of
the contract is May 2018. On May 28, TCS shares close at INR 1800. In this case, the put option will
expire worthlessly.

You will lose the entire INR 5,000 paid as premium.

How future contracts improved derivatives trading in India?

Future contracts are similar to the forward contracts with some improvements. Forward contract derives
the values from the underlying spot prices. Under these contracts, two parties enter into an agreement to
trade at some point in future. They agree to trade at pre-specified price and time. Also, there is no
exchange of money during the time of entering the agreement. Future and forward contracts are derivatives
market instruments in India.

However, trading with the forward contracts have deep limitations like –

1. There is lack of any centralized trading mechanism,

2. No predefined settlement procedure,

3. Liquidity was always a concern, and

4. Counterparty risk is always there.

Future contracts, however, overcome all these forward contract limitations. All future contracts are
standardized. Trading in the future contract is centralized. Stocks exchanges facilitate centralized trading
mechanism in this derivatives instrument. Further, there is no counterparty risk involved with future
contracts. There is always clearing corporations behind every side of a transaction.

At present, there are five clearing corporations operational in India, namely –

1. India International Clearing Corporation (IFSC) Limited

2. Indian Clearing Corporation Ltd

3. Metropolitan Clearing Corporation of India Ltd

4. National Securities Clearing Corporation Ltd

5. NSE IFSC Clearing Corporation Limited

The other features that differentiate future from the forward contracts are –

1. The increased time to expiration does not increase the counterparty risk in future contracts, and
2. Future contract markets are highly liquid in comparison to forward markets.

There are various participants in the derivatives trading in India. Learn about the derivatives market
participants such as hedgers, arbitrageurs, and speculators in the blog.

Indian derivatives trading instruments and its type

In order to understand instruments for the derivatives market, let us concentrate over NSE platform.
Mainly two types of derivatives instruments, namely futures and options.

All future contracts have cash settlement over NSE. Any future contract is always made between two
persons. But clear corporation always takes opposite position against any order. Thus, there is always an
opposite party by default in each trade. Unlike forward contracts, in future contract money transfer takes
place during the time of entering the contract.

Similarly, while entering an option contract, the buyer of an option pays the premium. With this payment,
the buyer gets the right to exercise his option to buy at the expiration date. On the other hand, the seller of
options receives the premium. Due to this he/she is obliged to sell/buy the asset in the situation when buyer
exercises his right.

In general, options are of two types. call options and put options. All options at NSE also settle at
cash. When you buy a call option, you receive the right but not obligation to buy the asset at predefined
price and quantity at or on the future date. On the other hand, if you buy put options you get the right but
not obligation to sell the asset at predefined price and quantity at or on the future date.

Similarly, you can also write the options. When you sell a call or put options we call it as writing options.
One thing you must remember that while writing an option you receive the premium and when you buy
options you will need to pay the premium. Get yourself acquainted with equity derivatives trading
strategies for NSE with Rmoney India market intelligence.

Products of derivatives instruments at NSE

NSE has various derivatives product for the underlying stocks. You can trade on future and options of
both indices and single stocks. You can trade in Nifty 50 future, CNX IT Index, Bank Nifty index, CNX
Nifty Junior Index, and Nifty Midcap 50 index.

But you can trade only on long-dated options contract on Nifty 50. You can also have the option to trade
in some features of individual stocks and their options. Regarding options, you must remember, that all
options on individual stocks are American type of options. While all index-based options are European
options. Under American option, you can exercise your right any time up to the expiration date. While
under European option you can exercise your right only on the expiration date.
You can learn more about types of derivatives trading in India on one of my blog. In this blog, you will not
only know the various types of derivatives instruments will come to know various sources where you can
look for information on derivatives trading in India.

The 4 Basic Types of Derivatives


In the previous articles we discussed about what derivative contractsare and what are the uses of
such contracts? However, one important point needs to be noticed. Today, if a new person wants to
buy a derivative contract, they will be bewildered at the sheer amount of choice that they will have at
their disposal. There are hundreds or even thousands of types of contracts that are available in the
market. This may make it seem like a difficult and confusing task to deal with derivatives. However,
that is not the case. True, that there are hundreds of variations in the market. However, these
variations can all be traced back to one of the four categories. These four categories are what we call
the 4 basic types of derivative contracts. In this article, we will list down and explain those 4 types:

Type 1: Forward Contracts


Forward contracts are the simplest form of derivatives that are available today. Also, they are the
oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a future
date. The price at which this transaction will take place is decided in the present.

