Chapter 9 Financial Derivatives Markets and Instruments

Derivatives: Definition and Evolution

Derivatives are contracts whose value is not independent but is derived from the price of another asset called the underlying. The underlying can be a share, a stock-market index, an interest rate, a commodity or a currency. When the price of that underlying moves, the value of the derivative changes accordingly; without an identifiable underlying, the concept of a derivative has no meaning. A gold futures contract, for example, derives its value from the prevailing price of gold.

A practical way to grasp derivatives is to consider an agricultural example. A cotton farmer faces the risk that prices may rise before harvest and then fall at harvest time. To eliminate that uncertainty the farmer can agree today to sell his crop at a fixed price for delivery in the future by entering into a forward or futures contract. That agreement, traded in the derivatives market, fixes the price regardless of subsequent spot‑market movements, thereby hedging the farmer’s exposure.

Derivatives perform a role similar to insurance. Whereas traditional insurance protects against specific perils such as fire or flood, derivatives protect against market risks — fluctuations in interest rates, currency rates, commodity prices and equity prices. By enabling parties to transfer or share market risk, derivatives broaden the ways risks can be redistributed across market participants, applying to products as varied as coffee and cotton, live cattle and debt instruments.

Historically, derivatives began as hedging instruments in commodity markets and have a long recorded existence in commodity futures and options. Financial derivatives—contracts whose underlying are financial assets such as bonds, equities, stock indices or foreign exchange—became prominent after the 1970s. Today they account for a large share of market activity in advanced regions; roughly three‑quarters of financial market activity in Europe, North America and East Asia involves derivatives. The market has also expanded enormously in both variety and turnover: futures, options, forwards, swaps, puts, calls and various index‑linked and hybrid contracts now coexist, and the notional value of underlying assets linked to these instruments is measured in many trillions of dollars—far larger than the value of stocks traded on any single exchange.

The explosive growth of derivatives in recent decades reflects several interrelated factors. Greater volatility in global financial markets has increased demand for risk‑management tools. Advances in information and communications technology, along with cheaper computing power, have reduced trading costs and made complex instruments feasible. Progress in financial theory has produced models and strategies that help market participants combine risk and return more efficiently across many assets. Political and policy shifts toward market‑oriented frameworks and financial deregulation have transferred more risk to private actors and expanded opportunities for private risk management. Finally, deeper integration between domestic and international financial markets has widened the scope and scale of derivative trading. Together, these forces have transformed derivatives from niche hedging devices into central instruments of modern finance.

Economic Functions of Derivatives

Derivatives play several important economic roles by making markets more efficient and participants more willing to engage with underlying assets. Their primary social function is to allow hedging—effectively providing insurance against adverse price movements. By enabling producers, investors and other market participants to lock in prices or offset exposure, derivatives reduce the risk of holding the underlying asset and thereby increase the appetite to own it.

Greater risk management capability and the presence of varied market participants—hedgers, speculators and arbitrageurs—tend to deepen trading activity, which in turn improves liquidity in the underlying market. A liquid market, where buyers and sellers can trade large quantities close to the true value, benefits from derivative instruments because they broaden participation and raise overall trading volumes.

Trading derivatives is also typically less expensive than trading the underlying instruments, which lowers transaction costs. By providing standardized contracts and centralized execution and clearing, derivatives reduce search, negotiation and settlement frictions, making it cheaper and quicker to transfer risk.

Derivatives contribute importantly to price discovery. Futures and options prices incorporate market participants’ collective expectations about future cash-market prices, often leading and informing spot prices. As contract expiry approaches, derivatives prices converge with underlying prices, so derivatives both signal expected future levels and help reveal current fair values.

For investors, derivatives offer flexible ways to reshape the risk–return profile of a portfolio. Combinations of underlying securities and derivative positions can be used to hedge specific exposures, synthesize payoffs, or create less risky positions from otherwise risky assets. The variety of contract types and strategies gives market participants precise tools to meet their individual risk-management objectives.

Finally, derivatives markets generate a range of indicators that cash markets monitor for information about market direction and sentiment. Commonly watched measures include Nifty discounts (when Nifty futures trade below the cash index), open interest (the total number of outstanding derivative contracts), the put–call ratio (the number of outstanding put options divided by call options), and net purchases or sales by foreign institutional investors (FIIs) in the derivatives segment. Together, these signals help participants anticipate the magnitude and direction of likely market moves.

SCRA Definition of Derivatives

Under the Securities Contracts (Regulation) Act, 1956, the term "derivatives" is given a broad meaning. It covers both securities that themselves derive from other instruments—for example those based on a debt instrument, share, loan (secured or unsecured), a risk instrument, a contract for differences, or any other form of security—and contracts whose value is determined by the price or an index of prices of underlying securities.

Evolution of Derivatives Markets

Forward delivery contracts—agreements to deliver a specified commodity at a fixed price, place and date—have a long history. They were used in ancient Greece and Rome to stabilise supply and prices: Roman emperors, for example, entered forward contracts to secure grain for the populace, while farmers and merchants used them to hedge against uncertain future prices. In other words, forwards have existed for centuries as a tool to manage price risk.

The first organised commodity exchange emerged in early 18th century Japan, but the modern formal exchange tradition began with the Chicago Board of Trade (CBOT), established in 1848. The CBOT addressed problems of credit risk and provided a centralised venue for negotiating forward contracts; out of this forward trading evolved the more standardised futures contracts. By the 1860s the CBOT was trading “to arrive” contracts, and in 1865 it listed the first exchange-traded futures. The Chicago Mercantile Exchange (CME) traces its roots back to mid‑19th century bodies such as the Chicago Produce Exchange and the Chicago Butter and Egg Board and was formally organised in 1919.

Financial futures followed more than a century later. The first currency futures were introduced in the United States on May 16, 1972, at the International Monetary Market (IMM), a division of the CME, and initially covered major currencies such as the pound, Canadian dollar, yen, Swiss franc and German mark. Interest-rate futures began trading on the CBOT on October 20, 1975, and stock-index futures appeared in the early 1980s, with the first contracts traded on the Kansas City Board of Trade on February 24, 1982. International linkages among exchanges also developed; one early example was the trading connection formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are nearly as old as futures. Aristotle records a story of Thales (around 332 BC) who, by paying a small fee in advance, secured the right to use olive presses during harvest and later sold those rights at a profit—an early example of call-like contracts. Options reappeared prominently in the 17th century during the Dutch tulip mania, when contracts on tulip bulbs were widely traded and speculative excesses contributed to the market’s collapse in 1637; the episode highlighted the risks when there is no mechanism to guarantee contract performance.

Modern forms of puts and calls began to appear in the 19th century. An American financier, Russel Sage, is credited with creating early puts and calls in 1872, which were traded over the counter. Agricultural options were common in 19th‑century England and the United States, and equity options remained largely an OTC market until the 1970s. To organise trading, market participants formed bodies such as the Put and Call Brokers and Dealers’ Association in the early 20th century.

A major milestone for exchange-listed options was the establishment of the Chicago Board Options Exchange (CBOE) on April 26, 1973. That same year, Black, Scholes and Merton published the option pricing model that became known as the Black‑Scholes formula; by providing a method to value options, it helped increase market confidence and liquidity. The American Stock Exchange and the Philadelphia Stock Exchange began trading options in 1975, and through the 1980s and 1990s the markets for both futures and options expanded rapidly. The end of the Bretton Woods fixed-exchange-rate system and the shift to floating currencies opened the way for numerous financial derivatives that serve as risk-management tools in volatile markets.

By the turn of the century the two dominant U.S. futures venues were CBOT and CME. In 2001 CBOT listed 48 futures and options contracts and recorded annual volumes exceeding 211 million contracts. The CBOE became the largest exchange for stock options, trading contracts on major indices such as the S&P 100 and S&P 500, while the Philadelphia Stock Exchange specialised in foreign-exchange options. The most actively traded equity indices included the S&P 500, the Dow Jones Industrial Average, the Nasdaq 100 and the Nikkei 225; U.S. indices and the Nikkei effectively traded around the clock, with the Nikkei also listed on the CME.

On a global scale, trading volumes at the start of the 21st century reflected the internationalisation of derivatives markets. Eurex, the German–Swiss derivatives exchange, was the largest financial‑futures exchange at the end of 2001 with a record volume of more than 556 million contracts (about an 18.8 percent share among international futures and options exchanges). The CME traded some 333 million contracts in 2001 (an 11.3 percent share), the CBOE about 276 million contracts, and London’s LIFFE approximately 177 million contracts.

A brief timeline helps capture the broad sweep of development: in the ancient period forward-like contracts existed; Japanese rice futures were prominent in the 1400s; Dutch tulip options featured in the 1600s; puts and calls evolved in the 1800s. The modern listed era saw currency futures in 1972, stock options in 1973, treasury-bond futures in 1977, eurodollar futures in 1981, index futures in 1982 and stock-index options in 1983. During the 1980s and early 1990s new instruments such as foreign index warrants, swap futures, insurance futures, flex options and various OTC derivatives—currency and interest-rate swaps, currency and bond options, equity derivatives and hybrid products—further broadened the landscape.

Major exchanges around the world trade a wide range of underlying instruments—agricultural commodities, metals, energy, currencies, government bonds and stock indices. Examples include the American Stock Exchange (trading contracts linked to indices such as the Hang Seng and the Nikkei), the Chicago Board Options Exchange (options on indices like the NASDAQ‑100 and S&P series), the Chicago Board of Trade (agricultural staples such as corn, oats and wheat, along with treasury bonds and notes), and the Chicago Mercantile Exchange (livestock, treasury bills, eurodollars, major currencies, and equity-index futures such as the S&P 500 and Nikkei‑225). Other venues—COMEX for metals, the Coffee, Sugar & Cocoa Exchange for soft commodities, the Hong Kong Futures Exchange for Hang Seng and gold contracts, the International Petroleum Exchange in London for Brent crude, and exchanges in Osaka, Sydney, Singapore and Tokyo—round out a global network that links producers, users and investors seeking to hedge price risk or take positions on future price movements.

Financial transactions and asset–liability positions expose participants to a variety of price and valuation uncertainties. Derivatives are financial contracts that reallocate these uncertainties: they move risk away from those who hold exposures but prefer not to bear them, toward counterparties who have the capacity or appetite to assume that risk. In practice, derivatives are widely used to hedge exposures, allowing firms and investors to stabilize cash flows and protect the economic value of assets and liabilities.

