4.1 Derivatives Basics

What Is a Derivative?

Quick Answer: A derivative is a financial contract whose value is derived from an underlying asset, index, or reference rate. The three economic motives for using derivatives are hedging (reducing existing price risk), speculation (taking a view on price direction to profit), and arbitrage (exploiting price differences across markets for a risk-free gain). On Indian exchanges the F&O segment trades equity and index derivatives under SEBI-regulated lot sizes and position limits.

Derivatives do not create the underlying — they redistribute the price risk that already exists. A wheat farmer worried about falling prices and a miller worried about rising prices can enter a contract that fixes a future price; both have hedged. A trader with no wheat exposure who buys that same contract to profit from a price move is speculating. An arbitrageur who sees the same stock priced differently on two exchanges locks in a risk-free spread.

The Three Motives

Forwards vs Futures

A forward contract is a private, over-the-counter (OTC) agreement to buy or sell an asset at a specified price on a future date. Terms (quantity, quality, date) are customised, and each party bears the counterparty risk that the other may default. Forwards are common in currency (inter-bank) and commodity markets in India.

A future contract is a standardised, exchange-traded version of a forward.

Daily mark-to-market (MTM) means gains and losses are settled in cash every trading day, so risk does not accumulate to expiry. The clearing corporation (NSE Clearing Limited, "NCL", for NSE; Indian Clearing Corporation Limited, "ICCL", for BSE) becomes the buyer to every seller and the seller to every buyer, guaranteeing performance through a margin system.

Options: Calls and Puts

An option gives the buyer the right, but not the obligation, to buy or sell the underlying at a fixed strike price on or before a specified expiry date. The buyer pays a premium to the seller (writer) for this right.

• Call option (CE): The right to buy the underlying at the strike price. A call buyer profits when the underlying rises above the strike (plus the premium).
• Put option (PE): The right to sell the underlying at the strike price. A put buyer profits when the underlying falls below the strike (minus the premium).

Four basic positions exist:

1. Long Call — right to buy; limited loss (premium), unlimited upside.
2. Long Put — right to sell; limited loss (premium), large upside if price falls.
3. Short Call (write a call) — obligation to sell; premium income, but unlimited loss if the underlying rises (uncovered).
4. Short Put (write a put) — obligation to buy; premium income, large loss if the underlying falls.

Option Styles in India

All equity and index options on NSE and BSE are European-style, meaning they can be exercised only on the expiry date, never before. (American-style options, by contrast, can be exercised any time before expiry.) European style was chosen to simplify assignment risk for option writers. In practice, an in-the-money option is sold in the market before expiry rather than exercised early, and the clearing corporation auto-exercises in-the-money options at expiry.

Settlement in India

• Index options (Nifty, Bank Nifty, etc.) — cash-settled; the difference between the strike and the final settlement price is paid/received in cash.
• Stock options — physically settled at expiry; a long in-the-money call receives shares and pays the strike × lot, while a short call must deliver shares. This requires both capital and a demat account.

Swaps Basics

A swap is an OTC contract in which two parties agree to exchange cash flows based on different reference rates. The most common is an interest-rate swap — one party pays a fixed rate and receives a floating rate (e.g., MCLR-linked), and the other does the opposite. Swaps are used to manage interest-rate or currency exposure and are predominantly institutional (banks and corporates); they are not traded on the F&O segment and are outside the retail scope of this certification.

The Indian F&O Segment

Equity derivatives in India trade on the F&O (Futures & Options) segment of NSE and BSE, which went live in 2001. The dominant underlyings are equity indices (Nifty 50, Nifty Bank, Sensex) and individual stocks. SEBI regulates the segment through three levers:

1. Lot size — the minimum tradable quantity per contract. Under SEBI's October 1, 2024 circular strengthening the equity index derivatives framework, a new index derivative contract must have a value of at least ₹15 lakh at introduction (raised from ₹5 lakh), and on each review the contract value must stay within the ₹15–20 lakh band. NSE and BSE applied the larger lot sizes to new index contracts from November 20, 2024, as part of SEBI's 2024 package to curb retail speculation.
2. Position limits — caps on how much a single entity can hold, to prevent manipulation. SEBI's May 2025 overhaul introduced delta-adjusted Future Equivalent Open Interest (FutEq OI) measured at the portfolio level, with a market-wide position limit (MWPL) per stock and PAN-level limits on index options (₹1,500 crore net, ₹10,000 crore gross, end-of-day).
3. Margin requirements — initial margin + exposure margin, collected upfront; MTM settled daily.

When open interest in a stock crosses 95% of its MWPL, it enters the F&O ban list — no new positions may be created until OI falls to or below 80%.

The Asymmetry of Option Risk

Quick Answer: For an option buyer, the maximum loss is the premium paid — the right, not the obligation, means you walk away if it is unprofitable. For an option seller (writer), a call sold without owning the underlying (uncovered/naked) has theoretically unlimited loss, because the underlying can rise without limit. This asymmetry is the single most important risk concept in F&O.

A widely cited SEBI study found that 9 out of 10 individual traders in equity F&O lose money. The buyer's downside is capped at the premium, but so is their win rate; the seller's upside is capped at the premium, but their downside is open. Understanding this before recommending any F&O product is essential for any PAIA.