However, a forward contract takes place between two counterparties. This means that the exchange
is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit
risk. Also, before the internet age, finding an interested counterparty was a difficult proposition.
Another point that needs to be noticed is that if these contracts have to be reversed before their
expiration, the terms may not be favorable since each party has one and only option i.e. to deal with
the other party. The details of the forward contracts are privileged information for both the parties
involved and they do not have any compulsion to release this information in the public domain.

Type 2: Futures Contracts


A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures
contracts also mandate the sale of commodity at a future data but at a price which is decided in the
present.

However, futures contracts are listed on the exchange. This means that the exchange is an
intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in
any way. Exchange contracts come in a pre-decided format, pre-decided sizes and have pre-decided
expirations. Also, since these contracts are traded on the exchange they have to follow a daily
settlement procedure meaning that any gains or losses realized on this contract on a given day have
to be settled on that very day. This is done to negate the counterparty credit risk.

An important point that needs to be mentioned is that in case of a futures contract, they buyer and
seller do not enter into an agreement with one another. Rather both of them enter into an agreement
with the exchange.

Type 3: Option Contracts


The third type of derivative i.e. option is markedly different from the first two types. In the first two
types both the parties were bound by the contract to discharge a certain duty (buy or sell) at a certain
date. The options contract, on the other hand is asymmetrical. An options contract, binds one party
whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party
has the obligation to buy or sell at a later date whereas the other party can make a choice. Obviously
the party that makes a choice has to pay a premium for the privilege.

There are two types of options i.e. call option and put option. Call option allows you the right but not
the obligation to buy something at a later date at a given price whereas put option gives you the right
but not the obligation to sell something at a later date at a given pre decided price. Any individual
therefore has 4 options when they buy an options contract. They can be on the long side or the short
side of either the put or call option. Like futures, options are also traded on the exchange.

Type 4: Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to
exchange their streams of cash flows. For instance, at a later date, one party may switch an uncertain
cash flow for a certain one. The most common example is swapping a fixed interest rate for a floating
one. Participants may decide to swap the interest rates or the underlying currency as well.

Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are
usually not traded on the exchange. These are private contracts which are negotiated between two
parties. Usually investment bankers act as middlemen to these contracts. Hence, they too carry a
large amount of exchange rate risks.

So, these are the 4 basic types of derivatives. Modern derivative contracts include countless
combinations of these 4 basic types and result in the creation of extremely complex contracts.

What are Derivatives?


Derivatives are financial contracts whose value is linked to the value of an
underlying asset. They are complex financial instruments that are used for
various purposes, including hedging and getting access to additional assets
or markets.
Most derivatives are traded over-the-counter (OTC). However, some of the
contracts, including options and futures, are traded on specialized
exchanges. The biggest derivative exchanges include the CME Group
(Chicago Mercantile Exchange and Chicago Board of Trade), the Korea
Exchange, and Eurex.
History of the Market

Derivatives are not new financial instruments. For example, the emergence
of the first futures contracts can be traced back to the second millennium
BC in Mesopotamia. However, the financial instrument was not widely used
until the 1970s. The introduction of new valuation techniques sparked the
rapid development of the derivatives market. Nowadays, we cannot
imagine modern finance without derivatives.

Types of Derivatives

1. Forwards and futures

These are financial contracts that obligate the contracts’ buyers to purchase
an asset at a pre-agreed price on a specified future date. Both forwards and
futures are essentially the same in their nature. However, forwards are more
flexible contracts because the parties can customize the underlying
commodity as well as the quantity of the commodity and the date of the
transaction. On the other hand, futures are standardized contracts that are
traded on the exchanges.

2. Options

Options provide the buyer of the contracts the right but not the obligation
to purchase or sell the underlying asset at a predetermined price. Based on
the option type, the buyer can exercise the option on the maturity date
(European options) or on any date before the maturity (American options).