Broadly speaking, three types of price risk drive the demand for derivatives. Market risk (also called systematic risk) arises from forces that affect the entire market—shifts in investor sentiment, macroeconomic news or geopolitical events—that move security prices up or down in a correlated way; because it stems from economy‑wide factors, it cannot be eliminated simply by diversifying a portfolio. Interest rate risk affects fixed‑income instruments such as treasury bills, government securities and bonds: when benchmark interest rates rise, the market prices of existing fixed‑rate securities tend to fall, and vice versa. Exchange rate risk occurs whenever transactions or positions involve foreign currency—imports, exports, cross‑border loans or investments—because changes in currency values alter the domestic‑currency value of those exposures. To manage these risks, market participants use equity derivatives, interest‑rate derivatives and currency derivatives as hedging tools that transfer specific exposures to counterparties willing to accept them.

Principal Derivative Instruments

Derivatives have become a central part of modern finance, offering ways to transfer risk, speculate, and arbitrage across markets. The principal classes are forwards, futures, options, swaps and warrants; more complex instruments, such as swaptions, are formed by combining these basic types.

A forward contract is a bilateral agreement under which two parties commit to exchange a specified asset at a predetermined price on a future date. Forwards are typically traded over‑the‑counter (OTC) and are customised to the needs of the counterparties rather than standardized by an exchange, which makes them flexible but also exposes parties to counterparty credit risk.

Futures are the exchange‑traded cousins of forwards. They fix the terms of a future exchange in a standardized contract that is legally enforceable and cleared through an exchange, which reduces counterparty risk through margining and daily settlement. Common categories include stock‑index futures, interest‑rate futures and currency futures.

Options give the buyer the right, but not the obligation, to buy or sell an underlying asset under specified terms, while the option writer (seller) takes the corresponding obligation if the buyer exercises. Call options confer the right to buy the underlying at a stated strike price on or before a specified date; put options confer the right to sell. Options trade both OTC and on exchanges, and their main varieties include stock options, bond options, currency options, index options, and options on other derivatives such as futures and swaps.

Warrants resemble long‑dated call options issued by a company, typically with maturities measured in years (often three to seven years). They are issued as a means of raising capital or as an attachment to other securities (for example, bonds) to make those securities more attractive. When a warrant is exercised the issuing firm generally issues a new share, which dilutes existing equity; many warrants are detachable and can be traded separately. Warrants are also written on indices and currencies.

Swaps are customised OTC agreements in which counterparties exchange streams of cash flows or obligations according to specified terms. The most common forms are interest‑rate swaps (exchanging fixed for floating interest payments) and currency swaps, but swaps can also take the form of bond swaps, coupon swaps, or exchanges combining debt and equity features.

Swaptions are options on swaps: they give the holder the right, but not the obligation, to enter into a swap at a future date. Rather than the call/put terminology used for standard options, swaptions are described as payer swaptions (the right to pay fixed and receive floating) and receiver swaptions (the right to receive fixed and pay floating). Swaptions become exercisable at the option’s expiry and are an important tool for managing interest‑rate exposure.

Key Characteristics of Derivatives

The derivatives market shares basic features with other financial markets—price discovery, liquidity and a platform for buyers and sellers—but it also has several distinctive characteristics that every investor should understand.

Most fundamentally, derivatives are highly leveraged instruments. An investor pays only a fraction of the contract’s value as margin and thus can take a large exposure with relatively little capital. This amplifies both potential gains and potential losses compared with investing directly in the underlying asset. Because of this leverage, investors can establish large positions even when they do not own the underlying security.

A clear market view is therefore critical in derivatives trading. Profits and losses depend heavily on the correctness and timing of that view; derivatives are, in effect, double-edged swords. Unlike cash equities, most derivative contracts also have a fixed lifespan: they expire on a predetermined date. That finite life makes derivatives especially useful for expressing short-term expectations about a stock or an index, whether for hedging or speculative purposes.

The derivatives market also allows strategies not feasible in the cash market. An investor can take long and short positions on the same underlying asset simultaneously, enabling sophisticated hedging and arbitrage strategies. At the same time, derivatives carry risks that differ from those of stocks. While a stock’s value can fall dramatically, an option can lose its entire value on expiry if it is not exercised, creating discrete downside outcomes that do not occur with direct equity ownership.

Derivatives are flexible instruments that let investors translate a specific market view into a variety of trades depending on risk appetite and available capital. For example, if an investor is bullish on a stock such as Infuses, they could buy futures, buy a call option, or sell a put option. Conversely, a bearish view can be implemented by selling futures, buying a put, or writing a call.

Finally, margin-based trading makes derivatives especially capital-efficient. Typical margin requirements are about 12% for futures and around 8% for options, so a relatively small deposit can control a large notional position—by depositing, say, Rs.25,000 it may be possible to trade Nifty futures worth around Rs.22 lakh. This efficiency underlines both the appeal and the risk of derivatives: modest capital can generate large exposures, so disciplined risk management is essential.

Exchange-Traded versus OTC Derivatives

Over the past decades the over‑the‑counter (OTC) derivatives market has expanded rapidly—by roughly 40 per cent a year globally—driven in large part by advances in information technology that make bilateral dealing by telephone, fax and electronic communication both fast and scalable. This stands in contrast to exchange‑traded derivatives, which are standardized contracts traded on organised venues with centralised order books, formal trading rules and regulatory oversight.

The OTC market’s primary attraction is flexibility: contracts can be customised to the precise needs of counterparties. That flexibility, however, comes with structural weaknesses. OTC trading typically lacks the formal risk‑management rules, centralised position limits, margining systems and regulatory authority that underpin market stability on exchanges. Moreover, features inherent to OTC activity—rapidly changing gross and credit exposures, information asymmetries between counterparties, effects on aggregate credit availability, and a high concentration of activity in a few large institutions—magnify systemic risk because these markets occupy a central position in the global financial system. The problems created by highly leveraged institutions and their OTC positions were a major source of the market turbulence seen in 1998.

India treats OTC derivatives differently from many jurisdictions: under Indian law OTC derivatives are considered illegal. Reflecting that stance, the L. C. Gupta Committee on derivatives recommended only the use of exchange‑traded instruments and did not endorse OTC contracts.

Participants in Derivatives Markets

Derivatives markets are sustained by three distinct types of participants: hedgers, speculators, and arbitrageurs. Each plays a complementary role that supports price discovery, liquidity and the overall stability of the market.

Hedgers enter derivatives markets to reduce or eliminate a risk they already face from price movements in an underlying asset. By taking an offsetting position—for example, selling futures to protect against a fall in the cash price—hedgers transfer unwanted price risk to other market participants. Their primary objective is protection, not profit from market movements.

Speculators, by contrast, trade derivatives primarily to profit from anticipated price changes. They willingly assume risk in the hope of higher returns, and their positions can amplify both gains and losses because derivatives often provide leverage. Although speculators do not seek to eliminate risk, their trading is essential: they supply liquidity, help reveal information through prices, and make it possible for hedgers to execute protective trades.

Arbitrageurs exploit price differences for the same asset across two or more markets by entering offsetting transactions simultaneously. For instance, if a futures contract trades significantly above the cash price, an arbitrageur might buy the asset in the cash market and sell the futures contract to lock in a risk-free profit. In doing so, arbitrageurs tighten price discrepancies, contribute to uniform pricing across venues, and improve market liquidity.

A healthy derivatives market needs all three types of participants. Hedgers and longer-term investors give the market economic purpose by transferring and managing real-world risk, preventing it from becoming mere gambling. Speculators provide the liquidity and depth that allow trades to be executed efficiently, while arbitrageurs enforce consistent pricing and aid price discovery. Together, these roles enable smoother functioning and greater liquidity in derivatives markets.

Forwards and Futures Markets

A forward contract is a privately negotiated agreement between two parties to buy or sell an asset at a price agreed today, with settlement on a specified date in the future. Being over‑the‑counter (OTC), forwards are not traded on exchanges and do not have standardized terms or central clearing; instead the two counterparties themselves negotiate all material features of the deal.

In a forward the parties take opposite positions: the buyer commits to a long position, agreeing to purchase the asset on the future date at the agreed price, while the seller takes the short position, agreeing to deliver the asset and receive that price on the same date. Because every term—delivery date, price, quantity, and even quality of the asset—is set bilaterally, each forward contract is effectively unique.

This bespoke nature has several practical consequences. Contract sizes, expiries and asset specifications vary from one deal to another, so forward prices are usually not published or publicly observable. Settlement is generally by delivery of the underlying on expiry, and if a party wishes to unwind the position before maturity it must typically negotiate with the original counterparty, which limits transferability and can be costly.

Despite these limitations, some forward markets are deep and liquid—most notably foreign exchange and interest‑rate forwards. For many corporates and financial institutions forwards remain the dominant tool for hedging currency exposures. For example, an exporter expecting dollar receipts in three months can sell dollars forward to lock in a rupee value, while an importer needing dollars can buy forward to protect against adverse exchange‑rate movements.

The most important risk in forward contracts is counterparty risk: because the agreement is bilateral and not centrally cleared, either party may default on its obligation. This default risk, together with non‑transferability and the lack of public pricing, are the principal drawbacks that distinguish forwards from exchange‑traded or centrally cleared derivatives.

Futures contracts are standardized, exchange‑traded agreements to buy or sell a specified quantity of a financial instrument or commodity in a designated future month at a price agreed between buyer and seller. Each contract specifies certain standard attributes: the quantity of the underlying asset, the quality where relevant (quality is generally not specified for financial futures), the delivery month or date, the unit in which price is quoted and the minimum price change or tick size, and the place of settlement. A tick denotes the smallest permissible movement in the contract price, up or down.

A futures contract is essentially a kind of forward contract in economic terms—the payoff profile and basic utility (hedging, speculation) are similar—but the two differ substantially in their institutional features and risk management. The most important distinction is venue and standardization: while forward contracts are negotiated bilaterally over the counter and fully customized, futures contracts are traded on organized exchanges and are standardized so that only the price is left to be determined by the market.

Because futures trade on exchanges, their prices and other trading information are transparent to all market participants; OTC forward markets, being private bilateral agreements, lack that transparency. Standardization and centralized trading also tend to make futures more liquid than forwards, which may be hard to transfer because of bespoke terms. Futures markets typically offer a range of contract maturities, whereas a forward generally has a single, negotiated settlement date.

