Image courtesy: (BloombergQuint) 

BQLearning: Beginner’s Guide To F&O 

BQLearning is a show that seeks to demystify financial markets, economic theories, legal processes and political structures.

In this series we explain how the most commonly used derivatives—futures and options—work in equity markets, the advantages they offer and the risks associated with them.

What Is A Forward Contract?

A forward contract is a customised contract between two parties to buy or sell an asset or security at a specified price on a future date. This contract, which is agreed and signed on by both the parties, is a forward contract.

This contract helps ensure that both parties have a buffer against volatility in the price movement of the asset or security.

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Standardisation Of Contracts And Role Of Exchanges

A forward contract is the basis for a futures contract. But for it to work, a few conditions need to be met. Agreement on quantity and price of a security is one. That the contract will be upheld by the parties involved is another.

This is where stock exchanges come into play. This video explains the need to standardise contracts and the role an exchange plays in creating markets for such derivative contracts.

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What Is A Futures Contract?

For an exchange to standardise and facilitate trade of futures contracts, it needs to determine:

  • The size of contract.
  • Date of contract settlement.
  • The advance sum expected from parties trading in the instrument. The price is agreed upon by participants involved in the transaction.

How do these components come together to make a futures contract?

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The Long And Short Of Derivatives

In the derivatives market, to buy a contract is to ‘go long’ and to sell a contract is to ‘go short’. But why use different terms when they mean the same thing? One word- leverage. Here’s how leverage works in the derivatives market.

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Premium And Discount In Futures

The price at which a futures contract trades is invariably different from the price of its its underlying asset in the cash market. It’s often higher than the spot, but it sometimes trades lower too. Here’s the reason behind the difference.

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What Is Expiry?

Expiry is the date up to which the agreement is valid or the last date that a trader can hold the contract. Beyond this date, the trade ceases to exist and the trader cannot hold that contract anymore. This is how expiration works in the futures market.

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Open Interest And Market-Wide Position Limit

Open interest is the number of contracts or positions outstanding in futures and options on an exchange. It may be denoted in a number of contracts or the number of shares. It's computed by summing up net open positions in the derivative of an index or stock.

These positions must be closed on expiry if not squared off earlier. Here’s how to interpret the change in open interest with respect to the movement in prices of that particular security.

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What Is Mark To Market?

To mark to market is to account for profit and loss incurred in holding a position in the futures contract on a periodic basis, in this case daily. The profit or loss is adjusted to the margin paid by participants to hold a position in the futures contract.

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