3. Swaps

Swaps are derivative contracts that allow the exchange of cash flows
between two parties. The swaps usually involve the exchange of a fixed
cash flow for a floating cash flow. The most popular types of swaps
are interest rate swaps, commodity swaps, and currency swaps.

Advantages of Derivatives

Unsurprisingly, derivatives exert a significant impact on modern finance,


because they provide numerous advantages to the financial markets:

1. Hedging risk exposure

Since the value of the derivatives is linked to the value of the underlying
asset, the contracts are primarily used for hedging risks. For example, an
investor may purchase a derivative contract whose value moves in the
opposite direction to the value of an asset the investor owns. In this way,
profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination

Derivates are frequently used to determine the price of the underlying


asset. For example, the spot prices of the futures can serve as an
approximation of a commodity price.

3. Market efficiency

It is considered that derivatives increase the efficiency of financial markets.


By using derivative contracts, one can replicate the payoff of the assets.
Therefore, the prices of the underlying asset and the associated derivative
tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets


Derivatives can help organizations get access to otherwise unavailable
assets or markets. By employing interest rate swaps, a company may obtain
a more favorable interest rate relative to interest rates available from direct
borrowing.

Disadvantages of Derivatives

Despite the benefits that derivatives bring to the financial markets, the
financial instruments come with some significant drawbacks. The drawbacks
resulted in disastrous consequences during the financial crisis of 2007-
2008. The rapid devaluation of mortgage-backed securities and credit-
default swaps led to the collapse of financial institutions and securities
around the world.

1. High risk

The high volatility of the derivatives exposes them to potentially huge


losses. The sophisticated design of the contracts makes the valuation
extremely complicated or even impossible. Thus, they bear a high inherent
risk.

2. Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the


extremely risky nature of derivatives and their unpredictable behavior,
unreasonable speculation may lead to huge losses.

3. Counter-party risk

Although derivatives traded on the exchanges generally go through a


thorough due diligence process, some of the contracts traded over-the-
counter do not include a benchmark for due diligence. Thus, there is a
possibility of counter-party default.
ypes of Derivatives and
Derivative Market
By
Srishti
-
February 1, 2012
12

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One of the key features of financial markets are extreme volatility. Prices of
foreign currencies, petroleum and other commodities, equity shares and
instruments fluctuate all the time, and poses a significant risk to those whose
businesses are linked to such fluctuating prices . To reduce this risk, modern
finance provides a method called hedging. Derivatives are widely used for
hedging. Of course, some people use it to speculate as well – although in
India such speculation is prohibited.

Derivatives are products whose value is derived from one or more basic
variables called underlying assets or

base . In simpler form,


derivatives are financial security such as an option or future whose value is
derived in part from the value and characteristics of another an underlying
asset. The primary objectives of any investor are to bring an element of
certainty to returns and minimise risks. Derivatives are contracts that
originated from the need to limit risk. For a better conceptual understanding
of different kind of derivatives, you can see this link.
Derivative contracts can be standardized and traded on the stock exchange.
Such derivatives are called exchange-traded derivatives. Or they can be
customised as per the needs of the user by negotiating with the other party
involved. Such derivatives are called over-the-counter (OTC) derivatives.

A Derivative includes:

(a) 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 ;

(b) a contract which derives its value from the prices, or index of prices, of
underlying securities.

Advantages of Derivatives:

1. They help in transferring risks from risk adverse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
3. They catalyze entrepreneurial activity.
4. They increase the volume traded in markets because of participation of risk
adverse people in greater numbers.
5. They increase savings and investment in the long run.
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materials!

Types of Derivative Instruments:

Derivative contracts are of several types. The most common types are
forwards, futures, options and swap.

Forward Contracts

A forward contract is an agreement between two parties – a buyer and a


seller to purchase or sell something at a later date at a price agreed upon
today. Forward contracts, sometimes called forward commitments , are very
common in everyone life. Any type of contractual agreement that calls for
the future purchase of a good or service at a price agreed upon today and
without the right of cancellation is a forward contract.