A further practical difference is the settlement process. Futures are marked‑to‑market daily: gains and losses are settled each day through margin accounts, so profit or loss is realized progressively. Forwards, by contrast, realize their net profit or loss only at maturity. Because most market participants close out futures positions before delivery, futures facilitate greater flexibility in exiting a hedge or speculative position; they can be reversed with any member of the exchange. Forward contracts are usually settled with the original counterparty and therefore are not as easily transferable.

The exchange framework also creates stronger safeguards against counterparty default. Futures exchanges use a central clearing house that acts as the counterparty to both sides of the trade and guarantees performance, substantially reducing bilateral credit risk. Forward contracts do not have this central guarantee and therefore carry counterparty default risk. Finally, futures markets operate under regulatory oversight, whereas forwards largely trade in less regulated OTC markets.

In short, forwards and futures are similar in economic purpose, but they differ in institutional setting, standardization, liquidity, transparency, settlement mechanics and credit risk. Because of these features, exchange‑traded futures are generally regarded as the more cost‑efficient and flexible instrument for hedging market risk.

Futures markets serve several important and interlinked roles in modern economies. At their most basic, they provide a mechanism for hedging: producers, processors and consumers can lock in prices for future delivery to protect themselves against adverse price movements, transferring that price risk to speculators who willingly accept it in pursuit of profit. This transfer of risk helps stabilise revenues and costs for commercial participants and supports smoother planning and investment decisions.

Beyond risk management, futures markets perform a vital price-discovery function. The prevailing futures price embodies collective expectations about the future spot price and, by extension, anticipated supply and demand conditions. Observing these quoted prices allows market participants to form informed forecasts about future market conditions and to adjust their production, purchasing and inventory plans accordingly.

Because futures prices aggregate and reflect dispersed information, they also assist in the efficient allocation of resources. Policymakers, firms and investors use futures signals to decide where and when to direct capital, labour and materials, thereby improving overall economic efficiency.

Finally, futures make transactions across time easier, faster and cheaper. Standardised contracts together with centralised clearing, margining and settlement reduce counterparty and settlement risk, lower transaction costs and speed up the execution of trades, enabling effective inter-temporal trade in commodities and financial assets.

A futures contract is a standardized forward agreement traded on an exchange to buy or sell an asset at a predetermined price on a specified future date. Unlike an over‑the‑counter forward, a futures contract is exchange‑traded and subject to daily settlement and standardized terms.

When an investor owns a futures position expecting prices to rise, they are said to be long; buying the underlying asset outright is also described as being long. Conversely, a short position arises when an investor has sold contracts or the asset without currently owning it, reflecting an expectation of falling prices. Long positions represent net overbought exposure, while short positions represent net oversold exposure.

The spot price is the current market price of an asset in the cash market, while the futures price is the quoted price at which the futures contract trades on the exchange. The difference between the two is called the basis; the basis typically varies over time, influenced by interest rates, expected dividends and other carry costs. Basis tends to narrow as expiry approaches and becomes zero on the contract’s expiry date, when the futures and spot prices converge.

Each futures contract specifies an expiry date—the last trading day after which the contract ceases to exist. On most Indian exchanges the expiry is the last Thursday of the expiry month, or the previous trading day if that Thursday is a trading holiday. Contract size defines the amount of the underlying asset deliverable under one contract; for example, on the NSE’s futures market a single contract corresponds to 200 Nifty units. Contract cycle denotes the portfolio of expiries available for trading — typically near (one month), next (two months) and far (three months). After the last Thursday, on the following Friday a new three‑month contract is introduced to preserve the rolling series.

To manage credit risk, exchanges require margin deposits from both buyers and sellers. Margin limits counterparty default by ensuring each party can cover adverse price movements. Margins are adjusted daily through marking‑to‑market, whereby gains and losses are credited or debited to the investor’s margin account at the end of each trading day. Different margin types include the initial margin, maintenance margin, variation (mark‑to‑market) margin and occasional additional margins called by the exchange.

The initial margin is the upfront collateral required when a futures position is opened and is sized to cover the largest likely one‑day loss. Exchanges typically compute this using a value‑at‑risk (VaR) approach based on historical price variance, often targeting coverage of price moves that occur more than 99% of the time (commonly approximated using three standard deviations). The maintenance margin is a lower threshold that must be maintained in the account; if the account balance falls below it, the trader receives a margin call. Variation margin is the daily amount credited or debited to reflect realised gains or losses; profits are added to the margin account, while losses must be met by the close of the next business day. An additional margin may be called by the exchange in exceptional volatility to pre‑empt systemic stress.

Hedging with futures requires determining the hedge ratio — the number of futures contracts needed to offset exposure. The optimal hedge depends on the contract value, the value of the position being hedged and the sensitivity of that position to the underlying index or asset (beta), as well as the correlation between the two. For index futures used to hedge a portfolio, the optimal number of contracts is equal to the portfolio’s beta multiplied by the ratio of the portfolio value to the futures contract price.

Most futures positions are closed out before expiry by taking an offsetting trade: a long position is closed by selling futures and a short by buying futures. When contracts are closed out prior to expiry the net gains or losses are settled in cash and no physical delivery occurs. If positions are held to expiry, settlement may be cash‑based or by physical delivery depending on the contract specifications.

Market structure terms relating to futures pricing include contango and backwardation. Contango describes the normal situation where futures trade above the expected future spot price, typically reflecting positive carry costs. Backwardation occurs when futures trade below the expected future spot price, which can happen if the cost of carry is negative or if the physical asset is scarce now but expected to be more plentiful later.

In India, index futures commonly trade with one‑, two‑ and three‑month maturities, all expiring on the last Thursday of the expiry month. As each month rolls over, the sequence of near, next and far contracts shifts accordingly. Throughout the life of a futures position the trader must continue to deal through the broker who executed the contract until it is closed or settled. Settlement is conducted on a mark‑to‑market basis, with final settlement typically cash‑settled on a T+1 basis; the daily settlement price is the futures contract’s closing price for the trading day, while the final settlement price is the closing price of the underlying on the last trading day.

A clearing house or clearing corporation serves as the central counterparty to all trades in the derivatives market and guarantees their settlement. By interposing itself between the buyer and the seller, a clearing entity eliminates direct counterparty risk: through full novation it becomes the legal counterparty to both legs of every trade, or alternatively it may provide an unconditional guarantee that ensures trades will be settled even if a member defaults.

Beyond this core role, the clearing house performs the operational and risk-control tasks necessary for a resilient market. It matches and reconciles transactions, conducts daily settlement and margining, and collects margin funds to cover potential losses. It also monitors members’ financial soundness, enforces net-worth requirements, and carries out inspection, surveillance and other supervisory functions to limit system-wide risk.

In India, the National Securities Clearing Corporation Limited (NSCCL) handles clearing and settlement for all transactions on the NSE’s futures and options segment. NSCCL operates an online position-monitoring system that tracks every clearing member’s open positions in real time, enabling timely risk assessment and margin calls.

Understanding how futures are priced is central to grasping the dynamics of the futures market. Futures prices are influenced by their relationship with the spot price, expectations about the future spot price, the basis, various spreads, and the cost of storage; these factors together determine how futures trade relative to the underlying asset.

The spot price is simply the price for immediate delivery of a good, also called the cash price. The term basis denotes the difference between the current cash price and the futures price for the same commodity: Basis = Cash price − Futures price. As a futures contract approaches maturity, this basis typically narrows and reaches zero at expiration. This process—known as convergence—reflects the tendency of the futures price to move toward the spot price. Because the basis is generally more stable than either the standalone futures or cash price, it is a key metric for hedging and speculative strategies; incorrect basis levels during a contract’s life can create arbitrage opportunities.

A spread is the difference between two futures prices and can be either an intra-commodity (or calendar) spread or an inter-commodity spread. An intra-commodity spread compares futures on the same underlying with different expiration dates and therefore reflects the relative cost of delivering a commodity at two points in time. An inter-commodity spread compares futures on different but related underlyings, such as gold versus silver. Spreads tend to be more stable than individual futures prices and are widely used by speculators and arbitrageurs; mispriced spreads likewise reveal arbitrage possibilities.

Expectations about the future spot price are another important determinant of futures prices. If market participants expect the spot price of a commodity to be substantially different at a future date, that consensus will be reflected in the futures price for delivery at that date. Similarly, the cost of storing the underlying asset until delivery—the storage cost—affects futures prices because it contributes to the overall cost of carrying the asset forward in time.

The cost of carry model summarises these carrying costs and explains futures pricing under a no-arbitrage condition. In its idealised form the model assumes frictionless markets: assets are divisible, there are no transaction costs or bid-ask spreads, no short-sale restrictions, borrowing and lending rates are the same, storage is unrestricted, and forward and futures prices are equal. Under this framework, the futures price equals the spot price plus carrying costs: F = S + Carry. Equivalently, when financing is the only carry cost and discrete compounding is used, the relationship can be written approximately as F = S(1 + r)^T, where r is the financing rate and T is the time to expiration. If this relation holds, no arbitrage exists; if actual futures prices are materially above or below this level, arbitrage strategies become possible.

Carrying costs include storage, insurance, transportation and financing. Storage covers warehousing, insurance protects against loss or damage, transportation moves the commodity where required, and financing is the interest cost of funds tied up in the asset. These components vary across contracts and can, in some cases, result in a negative net carrying cost. For many financial futures, such as equity index futures, the net holding cost is financing cost minus carry returns—the cash flows the asset provides to its holder, chiefly dividends or coupon payments. In those cases the futures price is adjusted for expected carry returns: F = S + C − CR, where CR denotes the present value of carry returns.

Stock index futures merit special mention because they are cash-settled and have no storage costs, but they are affected by dividends. The net cost of carry for an equity index equals the financing cost less the expected dividend yield of the index. Put simply, the fair futures price reflects the spot index adjusted for this net cost of carry; using discrete compounding, a practical pricing expression is F = S(1 + r − d)^T, where r is the financing rate, d the expected dividend yield, and T the time to expiry. For example, for a one-month Nifty futures contract when the spot index is 1,150, financing cost is 11% p.a. and expected dividend yield is 1% p.a., the fair futures value is approximately 1,150 × (1 + 0.10)^(1/12) ≈ 1,159.

Finally, movements in the cost of carry can convey market sentiment. A rising net cost of carry is often viewed as a bullish signal because it indicates investors are willing to incur higher costs to hold long exposure. In practice, investors who establish long positions in the cash market may use short positions in index futures to hedge that exposure, reflecting how futures and cash positions are interlinked in managing market risk.