Future Contracts
A futures contract is an agreement between two parties – a buyer and a
seller – to buy or sell something at a future date. The contact trades on a
futures exchange and is subject to a daily settlement procedure. Future
contracts evolved out of forward contracts and possess many of the same
characteristics. Unlike forward contracts, futures contracts trade on
organized exchanges, called future markets. Future contacts also differ from
forward contacts in that they are subject to a daily settlement procedure. In
the daily settlement, investors who incur losses pay them every day to
investors who make profits.

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Options Contracts

Options are of two types – calls and puts. Calls give the buyer the right but
not the obligation to buy a given quantity of the underlying asset, at a given
price on or before a given future date. Puts give the buyer the right, but not
the obligation to sell a given quantity of the underlying asset at a given price
on or before a given date.

Swaps
Swaps are private agreements between two parties to exchange cash flows
in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are interest
rate swaps and currency swaps.

1. Interest rate swaps: These involve swapping only the interest related cash flows
between the parties in the same currency.

2. Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

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SEBI Guidelines:
SEBI has laid the eligibility conditions for Derivative Exchange/Segment and
its Clearing Corporation/House to ensure that Derivative Exchange/Segment
and Clearing Corporation/House provide a transparent trading environment,
safety and integrity and provide facilities for redressal of investor grievances.
Some of the important eligibility conditions are :

1. Derivative trading to take place through an on-line screen based Trading System.
2. The Derivatives Exchange/Segment shall have on-line surveillance capability to
monitor positions, prices, and volumes on a real time basis so as to deter market
manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for dissemination
of information about trades, quantities and quotes on a real time basis through at
least two information vending networks, which are easily accessible to investors
across the country.
4. The Derivatives Exchange/Segment should have arbitration and investor
grievances redressal mechanism operative from all the four areas/regions of the
country.
5. The Derivatives Exchange/Segment should have satisfactory system of
monitoring investor complaints and preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate Investor
Protection Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the Clearing
Corporation/House shall interpose itself between both legs of every trade,
becoming the legal counterparty to both or alternatively should provide an
unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the overall
position of Members across both derivatives market and the underlying securities
market for those Members who are participating in both.
9. The level of initial margin on Index Futures Contracts shall be related to the risk of
loss on the position. The concept of value-at-risk shall be used in calculating
required level of initial margins. The initial margins should be large enough to
cover the one-day loss that can be encountered on the position on 99 per cent of
the days.
10. The Clearing Corporation/House shall establish facilities for electronic funds
transfer (EFT) for swift movement of margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent
Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate initial
margins deposited by Clearing Members for trades on their own account and on
account of his client. The Clearing Corporation/House shall hold the clients’
margin money in trust for the client purposes only and should not allow its
diversion for any other purpose.
13. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for
the trades executed on Derivative Exchange/Segment.

SEBI has specified measures to enhance protection of the rights of investors


in the Derivative Market. These measures are as follows:

1. 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.
2. 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.
3. 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.
4. 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.
Chapter 2.1:Introduction to Derivatives
We move on to the world of derivatives – considered one of the most complex financial instruments.

The derivative market in India, like its counterparts abroad, is increasingly gaining significance. Since the time
derivatives were introduced in the year 2000, their popularity has grown manifold. This can be seen from the fact
that the daily turnover in the derivatives segment on the National Stock Exchange currently stands at Rs. crore,
much higher than the turnover clocked in the cash markets on the same exchange.
Here we decode it for you.
If you want to read up our latest reports on derivatives markets, you can click here.
WHAT ARE DERIVATIVES:
Derivatives are financial contracts that derive their value from an underlying asset. These could be stocks,
indices, commodities, currencies, exchange rates, or the rate of interest. These financial instruments help you
make profits by betting on the future value of the underlying asset. So, their value is derived from that of the
underlying asset. This is why they are called ‘Derivatives’.
You can read about the advantages of trading in futures and options here.

The value of the underlying assets changes every now and then.

For example, a stock’s value may rise or fall, the exchange rate of a pair of currencies may change,
indices may fluctuate, commodity prices may increase or decrease. These changes can help an investor
make profits. They can also cause losses. This is where derivatives come handy. It could help you make
additional profits by correctly guessing the future price, or it could act as a safety net from losses in the
spot market, where the underlying assets are traded.

To understand the RBI rules about futures, click here.


WHAT IS THE USE OF DERIVATIVES:
In the Indian markets, futures and options are standardized contracts, which can be freely traded on
exchanges. These could be employed to meet a variety of needs.
Earn money on shares that are lying idle:
So you don’t want to sell the shares that you bought for long term, but want to take advantage of price
fluctuations in the short term. You can use derivative instruments to do so. Derivatives market allows
you to conduct transactions without actually selling your shares – also called as physical settlement.

Benefit from arbitrage:


When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put,
you are taking advantage of differences in prices in the two markets.

Protect your securities against


fluctuations in prices The derivative market offers products that allow you to hedge yourself against a fall
in the price of shares that you possess. It also offers products that protect you from a rise in the price of
shares that you plan to purchase. This is called hedging.

Transfer of risk:
By far, the most important use of these derivatives is the transfer of market risk from risk-averse
investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety,
while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way,
the risk is transferred. There are a wide variety of products available and strategies that can be
constructed, which allow you to pass on your risk.

If the benefits have intrigued you enough and you want to start trading right away, here is how to buy
and sell future contracts.
DERIVATIVE TRADING

WHO ARE THE PARTICIPANTS IN DERIVATIVES MARKETS:

On the basis of their trading motives, participants in the derivatives markets can be segregated into four
categories – hedgers, speculators, margin traders and arbitrageurs. Let's take a look at why these
participants trade in derivatives and how their motives are driven by their risk profiles.

 Hedgers: Traders, who wish to protect themselves from the risk involved in price movements, participate
in the derivatives market. They are called hedgers. This is because they try to hedge the price of their
assets by undertaking an exact opposite trade in the derivatives market. Thus, they pass on this risk to
those who are willing to bear it. They are so keen to rid themselves of the uncertainty associated with
price movements that they may even be ready to do so at a predetermined cost.
For example, let's say that you possess 200 shares of a company – ABC Ltd., and the price of these
shares is hovering at around Rs. 110 at present. Your goal is to sell these shares in six months. However,
you worry that the price of these shares could fall considerably by then. At the same time, you do not
want to liquidate your investment today, as the stock has a possibility of appreciation in the near-term.
You are very clear about the fact that you would like to receive a minimum of Rs. 100 per share and no
less. At the same time, in case the price rises above Rs. 100, you would like to benefit by selling them at
the higher price. By paying a small price, you can purchase a derivative contract called an 'option' that
incorporates all your above requirements. This way, you reduce your losses, and benefit, whether or not
the share price falls. You are, thus, hedging your risks, and transferring them to someone who is willing
to take these risks.
If you’re a hedger looking to shield your portfolio against small-cap crash, you might want to read up
on 5 ways to hedge against a small-cap crash.
DERIVATIVES TRADING PARTICIPANTS
 Speculators: As a hedger, you passed on your risk to someone who will willingly take on risks from you.
But why someone do that? There are all kinds of participants in the market.
Some might be averse to risk, while some people embrace them. This is because, the basic market idea
is that risk and return always go hand in hand. Higher the risk, greater is the chance of high returns.
Then again, while you believe that the market will go up, there will be people who feel that it will fall.
These differences in risk profile and market views distinguish hedgers from speculators. Speculators,
unlike hedgers, look for opportunities to take on risk in the hope of making returns.

Let's go back to our example, wherein you were keen to sell the 200 shares of company ABC Ltd. after
one month, but feared that the price would fall and eat your profits. In the derivative market, there will be
a speculator who expects the market to rise. Accordingly, he will enter into an agreement with you
stating that he will buy shares from you at Rs. 100 if the price falls below that amount. In return for giving
you relief from this risk, he wants to be paid a small compensation. This way, he earns the compensation
even if the price does not fall and you wish to continue holding your stock.

This is only one instance of how a speculator could gain from a derivative product. For every opportunity
that the derivative market offers a risk-averse hedger, it offers a counter opportunity to a trader with a
healthy appetite for risk.

In the Indian markets, there are two types of speculators – day traders and the position traders.