Classification of Futures Strategies

Futures trading strategies are structured plans investors use to act on expectations about future price movements. At the most basic level, an investor’s view of the market falls into one of four categories: bullish (expecting prices to rise), bearish (expecting prices to fall), volatile (expecting large, rapid price moves but with uncertain direction), and neutral (expecting little or no significant price movement). The choice of strategy flows directly from this market view and from the investor’s objectives and risk tolerance.

Broadly, futures strategies can be grouped into three types. Hedging strategies are designed to reduce or transfer risk—for example, producers or buyers use futures to protect against adverse price changes. Speculative strategies seek to profit from anticipated price moves by taking directional positions and accepting the corresponding risk. Arbitrage strategies exploit price discrepancies between markets or related instruments to earn risk‑adjusted profits and, in the process, contribute to market efficiency. Each category contains a range of specific techniques, selected according to the investor’s outlook and goals.

Index Futures Hedging Strategies

In India, futures contracts are available on two principal stock indices: the S&P CNX Nifty and the BSE Sensex. These stock index futures allow market participants to manage price risk without buying or delivering individual shares, because index futures are cash-settled rather than physically delivered.

Hedging with index futures means taking a position in the futures market to offset the price risk of an existing or anticipated position in the cash market. The aim of a hedge is to reduce portfolio volatility and lock in existing gains where desired; it is not intended to maximise returns. In practice, hedgers sell index futures when they are long the cash asset and buy index futures when they are short the cash asset, expecting that losses in one market will be offset by gains in the other as prices move in parallel.

An important input to sizing a hedge is the stock’s beta, which measures how much the stock moves relative to the market index. The market index is assigned a beta of one. A stock with beta 0.5 is half as volatile as the index; a stock with beta 2 is twice as volatile. For example, a stock with beta 1.2 tends to move about 20 percent more than the index, so a larger futures position will be needed to offset its greater volatility.

Index futures are particularly useful for mutual funds. Funds can reduce equity exposure quickly by selling index futures; they can invest money raised by new schemes in index futures to take immediate market exposure; and they can effect partial liquidation of a portfolio by selling index futures instead of selling individual shares where transaction costs would be higher. Beyond mutual funds, index futures help neutralise market volatility arising from sudden changes in foreign institutional investor flows.

The basic hedging strategies with index futures are straightforward: if you hold long stocks, you hedge by shorting index futures; if you are short stocks, you hedge by going long index futures. More broadly, a portfolio manager can reduce market exposure by shorting index futures or increase exposure by taking long futures positions, with the exact number of contracts adjusted for portfolio size and the betas of the underlying holdings.

An investor who believes a particular stock is undervalued may still fear that broad market movements will overwhelm that stock’s individual performance. To remove the risk associated with general market fluctuations while retaining exposure to the stock’s idiosyncratic return, the investor can go long the stock and short index futures. The short futures position offsets movements in the market index, so the overall portfolio is hedged against systematic (market) risk while preserving the investor’s view on the stock itself.

For example, suppose an investor holds a long position in Infosys worth ₹200,000 on September 1, 2001, and plans to hold it until September 25. If the stock’s beta is 1.2, the market exposure to be hedged equals beta times the stock position: 1.2 × ₹200,000 = ₹240,000. On that date the Nifty cash index is 1,000 and the nearest futures contract (expiring November 25, 2001) trades at about 1,020. With a futures market lot of 200 Nifties, one contract is worth 1,020 × 200 = ₹204,000. Selling one futures contract (short 200 Nifties) therefore roughly matches the required hedge. If the market later crashes—say, after a major shock—the decline in the stock position may be partly or wholly offset by gains on the short futures position, leaving the investor better protected against index-driven losses.

A second, concrete illustration: an investor buys 1,000 shares of Reliance at ₹2,200 (position value ₹2,200,000) and hedges by shorting 300 Nifty futures at 2,992 each (futures exposure ≈ ₹897,600). If the next day Reliance falls 5% (a loss of ₹110,000 on the stock) while the Nifty futures fall 4% (a gain of about ₹35,904 on the short futures), the hedge reduces the net loss to roughly ₹74,096. The example shows that shorting index futures does not eliminate stock-specific (company) risk, but it can substantially reduce losses caused by adverse market-wide movements.

If an investor believes a particular stock is overvalued but wants to protect against broad market movements, a common strategy is to take a short position in the stock while going long on index futures. This “short stock, long index futures” combination hedges the investor’s market or index exposure: losses on the short stock caused by a market rally can be offset, at least in part, by gains on the long index position.

For example, suppose an investor shorts 1,000 shares of Reliance at ₹200 each and hedges by buying 300 Nifty futures at 2,992 each. If, by the next day, Reliance rises 5% (to ₹210) and the Nifty futures rise 4% (to 3,111.68), the short Reliance position incurs a loss of (210 − 200) × 1,000 = ₹10,000. The long Nifty futures position yields a gain of (3,111.68 − 2,992) × 300 = ₹35,904. Combined, the two positions produce a net profit of ₹25,904.

The outcome illustrates two points: the hedge limits the investor’s exposure to a market-wide move, and the final result depends critically on the relative sizes of the stock and index positions (the hedge ratio). Choosing an appropriate hedge ratio is therefore essential to align protection with the investor’s view on stock‑specific versus market risk.

An investor who expects a near-term market decline can protect a stock portfolio by taking a short position in index futures. Since every diversified portfolio carries an implicit exposure to the market index, selling futures on that index offsets much of the portfolio’s market risk for a short period. This hedging is particularly useful around events that trigger volatility — for example, market uncertainty rises in the week before and the two weeks after a budget announcement — when investors wish to reduce short-term fluctuations without altering their underlying holdings.

Consider a simple example. An investor holds a portfolio worth ₹1,90,000 with a portfolio beta of 0.95. To neutralize market risk, he needs futures exposure equal to 0.95 × ₹1,90,000 = ₹1,80,500. In practice he sells index futures whose notional value approximates this amount. On 10 February 2002 the Nifty is at 1,125 and he sells 200 Nifty futures expiring on 10 March 2002 (notional value ₹2,25,000). After the budget announcement on 28 February the Nifty falls; by 5 March it is at 963 and he buys back his futures to close the hedge. His portfolio value has declined to ₹1,55,000, a loss of ₹35,000, while his short futures position produces a profit of ₹32,400 (the price drop from 1,125 to 963 on 200 contracts). The net loss after accounting for the futures hedge is therefore only ₹2,600, compared with an unhedged loss of ₹35,000. Conversely, had the market risen after the budget, the futures position would have reduced the portfolio’s gains.

This approach is also attractive to balanced mutual funds that want to reduce equity exposure without immediately selling stocks. Liquidating a large equity holding can depress prices and entail both market impact and timing costs. By shorting index futures, a fund can achieve the desired reduction in equity risk quickly and at lower transaction cost, while gradually selling actual holdings when market conditions are more favorable; as holdings are sold, the short futures position can be reduced correspondingly. In this way funds can preserve portfolio value during periods of market stress and manage transitions more efficiently.

When an investor or a fund has cash on hand or expects inflows soon but needs time to research and select equities, there is a real risk that the market index will move up before the purchases are completed. This is common for entities such as closed‑ended funds that have raised money through an IPO, or open‑ended funds that have issued fresh units; they often cannot deploy capital instantly because careful stock selection and portfolio construction take time. If the index rises during this period, the fund may be forced to buy shares at higher prices, increasing the cost of building the desired portfolio.

To protect against this timing risk, the investor can take a position in long index futures. A long futures position gains value if the market rises, offsetting the higher cost the investor would later incur when buying the underlying shares. As the investor gradually accumulates the chosen stocks, they can proportionately unwind the long futures, so that by the time the portfolio is fully built the hedge is removed. This approach lets the investor buy time for thorough research, use more patient or aggressive limit orders, and avoid being forced into overpriced purchases while still maintaining protection against upward market moves.

Speculative Strategies in Index Futures

Speculation in index futures rests on a simple choice of direction. If a trader expects the index to rise, they take a long position by buying index futures; if they expect the index to fall, they take a short position by selling index futures. When the market moves in the anticipated direction the position gains in value; if the market moves against the trader, the position incurs a loss.

Because futures are leveraged instruments, the potential for profit is magnified but so is the potential for loss, making disciplined risk management essential for anyone engaging in these speculative strategies.

If a speculator expects the market index to rise, the natural course is to buy index futures — to go long. Once long in index futures, the speculator gains when the index (and hence the futures price) rises, and incurs losses if it falls. The profit or loss equals the change in the futures price multiplied by the number of contracts (and the contract size).

For example, suppose a speculator believes the Nifty will rise and buys 200 August Nifty futures on August 1, 2002. By mid‑August the Nifty has moved higher and the August contract has risen accordingly. The speculator closes the position on August 16, 2002, selling the 200 contracts at the higher price and realising a net profit of ₹74,000.

If a speculator expects the market index to fall, the natural strategy is to sell index futures. By selling—or going short—on an index futures contract the trader profits when the index declines and incurs losses if the index rises.

Index futures are issued with a range of expirations. Contracts with longer maturities suit longer‑term forecasts of index movement, while shorter‑dated contracts are generally more liquid: they trade more frequently and tend to have tighter bid–ask spreads. When choosing among contracts, a speculator will normally sell the contract that appears most overvalued relative to the expected future level of the index or relative to the spot market.

A third trading approach is basis trading, which seeks to exploit movements in the basis—the difference between the futures price and the spot index. Basis traders typically combine positions in the cash index and the futures market to profit from predictable changes in that spread.

Basis trading is a spread strategy that focuses on the price difference, or “basis,” between futures contracts of different maturities. Rather than taking a directional view on the underlying index, the speculator is betting on changes in the cost of carry — for index futures, mainly the interest rate component — and how those changes will alter the spread between near‑term and longer‑dated futures.

If a trader expects the cost of carry to rise, they will “pay the basis”: short the near‑month future and go long the longer‑dated future. Conversely, if the trader expects the cost of carry to fall, they will “receive the basis”: go long the near‑month future and short the longer‑dated future. In both cases profit or loss comes from movements in the spread between the two maturities as the cost of carry changes.

Index and Futures Arbitrage

Index arbitrage exploits price differences between an index and the prices of the stocks that compose it. The basic idea is to use the futures market to lock in a profit or eliminate risk arising from temporary mispricings between the cash (spot) market and the futures market for a broad index such as the Nifty 50.