 A day trader tries to take advantage of intra-day fluctuations in prices. All their trades are settled by
by undertaking an opposite trade by the end of the day. They do not have any overnight exposure to
the markets.
 On the other hand, position traders greatly rely on news, tips and technical analysis – the science of
predicting trends and prices, and take a longer view, say a few weeks or a month in order to realize
better profits. They take and carry position for overnight or a long term.
If you’re a beginner at intra-day trading, you might want to read up on what Kotak Securities has to say
here.
 Margin traders: Many speculators trade using of the payment mechanism unique to the derivative
markets. This is called margin trading. When you trade in derivative products, you are not required to pay
the total value of your position up front. . Instead, you are only required to deposit only a fraction of the
total sum called margin. This is why margin trading results in a high leverage factor in derivative trades.
With a small deposit, you are able to maintain a large outstanding position. The leverage factor is fixed;
there is a limit to how much you can borrow. The speculator to buy three to five times the quantity that
his capital investment would otherwise have allowed him to buy in the cash market. For this reason, the
conclusion of a trade is called ‘settlement’ – you either pay this outstanding position or conduct an
opposing trade that would nullify this amount.
For example, let's say a sum of Rs. 1.8 lakh fetches you 180 shares of ABC Ltd. in the cash market at the
rate of Rs. 1,000 per share. Suppose margin trading in the derivatives market allows you to purchase
shares with a margin amount of 30% of the value of your outstanding position. Then, you will be able to
purchase 600 shares of the same company at the same price with your capital of Rs. 1.8 lakh, even
though your total position is Rs. 6 lakh.

If the share price rises by Rs. 100, your 180 shares in the cash market will deliver a profit of Rs. 18,000,
which would mean a return of 10% on your investment. However, your payoff in the derivatives market
would be much higher. The same rise of Rs. 100 in the derivative market would fetch Rs. 60,000, which
translates into a whopping return of over 33% on your investment of Rs. 1.8 lakh. This is how a margin
trader, who is basically a speculator, benefits from trading in the derivative markets.

 Arbitrageurs: Derivative instruments are valued on the basis of the underlying asset’s value in the spot
market. However, there are times when the price of a stock in the cash market is lower or higher than it
should be, in comparison to its price in the derivatives market.
Arbitrageurs exploit these imperfections and inefficiencies to their advantage. Arbitrage trade is a low-
risk trade, where a simultaneous purchase of securities is done in one market and a corresponding sale
is carried out in another market. These are done when the same securities are being quoted at different
prices in two markets.

In the earlier example, suppose the cash market price is Rs. 1000 per share, but is quoting at Rs. 1010 in
the futures market. An arbitrageur would purchase 100 shares at Rs. 1000 in the cash market and
simultaneously, sell 100 shares at Rs. 1010 per share in the futures market, thereby making a profit of Rs.
10 per share.

Speculators, margin traders and arbitrageurs are the lifeline of the capital markets as they provide
liquidity to the markets by taking long (purchase) and short (sell) positions. They contribute to the overall
efficiency of the markets.

Whether you are an Arbitrageur, Speculator, Margin Trader or Hedger, you stand to benefit from Kotak
Securities extensive research reports. Click here to read the latest research reports on derivatives
market.
WHAT ARE THE DIFFERENT TYPES OF DERIVATIVE CONTRACTS:

There are four types of derivative contracts – forwards, futures, options and swaps. However, for the time
being, let us concentrate on the first three. Swaps are complex instruments that are not available for
trade in the stock markets.

 Futures and forwards: Futures are contracts that represent an agreement to buy or sell a set of assets at
a specified time in the future for a specified amount. Forwards are futures, which are not standardized.
They are not traded on a stock exchange.
For example, in the derivatives market, you cannot buy a contract for a single share. It is always for a lot
of specified shares and expiry date. This does not hold true for forward contracts. They can be tailored to
suit your needs.

 Options: These contracts are quite similar to futures and forwards. However, there is one key difference.
Once you buy an options contract, you are not obligated to hold the terms of the agreement.
This means, even if you hold a contract to buy 100 shares by the expiry date, you are not required to.
Options contracts are traded on the stock exchange.

Read more about what is options trading.

HOW ARE DERIVATIVE CONTRACTS LINKED TO STOCK PRICES:

Suppose you buy a Futures contract of Infosys shares at Rs 3,000 – the stock price of the IT company
currently in the spot market. A month later, the contract is slated to expire. At this time, the stock is
trading at Rs 3,500. This means, you make a profit of Rs. 500 per share, as you are getting the stocks at a
cheaper rate.

Had the price remained unchanged, you would have received nothing. Similarly, if the stock price fell by
Rs. 800, you would have lost Rs. 800. As we can see, the above contract depends upon the price of the
underlying asset – Infosys shares. Similarly, derivatives trading can be conducted on the indices also.
Nifty Futures is a very commonly traded derivatives contract in the stock markets. The underlying
security in the case of a Nifty Futures contract would be the 50-share Nifty index.

HOW TO TRADE IN DERIVATIVES MARKET:

Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.

 First do your research. This is more important for the derivatives market. However, remember that the
strategies need to differ from that of the stock market. For example, you may wish you buy stocks that
are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market, this
would need you to enter into a sell transaction. So the strategy would differ.

 Arrange for the requisite margin amount. Stock market rules require you to constantly maintain your
margin amount. This means, you cannot withdraw this amount from your trading account at any point in
time until the trade is settled. Also remember that the margin amount changes as the price of the
underlying stock rises or falls. So, always keep extra money in your account.
 Conduct the transaction through your trading account. You will have to first make sure that your account
allows you to trade in derivatives. If not, consult your brokerage or stock broker and get the required
services activated. Once you do this, you can place an order online or on phone with your broker.
 Select your stocks and their contracts on the basis of the amount you have in hand, the margin
requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have
to pay a small amount to buy the contract. Ensure all this fits your budget.

 You can wait until the contract is scheduled to expiry to settle the trade. In such a case, you can pay the
whole amount outstanding, or you can enter into an opposing trade. For example, you placed a ‘buy
trade’ for Infosys futures at Rs 3,000 a week before expiry. To exit the trade before, you can place a ‘sell
trade’ future contract. If this amount is higher than Rs 3,000, you book profits. If not, you will make
losses.
Thus, buying stock futures and options contracts is similar to buying shares of the same underlying
stock, but without taking delivery of the same. In the case of index futures, the change in the number of
index points affects your contract, thus replicating the movement of a stock price. So, you can actually
trade in index and stock contracts in just the same way as you would trade in shares.
WHAT ARE THE PRE-REQUISITES TO INVEST

As said earlier, trading in the derivatives market is very similar to trading in the cash segment of the
stock markets.

If you want to read up more about derivatives expiry, you can visit here.
This has three key requisites:
 Demat account: This is the account which stores your securities in electronic format. It is unique to every
investor and trader.
 Trading account: This is the account through which you conduct trades. The account number can be
considered your identity in the markets. This makes the trade unique to you. It is linked to the demat
account, and thus ensures that YOUR shares go to your demat account. Click here if you want to open a
trinity account that relives you from the hassles of operating different demat, trading and savings bank
accounts.
 Margin maintenance: This pre-requisite is unique to derivatives trading. While many in the cash segment
too use margins to conduct trades, this is predominantly used in the derivatives segment.

Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required
to deposit only a percentage of the value of your outstanding position with the stock exchange,
irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money,
covers an initial margin and an exposure margin. These margins act as a risk containment measure for
the exchanges and serve to preserve the integrity of the market.
 You are expected to deposit the initial margin upfront. How much you have to deposit is decided by the
stock exchange.

It is prescribed as a percentage of the total value of your outstanding position. It varies for different
positions as it takes into account the average volatility of a stock over a specified time period and the
interest cost. This initial margin is adjusted daily depending upon the market value of your open
positions.

 The exposure margin is used to control volatility and excessive speculation in the derivatives markets.
This margin is also stipulated by the exchanged and levied on the value of the contract that you buy or
sell.

 Besides the initial and exposure margins, you also have to maintain Mark-to-Market (MTM) margins. This
covers the daily difference between the cost of the contract and its closing price on the day of purchase.
Thereafter, the MTM margin covers the differences in closing price from day to day.