If an investor has cash and wants exposure to the index without bearing price risk or counterparty risk, they can buy all the constituent stocks in the cash market and simultaneously sell the equivalent index futures contract. This combination locks in the price differential: the investor is fully hedged against price movements in the underlying stocks, and settlement risk is minimised because the National Securities Clearing Corporation Limited (NSCCL) guarantees trades on the exchange. Conversely, an investor who already holds the securities can sell them in the cash market and use index futures to replicate the long position, allowing the sale proceeds to be invested until the futures contract expires. NSE’s NEAT trading platform facilitates such buy and sell orders efficiently.

Arbitrage arises whenever the futures price deviates from the spot price adjusted for the cost of carry (financing costs, dividends and other carrying charges). If the futures price F is greater than the spot price S adjusted for carrying cost—i.e., F > S(1 + r)—arbitrageurs will borrow funds, buy the underlying stocks in the cash market, sell futures, and carry the position forward to deliver against the futures contract. This strategy is known as cash-and-carry arbitrage. If the futures price is below the adjusted spot—F < S(1 + r)—the reverse operation is profitable: sell the underlying asset, invest the proceeds, and buy the futures contract; this is called reverse cash-and-carry. These trades continue until the mispricing is eliminated and prices return to equilibrium.

Arbitrage also appears when the basis (the difference between spot and futures) or the spread between two futures contracts is out of line. When the spread between a near-month and a far-month futures contract narrows, an arbitrageur will buy the far-month and sell the near-month contract; when the spread widens, the arbitrageur will sell the far-month and buy the near-month. Such calendar or spread trades are driven by expectations about time-bound events and carrying costs and help restore correct relative pricing as the market adjusts.

Practical examples illustrate how traders use these strategies. If markets expect a favourable budget but are already long in a particular month’s futures, that month may become overvalued; selling the overvalued month and buying a cheaper near-month future can exploit the expected convergence to fair value. Calendar spreads are also used when traders have a clear view on timing—for instance, anticipating a good monsoon or an interest-rate cut. A favourable monsoon may boost near-term agricultural and related market prospects, prompting traders to buy the near month and sell the distant month. Similarly, if interest rates are expected to fall, the carrying cost declines and the relative values of near and distant futures can change, creating opportunities to profit from the shift.

Options: Nature, Types and Trading

An option is a contract that gives its holder the right—but not the obligation—to buy or sell a specified quantity of an underlying asset at a predetermined price (the strike price) on or before a specified date. The term "option" therefore emphasizes choice: the holder may exercise the right if it is advantageous, or let it lapse if not. Common underlyings include physical commodities such as wheat, rice, cotton, oilseeds or gold, as well as financial instruments like equity shares, stock indices and bonds. The right to buy is known as a call option and the right to sell as a put option.

Unlike forward or futures contracts, where both parties are obliged to complete the transaction at maturity, an option places the obligation only on the seller (writer) if the holder chooses to exercise. To acquire this privilege the holder pays a price, called the premium; if the holder decides not to exercise the option, the loss is limited to that premium. This limited downside for the buyer, coupled with asymmetric payoff potential, is what fundamentally distinguishes options from forwards and futures.

An option is a contract that gives its holder the right, but not the obligation, to buy or sell an underlying asset at a specified price by a specified date in exchange for a premium. The two basic forms are the call option, which confers the right to buy the asset, and the put option, which confers the right to sell the asset. Exercising the option is the act of using that right; the predetermined price is commonly called the strike price and the final date on which the right can be exercised is the expiry date.

Options also differ by exercise rules. European-style options can be exercised only on the expiry date, whereas American-style options may be exercised at any time up to and including expiry, allowing for early exercise. Both forms are used in markets worldwide; European options are generally easier to analyse, and many properties of American options are inferred from their European counterparts.

In terms of trading venue, options may be over-the-counter (OTC) contracts or exchange-traded contracts. OTC options are privately negotiated, bespoke agreements tailored to the needs of the counterparties. Exchange-traded options, by contrast, are standardized contracts bought and sold on organised exchanges; most exchange-traded options follow the American exercise convention.

Option Contract Fundamentals

An option is a contract that gives its holder the right—but not the obligation—to buy or sell an underlying asset at a predetermined price on or before a specified date. That specified date, often called the expiry date, is when the contract expires. European-style options can be exercised only on the expiry date itself, whereas American-style options may be exercised at any time up to and including that date.

The price at which the underlying asset can be bought or sold under the option is the strike price (also called the exercise price). This price is fixed in the contract and determines whether exercising the option is economically attractive for the holder.

The seller of an option is known as the option writer. By writing the option, the seller takes on an obligation: if the holder exercises the option, the writer must sell (in the case of a call) or buy (in the case of a put) the underlying asset at the strike price. Writers receive the option premium as compensation for this obligation. The profit and loss profile for writers is the mirror image of the buyer’s: the maximum profit for a writer when an option expires worthless is the premium received, while potential losses can be large—unlimited for a naked call writer and limited but substantial for a put writer. Because of these asymmetric risks, option writing requires disciplined risk management and active market participation.

The amount paid by the buyer to the seller for the option is the option premium. Its value is influenced by several measurable factors: the strike price relative to the current asset price, time remaining until expiration, the current price level of the underlying asset, the asset’s volatility (variance of returns), the prevailing risk-free interest rate, and any expected dividends during the option’s life. Generally, call premiums rise with higher underlying prices, longer time to expiry, greater volatility, and higher interest rates, and fall as the strike price or expected dividends increase. Put premiums tend to rise with higher strike prices, longer time to expiry, greater volatility, and higher expected dividends, and fall as the underlying price or interest rates increase. Non-quantifiable influences—such as market participants’ differing views of future volatility, supply and demand dynamics in both the option and underlying markets, and the market’s liquidity—also affect premiums.

To bring consistency to option prices and to help traders quote bids and offers quickly, quantitative pricing frameworks are used. The two most widely used models are the Black–Scholes model and the binomial model; both provide methods for valuing calls and puts and for relating their prices to each other.

Finally, most organised option markets use an intermediary—typically a clearinghouse—that stands between buyers and writers and guarantees contract performance. This central counterparty reduces counterparty risk and allows participants to close out positions before expiry by entering into offsetting trades.

An investor buys a call option giving the right to purchase 100 Reliance shares at a strike price of ₹2,300, expiring on 15 October 2002. The stock is currently trading at ₹2,250 and the option premium is ₹25 per share, so the investor pays an initial outlay of ₹2,500 (100 × ₹25).

If, by expiry, the market price rises to ₹2,400 the investor can exercise the option: paying ₹230,000 (100 × ₹2,300) to acquire the shares and immediately selling them in the market for ₹240,000 (100 × ₹2,400). The gross gain from the price difference is ₹10,000, from which the ₹2,500 premium is deducted, leaving a net profit of ₹7,500.

If instead the share price falls to ₹2,000 by expiry, the investor will let the option expire unexercised because buying at ₹2,300 would be uneconomic. The investor’s loss is limited to the premium paid, ₹2,500. This limited downside and the unlimited upside — because there is no theoretical upper limit to how high the stock price can rise — are key features of owning a call option.

For example, an investor buys a put option that gives him the right to sell 100 Reliance shares at a strike price of Rs.300 per share, expiring on October 15, 2002. He pays a premium of Rs.25 per share (Rs.2,500 in total). If the market price falls to Rs.200, he can buy 100 shares in the market at Rs.200 and immediately sell them at the strike price of Rs.300. The gross difference is Rs.10,000 (100 × Rs.100), and after deducting the Rs.2,500 premium his net profit is Rs.7,500. If instead the market price rises to Rs.350, he will let the option expire unexercised and his loss is limited to the premium paid (Rs.2,500). It is therefore sensible to exercise a put only when the market price is below the strike price. When the strike exceeds the market price the option has intrinsic value; the buyer’s premium comprises that intrinsic value, if any, plus a time value component. The maximum possible gain for the buyer is constrained by the fact that a stock’s price cannot fall below zero—so the per‑share upside is at most the strike price less the premium paid.

At any time, several put strikes are quoted for a single stock—for example, Reliance strikes of Rs.320, Rs.300, Rs.280, Rs.260 and Rs.220. Exchanges typically list a minimum of five strike prices; for highly volatile scrips there may be around seven. Higher strike puts command higher premiums and therefore begin to protect the investor sooner (they become in‑the‑money at a smaller fall in the stock). Lower strike puts are cheaper, but the investor must be willing to absorb losses until the stock falls to that lower strike before protection kicks in.

Options Contracts: Terms, Margining and Greeks

Option buyers pay only the premium up front; they do not have to post margins. Exchanges, however, require margins from option writers because writers can face large — in some cases effectively unlimited — losses. To quantify that risk, the margining system used in India relies on the SPAN methodology developed by the Chicago Mercantile Exchange. SPAN runs 16 hypothetical scenarios for each option position, varying assumed price moves and volatility changes, and computes the potential loss in each scenario. The highest of these losses is treated as the margin requirement.

Practically, an option writer can expect to post margins of roughly 20–40% of the notional contract value, with higher margins applied when the underlying security is more volatile. Margins may be provided to the broker in cash, cash equivalents or eligible equity securities. Cash equivalents typically include government securities, debt securities, bank guarantees, fixed deposits and treasury bills.

In terms of rights and obligations: a call option buyer acquires the right to buy the underlying asset at the specified price, while the call option writer is obliged to sell that asset at the specified price if the option is exercised. Conversely, a put option buyer has the right to sell the underlying at the specified price, and the put writer must buy the underlying at that price if assigned.

The underlying of an option is the specific security or asset on which the contract is written; movements in the underlying’s price determine the option’s value. The buyer pays an option premium to the seller for the right—though not the obligation—to buy (call) or sell (put) the underlying at a pre-determined price known as the strike (or exercise) price.

Exchanges list strike prices in relation to the cash-market price of the underlying. SEBI requires at least three strike prices — one near the spot, one above and one below — while exchanges commonly list a wider range (for example, many series offer two strikes above and two below the spot). For index options, exchanges use fixed point intervals (NSE uses 20-point intervals for Nifty options; BSE uses 50 points for Sensex options). Stock-option strike intervals follow a slab structure tied to the stock price so that lower-priced stocks have proportionately smaller intervals; for instance, stocks trading below ₹100 typically use a 5% interval.

The expiration date is the day the option contract ceases to exist; on that date the option is either exercised or it expires worthless. The exercise date is when the holder actually exercises the right. In European-style options the only exercise date is the expiry date itself; in American-style options the holder may exercise on any trading day up to and including expiry.

Open interest is the total number of outstanding option contracts that have not been exercised, expired or squared off. Changes in open interest signal whether fresh positions are being created or existing positions closed; interpreting open interest requires looking at concurrent price and volume movements. For example, rising open interest together with rising prices typically indicates fresh long entry, while rising open interest with falling prices usually reflects new short positions. Conversely, falling open interest alongside price moves suggests positions are being liquidated or profit booked.

An option holder (buyer) acquires the right to buy or sell the underlying at the strike, enjoying limited downside (loss limited to the premium paid) and potentially large upside (in the case of calls, theoretically unlimited). The option seller or writer assumes the obligation to deliver or take delivery of the underlying if the holder exercises; the seller’s profit is limited to the premium received, while potential losses can be large.

An option class comprises all listed options of a particular type (all calls or all puts) on a given underlying. An option series refers to all contracts within a class that share the same strike price and expiry date. Assignment is the process by which, when an option holder exercises, a specific option seller is randomly chosen and notified that they must fulfil the contractual obligation.

The put–call ratio (PCR) measures the number of puts traded or outstanding relative to calls and is used as a broad sentiment indicator: a falling PCR implies relatively more call activity and is often read as bullish, while a rising PCR suggests relatively more put activity and may be interpreted as bearish. The PCR can be calculated for an individual stock, an index or the entire derivatives market.

Moneyness describes whether exercise would be immediately profitable. A call is in-the-money (ITM) when the spot price S exceeds the strike X (S > X); for a put the put is ITM when S < X. An at-the-money (ATM) option has S approximately equal to X; an out-of-the-money (OTM) option has no immediate exercise value (for a call, S < X; for a put, S > X). Deep ITM or deep OTM indicate a large gap between S and X. For example, a call with strike 4,900 when the index is at 5,100 is in the money, while that same call would be out of the money if the index were 4,700.

An option’s premium consists of two components: intrinsic value and time value. Intrinsic value is the immediate exercise value: for a call it is max(S − X, 0), and for a put it is max(X − S, 0). Only ITM options have positive intrinsic value; intrinsic value can never be negative. Time value is the portion of the premium in excess of intrinsic value and represents the price buyers pay for the possibility that the option will become more valuable before expiry. Time value declines as expiry approaches — an effect known as time decay — and this decay accelerates in the final days. Time value is typically highest for ATM options and increases with the market’s expectation of volatility, since greater volatility raises the chance of large favourable moves in the underlying. For example, if a stock trades at ₹50, a call with strike ₹49 that trades at a premium of ₹4 has an intrinsic value of ₹1 and a time value of ₹3.

Settlement can be cash-based or delivery-based. Index options are cash-settled because physically delivering an index is impractical; on expiry the contract is settled by paying the difference between the settlement price and the strike. Delivery-based settlement involves the transfer of the underlying securities and is the usual mode for individually settled stock options where physical delivery is required.

LEAPS (Long-term Equity Anticipation Securities) are long-dated options with expiries extending up to around three years, offering the right to buy or sell the underlying over a much longer horizon than standard short-term options. They allow investors to take long-term directional exposure without buying the underlying outright.

Option Greeks are analytical measures of how an option’s price responds to changes in key factors. Delta measures the sensitivity of the option premium to a small change in the underlying’s price: positive for long calls and negative for long puts. Gamma measures the rate of change of delta as the underlying price moves; long positions typically have positive gamma, short positions negative. Theta quantifies time decay — the rate at which an option’s value erodes as time passes — and is usually negative. Rho measures sensitivity to changes in interest rates (positive for calls, negative for puts) and is typically more relevant for long-dated options. Vega measures sensitivity to implied volatility: higher vega means the option’s price is more responsive to changes in expected volatility, and both calls and puts gain value when volatility rises. Traders use these Greeks to manage and hedge the risks of complex option positions.

Futures and Options: Structure, Risk and Pricing

Both futures and options are exchange-traded derivative contracts whose existence depends on trading activity: if market participants do not buy and sell them, the contracts effectively do not come into being. Trading in these instruments is essentially zero-sum—one trader’s gain is another’s loss—yet the two instruments differ fundamentally in structure, risk and pricing.

A futures contract is an agreement to buy or sell a specified quantity of an underlying asset at an agreed price on or before a specified date, and it creates a binding obligation for both counterparties to perform. By contrast, an option gives the buyer a right—but not an obligation—to buy (call) or sell (put) the underlying asset; the seller (writer) of the option, however, is obliged to fulfil the contract if the buyer exercises the right. In short, futures impose mutual obligation, while options confer rights to buyers and obligations to sellers.

These structural differences produce different risk profiles. Futures have a symmetric risk profile: both buyer and seller face potentially unlimited gains and losses as the underlying price moves. Options are asymmetric. A buyer’s downside is limited to the premium paid, while upside can be large (sometimes effectively unlimited). A seller of an option, in contrast, faces potentially unlimited downside but can only earn the premium received.

Pricing behaviour also differs. Futures prices move primarily in line with the underlying asset’s price. Option prices, however, depend on multiple dimensions: the underlying price, the time remaining to expiry, and the volatility of the underlying—factors that together determine an option’s intrinsic and extrinsic value. This multi-dimensional sensitivity gives options added complexity and flexibility as instruments of exposure.

There is also a practical cost difference. Entering a futures position does not require payment of a premium like an option; instead, participants typically post margin or collateral to cover potential losses during the contract’s life. Purchasing an option requires payment of a premium up front. Regulatory and operational requirements tend to be more involved for options, and option strategies—because they can combine positions across strikes and maturities—are generally more complex than most futures strategies.

Despite these differences, both futures and options are widely available around the world and together furnish market participants with a broad set of tools for hedging, speculation and risk management.

Benefits and Applications of Options

Options are flexible derivative instruments that have transformed modern finance and become an important tool in corporate risk management. Firms use options to shape their financing and hedging strategies because these contracts allow precise control over downside exposure without necessarily giving up upside potential. In essence, options act like insurance against adverse price movements: a call option guarantees a maximum purchase price while a put option ensures a minimum selling price. When future prices are uncertain, hedgers buy options to secure these bounds and reduce the risk of large unexpected losses.

For individual investors and speculators, options offer significant leverage. By paying a relatively small premium, an option buyer gains exposure to an underlying asset of much greater value, yielding the possibility of large percentage gains if the asset moves favorably. At the same time, the buyer’s maximum loss is limited to the premium paid, so the downside is known in advance. These two features — capped risk and asymmetric reward — make options attractive for both speculative positions and structured trades.

Employee stock options (ESOPs) have become a common component of compensation packages. Because ESOPs typically include lock-in periods and exposure to market swings, holders sometimes use puts on the underlying stock to protect against declines and effectively lock in a sale price if the market falls below their chosen strike. Beyond individual investors, institutional players such as mutual funds and pension funds routinely use options to adjust portfolio risk, to enhance yield, or to gain targeted exposure without transacting in the underlying in full.

Options also enable strategies that would be costly or impossible with the underlying alone. They allow traders to take short exposure via purchased puts or written calls, to express views not only on the direction but on the speed and magnitude of price moves, and to trade based on anticipated changes in volatility. Because many option strategies replicate other combinations of assets, options make it possible to create synthetic positions and expose markets or contracts that would otherwise see little direct trading, thereby expanding market depth and flexibility.

Call Option Payoff Structure

The payoff from a call option at expiration is the positive difference between the underlying asset’s price and the strike (exercise) price; if the underlying is at or below the strike, the option expires worthless.

A call option gives its buyer the right, but not the obligation, to buy the underlying asset at a predetermined strike price. The buyer pays a premium up front for this right. The buyer’s maximum loss is limited to the premium paid, because they can simply let the option expire if it is out of the money. Conversely, the buyer’s profit potential is theoretically unlimited if the underlying price rises substantially. The buyer’s break‑even price at expiration equals the strike price plus the premium. For example, if the strike is ₹710 and the premium is ₹6, the option is worthless if the underlying is at or below ₹710 and the buyer loses ₹6; at ₹716 the buyer breaks even; at any price above ₹716 the buyer begins to make a profit. Because a long call gains intrinsic value one‑for‑one with a rise in the underlying, each ₹1 increase in the stock raises the option’s intrinsic value by approximately ₹1. There are no margin requirements for a call buyer, but time decay works against them: as expiration approaches, the option’s time value erodes and can fall to nearly zero if the option remains out of the money.

Every buyer has a corresponding seller, or writer, who takes the short call position. The seller receives the premium upfront and is obliged to deliver the underlying at the strike price if the buyer exercises. This makes the seller’s profit limited to the premium received, while their potential loss is unlimited if the underlying price rises sharply. The seller is typically required to post margin, which can change daily depending on the underlying’s price. The seller’s break‑even point is also the strike price plus the premium received. If the underlying falls, the call’s value usually declines; a seller can close the position by buying back the option at a lower price and realize a profit equal to the difference between the premium received and the repurchase cost. For instance, if a call was sold for ₹20 and, after a price decline in the underlying, the same call can be bought back for ₹10, the seller locks in a profit of ₹10 per option.

Payoff and Risk of Put Options

A put option gives its buyer the right, but not the obligation, to sell the underlying asset at a predetermined price (the strike price). The buyer pays a premium for this right and will exercise the option only if it is profitable to do so at expiration — that is, only if the market price of the underlying is below the strike price. If the option is out-of-the-money at expiration, the buyer simply lets it expire and incurs a loss equal to the premium paid.

For example, consider a put with a strike price of ₹2,200 and a premium of ₹8. If the underlying stock is trading above the strike at expiration — say ₹2,210 — the option is worthless and the buyer will not exercise; the loss to the buyer is the premium of ₹8. If the stock is trading below the strike — say ₹2,190 — the buyer can sell the stock for ₹2,200, obtaining an intrinsic gain of ₹10, and after accounting for the premium of ₹8 the net profit is ₹2.

A put buyer faces no margin requirements and has a limited downside risk: the maximum loss is the premium paid. The upside potential, while substantial if the underlying falls, is practically capped because the underlying’s price cannot fall below zero. Thus the maximum possible profit equals the strike price minus the premium paid. As the underlying price declines, the market value of the put generally rises, allowing the buyer to realise gains by selling the option before expiration. For instance, if a 280-strike put is quoted at ₹25 when the stock is trading at ₹285, and the stock falls to ₹265 so that the put rises to ₹35, an investor who sells the put would realise a profit of ₹10.

The payoff profile of a long put — showing limited loss (the premium) and rising gains as the underlying falls toward zero — is illustrated in Figure 9.2.

A put option seller (or writer) takes on the obligation to buy the underlying asset at the strike price if the option holder exercises it. In compensation for this obligation the seller receives an upfront premium, and while the position is open must meet exchange margin requirements to cover potential obligations. The seller’s profit is therefore limited to the premium received—there is no further upside—while the downside risk, though meaningful, is capped because an asset’s price cannot fall below zero. If the underlying becomes worthless, the seller’s maximum loss equals the strike price less the premium received (for example, with a strike of 100 and a premium of 10, the largest possible loss would be 90).

Option Pricing Models and Inputs

Option prices are produced by theoretical models that translate market inputs into a single fair value. The most widely used of these is the Black-Scholes option pricing model. Other common approaches include the binomial model developed by Cox, Ross and Rubinstein and the Addison Whaley model; these alternatives are somewhat more elaborate in their construction, but they generally generate option values that are not materially different from Black‑Scholes. Ready‑to‑use Black‑Scholes calculators are available on many websites, and spreadsheet programs often include the formula as a built‑in function. As a result, an investor no longer needs to memorise the algebraic formula—only the basic inputs (for example, the current asset price, the option’s strike price, time to expiry, volatility, and the risk‑free rate) must be supplied to obtain a theoretical option price.

The Black–Scholes option pricing model, developed by Fischer Black and Myron Scholes, provides a formula to value European-style options on non-dividend-paying stocks. Its key insight is that stock returns are better modelled as lognormal rather than normal: the logarithm of stock returns follows a normal (bell-shaped) distribution, which ensures stock prices cannot become negative and produces a skewed distribution for prices themselves.

The model rests on several simplifying assumptions and reduces the computational effort needed to value options. It assumes markets are frictionless, the underlying does not pay dividends, and the underlying’s percentage price changes follow a continuous stochastic process. Using stochastic calculus, Black and Scholes derive how an option’s price evolves as the underlying price and time to expiry change; in effect, only these two state variables enter the partial differential equation that determines option value.

Five primary factors determine an option’s value: the current underlying price, the strike (exercise) price, the time to expiration, the volatility of the underlying, and the risk-free interest rate. The underlying stock price is important because any future movement affects the option’s payoff. The strike price is fixed for the option’s life and therefore provides the benchmark against which the underlying’s price is compared. Time to expiry matters because longer-dated options have more opportunity to move into profitable positions; other things equal, time value decreases as expiry approaches. The risk-free rate affects the present value of future payoffs: higher interest rates tend to raise call prices and reduce put prices because the discounted strike is worth less in present terms. Volatility measures the magnitude and frequency of underlying price movements; higher volatility increases the probability of extreme outcomes and therefore raises option premiums.

Of these inputs, volatility is the hardest to determine and, once other inputs are hedged away, it becomes the principal determinant of an option’s market price. Volatility can be measured in several ways. Historical (realized) volatility is computed from past price changes—typically the standard deviation of daily returns over a chosen look-back period—then annualized by multiplying the daily standard deviation by the square root of the number of trading days per year (commonly taken as about 250). Forecast volatility is an analyst’s or model’s estimate of future variability. Implied volatility is the market’s consensus about future volatility: it is the value of volatility that, when substituted into the pricing formula together with observed market inputs, reproduces the option’s market price. Traders compare their own forecast of future volatility with implied volatility; if implied volatility exceeds their forecast, the market is pricing higher expected risk (or possibly mispricing or anticipating news), and vice versa.

The Black–Scholes formula for a European call option on a non-dividend-paying stock is conventionally written as
C = S·N(d1) − K·e^(−rT)·N(d2),
and for a put as
P = K·e^(−rT)·N(−d2) − S·N(−d1),
where
d1 = [ln(S/K) + (r + σ^2/2)·T] / (σ·√T), and d2 = d1 − σ·√T.
Here S is the current stock price, K the strike price, r the continuously compounded risk-free interest rate, T the time to expiry in years, σ the annualized volatility, and N(·) the cumulative distribution function of the standard normal distribution. N(d1) also has an interpretation as the option’s delta, the sensitivity of the option price to small changes in the underlying price. The term e^(−rT) discounts the strike price to present value on a continuous-compounding basis.

Practical points: convert all inputs to consistent units—time in years and volatility annualized. If daily standard deviation is used, annualize by multiplying by √(number of trading days), typically √250. For the risk-free rate, Black–Scholes uses the continuously compounded rate; for example, an annual rate of 12% quoted as a simple rate corresponds to r = ln(1.12) for continuous compounding. These careful conversions ensure the model’s inputs are compatible and the resulting option value is meaningful.

Black–Scholes Model Assumptions

The Black–Scholes option pricing model is built on several simplifying assumptions designed to make option valuation tractable. It assumes frictionless markets — no transaction costs or taxes — and that securities are perfectly divisible. The model further presumes no dividends are paid on the underlying stock during the option’s life, continuous trading in the security, the absence of riskless arbitrage opportunities, and that investors can borrow and lend at the same constant short‑term risk‑free rate r.

Within this framework, Black–Scholes provides an analytical method to compute a theoretical, or “fair,” option price. Practical calculators based on the model require a few basic inputs: the current share (spot) price, the option’s strike price, the time remaining to expiry, the asset’s volatility (a measure of expected price fluctuations), and the risk‑free interest rate. The output helps investors assess an option’s fair value, understand how its value responds to changing market conditions, and compare the model price with the prevailing market price to judge whether an option appears underpriced or overpriced.

Option Spread Strategies

In options markets the risk profiles of buyers and sellers are essentially opposite. Buyers face a limited downside—the maximum loss is generally the premium paid—while their upside can be very large and, in the case of a call, effectively unlimited. Sellers, conversely, receive a limited reward (the premium received) but incur the risk of very large, potentially unlimited, losses if the market moves sharply against their position.

To manage those asymmetries, traders use spreads, which combine two or more options of the same type (all calls or all puts) to create a position with defined, limited profit and loss. A simple example is buying one call and selling another call with a different strike or expiry; this is called a spread. Spreads let a trader express a bullish or bearish view, reduce net cost to finance other option purchases, or otherwise shape risk–reward in ways single options cannot—hence their popularity with speculators. Spreads are commonly classified as vertical (different strikes, same expiration), horizontal or calendar (same strike, different expirations), and diagonal (different strikes and different expirations); each type offers a different degree of risk reduction and payoff profile.

Vertical spreads arise when an investor simultaneously buys and sells options on the same underlying asset with the same expiration date but different strike prices. Also known as price spreads, they produce a constrained payoff profile—capping both potential gains and potential losses compared with a single option position. Vertical spreads can be created with either calls or puts and are used to express modest bullish or bearish views depending on which strikes are paired.

A bull spread is an options strategy constructed by buying a lower‑strike option and selling a higher‑strike option on the same underlying with the same expiry. It can be implemented with either calls or puts and is used when an investor expects a moderate rise in the underlying price. The structure limits both the upside potential and the downside risk compared with a single long option.

Using calls, the buyer of a bull spread purchases a call with an exercise price below the current index and sells a call with an exercise price above the current index. The payoff increases as the index rises above the lower strike, but is capped once the index exceeds the higher strike. For example, suppose an investor buys one lot of February 1,100 Nifty calls at a premium of 96 and sells one lot of February 1,200 Nifty calls at a premium of 60. If Nifty closes between 1,100 and 1,200, the intrinsic payoff equals the amount by which the index exceeds 1,100. If the index closes at 1,160, the payoff is 60. The cost of setting up the spread is 36 (96 − 60), and the net profit at that closing level is 24 (60 − 36). Because the lower‑strike call is more expensive than the higher‑strike call, a call‑based bull spread is established for a net debit.

Key relationships for a call‑based bull spread are:
- Maximum profit = (higher strike − lower strike) − net premium paid.
- Maximum loss = net premium paid (premium paid for lower‑strike call minus premium received for higher‑strike call).
- Breakeven = lower strike + net premium paid.

Bull spreads with calls can be classified by the initial moneyness of the two calls: both calls out‑of‑the‑money (most aggressive), one in‑the‑money and one out‑of‑the‑money (moderately aggressive), or both in‑the‑money (least aggressive). The choice among these reflects how much risk and how much initial cost the investor is willing to accept.

When constructed with puts, the bull spread is formed by buying a put with a lower exercise price and selling a put with a higher exercise price. In this case the higher‑strike put command a larger premium, so the spread typically generates a net initial credit. For a put‑based bull spread:
- Maximum profit = net premium income (net credit).
- Maximum loss = (higher strike − lower strike) − net premium received.
- Breakeven = higher strike − net premium received.

Because call‑based bull spreads require the net premium to be paid upfront, margin requirements for call spreads are generally lower than for put‑based spreads, and the potential for additional loss beyond the paid premium is negligible. Finally, within a single monthly series an investor may create up to 42 distinct spreads on a single scrip — 21 using calls and 21 using puts.

A bear spread reflects a mildly to moderately bearish view: the investor expects the underlying price to fall and constructs the position to profit if it does. In general, a bear spread is a vertical spread created by buying the option with the higher strike and selling the option with the lower strike; it can be implemented with either calls or puts.

When created with calls, the bear spread involves selling a call with a lower strike and buying a call with a higher strike. Because lower-strike calls are more expensive, this is normally a net credit strategy. The trader’s maximum profit is the net premium received up front. The maximum loss equals the difference between the two strike prices minus that net premium. The break-even point on expiry is the lower strike plus the net premium received. Thus this call-based bear spread limits both potential profit and potential loss.

If implemented with puts, the bear spread is formed by buying a put at the higher strike and selling a put at the lower strike. Since higher-strike puts cost more, this is a net debit strategy. The maximum profit equals the difference between the strikes minus the net premium paid, while the maximum loss is limited to the net premium paid. The break-even point is the higher strike less the net premium paid. Like the call version, the put-based version caps both upside and downside exposure.

For example, consider an investor who sells a February 1,400 Nifty call for Rs. 296 and buys a February 1,500 Nifty call for Rs. 60. The position generates a net credit of Rs. 236. If the index closes at 1,420 on expiry, the short 1,400 call is in the money by 20 points, creating a loss of 20. Subtracting that from the Rs. 236 net credit leaves a profit of Rs. 216. This illustrates how a bear vertical spread offers a controlled, limited-risk way to express a modestly bearish market view: the investor expects prices to fall, or at least not to rise above the lower strike by more than the net premium received.

A horizontal or calendar spread is an options strategy that uses two contracts with the same strike price but different expiration dates. The idea is to profit from the difference in time decay between the short-dated and long-dated options: the near-term option loses time value faster than the longer-term option. Traders typically use this strategy when they expect little movement or weakness in the near term but a rally or recovery later on.

A typical call calendar spread is established by selling a short‑maturity call and buying a longer‑maturity call at the same strike. Because the long option has more time value, the position requires an initial net debit. The short option, being nearer to expiry, will generally decline in value more rapidly than the long option; if the stock price is near the strike when the short option expires, the trader can often realise a profit as the time decay has worked in their favour. The downside risk is limited to the initial premium paid to set up the spread, but there is the additional operational risk that the sold short option may be exercised early (assignment).

Calendar spreads can be constructed with puts as well as calls; in that case the investor buys the longer‑dated put and sells the shorter‑dated put at the same strike. Traders choose strike placement to reflect their near‑term bias: a bullish calendar typically uses a strike above the current stock price, while a bearish calendar uses a lower strike. A reverse calendar (sometimes called a negative calendar) flips the structure — buying the short‑dated option and selling the longer‑dated option — and therefore has a different risk‑reward profile.

Overall, the essential features of a calendar spread are identical strikes, differing expiries, an initial net premium outlay (when the long option is more expensive), limited downside (the net debit), and profit potential when time decay and price movement align with the trader’s expectation.

A diagonal spread blends the two basic option-spread dimensions — strike price and expiry — by using options with different strikes and different expiration dates. In practice, this lets an investor express differing short-term and long-term views on the underlying while simultaneously taking advantage of time decay on the near-dated leg and longer exposure on the distant leg.

A diagonal bull spread is used when an investor expects weakness in the immediate term but a rally over a longer horizon. The typical construction is to sell a near-dated call and buy a longer-dated out‑of‑the‑money call. If the longer call is retained after the short call expires, the profit potential to the upside can be substantial; however, the position’s maximum loss is limited and equals the difference in strikes adjusted by the initial debit or credit when the spread was established. One must also bear the risk that the short call could be assigned (exercised) before expiry.

A diagonal bearish strategy reflects the opposite view: little or modest near‑term upside but a decline later. It is implemented by selling a near-dated put and buying a longer-dated out‑of‑the‑money put. If the long put remains in place after the short put expires, the strategy can capture large profits if the market falls; the maximum loss is similarly capped at the strike difference plus or minus the initial debit or credit. As with the bullish variant, early exercise or assignment of the short option is a practical risk to monitor.

Volatility Trading with Options

Volatility trading means taking positions that profit from changes in the market’s expectation of how much an asset’s price will move, rather than from a view on the price direction itself. Common approaches include straddles, strangles and butterflies, each tailored to different expectations about future volatility.

Straddles and strangles are types of “combinations” in options trading: they involve buying or selling both call and put options on the same underlying asset and typically the same expiry. A straddle uses a call and a put with the same strike price, while a strangle pairs a call and a put with different strikes; both are used when a trader expects large moves but is uncertain about the direction. A butterfly is a multi‑leg spread constructed from calls or puts that limits both risk and reward and is most effective when the trader expects low volatility and the price to remain near a target level.

A straddle is an options position created by buying (or selling) a call and a put on the same underlying asset with the same strike price and the same expiration date. Because the buyer must pay two option premiums, a straddle is relatively expensive; its payoff becomes attractive only if the underlying makes a large move in either direction. For this reason traders buy straddles ahead of anticipated high-volatility events—budget announcements, major divestments, corporate acquisitions, or court rulings—when they expect a big price swing but are unsure of the direction.

A long straddle is the simultaneous purchase of one call and one put with identical strike and maturity. A short straddle is the simultaneous sale of those two options. The buyer of a long straddle expects volatility to increase: if the underlying moves sharply up or down, one option will move into the money enough to more than offset the combined premium paid. The buyer’s maximum loss is limited to the total premium paid and occurs if the underlying price equals the strike at expiration. Upside profit potential is unlimited when the price rises, and large (but finite) when the price falls.

The seller of a short straddle takes the opposite view, expecting low volatility. The seller’s maximum profit is limited to the total premium received, achieved if the underlying closes exactly at the strike at expiration. Losses on a short straddle are asymmetric: they are unlimited on the upside because a rising stock can generate arbitrarily large losses on the short call, while on the downside the loss is large but bounded (the worst case is the stock falling to zero, in which case the short put’s payoff equals the strike price).

Example: suppose a stock trades at 7,690 and you buy a three‑month call and a three‑month put, both with strike 7,700. If the call premium is 40 and the put premium is 30, the total premium paid is 70. At expiration the long straddle breaks even at 7,700 ± 70: above 7,770 and below 7,630 the position is profitable. For instance, if the stock rises to 7,900, the call is worth 200 and the put worthless, so net profit = 200 − 70 = 130. If the stock falls to 2,550, the put is worth 5,150 and the call worthless, so net profit = 5,150 − 70 = 5,080. If the stock finishes at 7,700, both options expire worthless and the buyer’s loss equals the premium paid (70). The short straddle yields the mirror image of these payoffs for the seller.

Because the short straddle exposes the seller to potentially unlimited losses, it is considered a high‑risk strategy and should be used only by those who can tolerate large adverse moves or who can hedge the position. The long straddle is appropriate for traders or investors who anticipate substantial volatility but cannot or do not want to take a directional view.

A strangle is similar to a straddle in that it combines one call and one put with the same expiration, but the two options have different strike prices. In a typical strangle the call strike is set above the current stock price and the put strike below it, so both options are initially out‑of‑the‑money.

A long strangle involves buying the out‑of‑the‑money call and put with different strikes. Traders use this when they expect a large price movement but are unsure of the direction. Because the call provides unlimited upside if the price rises and the put provides limited downside gain if the price falls, the overall profit potential on the upside is unlimited while the profit if the market falls is capped by the put’s strike (and the stock cannot fall below zero). The maximum loss for the buyer is limited to the total premium paid for the two options.

A short strangle is the reverse: selling the out‑of‑the‑money call and put at different strikes. The seller profits if the underlying remains relatively stable or moves only slightly, since maximum gain equals the premiums received. However, the seller faces unlimited loss on a large upward move (because of the short call) and potentially large but bounded loss on a sharp downward move (because the stock cannot fall below zero). Compared with a straddle, a strangle typically costs less in premium but requires a larger price move to reach the break‑even points, so it is a more conservative—but still risky—way to bet on low volatility.

A butterfly spread is an options strategy that combines a bull and bear spread to profit when the underlying stock is expected to remain near a particular price at expiration. It is created by buying two options at the extreme strikes and selling two options at an intermediate strike, so that X1 < X2 < X3. For calls, the typical construction is: buy one call at a low strike X1, sell two calls at the middle strike X2, and buy one call at a high strike X3.

Example: suppose the stock currently trades at 91 and six‑month call premiums are: strike 85 = 10, strike 90 = 7, strike 95 = 5. An investor can form a butterfly by buying the 85 call, selling two 90 calls, and buying the 95 call. The net cost is 10 + 5 − 2×7 = 1 (a small net debit). Because the structure is symmetric, both risk and reward are limited. The maximum profit occurs when the stock finishes at the middle strike X2 (here 90). The maximum profit equals (X2 − X1) − net premium paid = (90 − 85) − 1 = 4. The maximum loss is limited to the net premium paid, i.e. 1.

Break‑even points are easy to compute: lower break‑even = X1 + net premium = 85 + 1 = 86; upper break‑even = X3 − net premium = 95 − 1 = 94. If the stock finishes outside the range 86–94, the investor incurs the maximum loss of 1. If the stock finishes at 90, the payoffs work out as follows: the 85 call is worth 5 (but cost 10), the 95 call expires worthless (cost 5), and the two short 90 calls generate the collected premiums (2×7 = 14). Netting these gives a profit of 4 at expiration.

The same payoff can be constructed with puts at the same strikes, or by appropriate combinations of calls and puts, provided the strikes and expiries match. One practical limitation of the butterfly is execution: obtaining the four legs at the desired strikes and prices can be difficult in illiquid markets and may incur higher transaction costs.

Volatility trading strategies trade off profit potential against the size and likelihood of losses. Straddles offer the widest profit opportunities because they benefit when the underlying makes a strong move in either direction; at the same time they can produce the largest losses when the anticipated move does not occur or is unfavorable, since the position’s outcome depends heavily on large price swings.

Strangles lower the maximum possible loss relative to a straddle—typically because they use out‑of‑the‑money strikes and therefore cost less—but that lower cap comes with a higher probability of a loss. In other words, they are cheaper to enter but need a larger or more precise move in the underlying to become profitable, so losses (or small gains) occur more frequently.

Butterflies are constructed to limit downside risk and thus involve only small potential losses, but this safety comes at the cost of a narrowly capped upside: profits are limited to a small range of underlying prices. A butterfly spread therefore behaves much like a short straddle in its payoff profile near the centre strike, but compared with a straddle it substantially reduces the risk of a large loss. The overarching principle across these strategies is straightforward: higher potential profits generally require taking on higher risk.

Put-Call Parity and Option Arbitrage

Pure arbitrage is the practice of earning a riskless profit from pricing mismatches without deploying the arbitrageur’s own funds. When the trader must commit personal capital, the process is referred to as quasi-arbitrage. In either case the arbitrageur takes offsetting positions: buying or selling a traded derivative while simultaneously taking the opposite position in a synthetically constructed instrument made from combinations of underlying assets.

Because these trades are executed simultaneously, arbitrageurs remove opportunities for riskless profit and in doing so help to enforce consistent relationships among prices. In options markets, for example, such activity is what underpins relationships like put–call parity. More generally, for arbitrage to work there must exist systematic, replicable links between the assets that can be combined to create a synthetic asset; when those links are broken by mispricing, arbitrage restores them.

Put-call parity is the fundamental relationship that links the prices of European put and call options on the same underlying, with the same strike and expiry. Intuitively, it expresses the fact that holding a call together with a risk-free investment that will pay the strike at expiry is economically equivalent to holding the underlying asset together with a put. In formula form (for a non‑dividend-paying stock) this is usually written as

c + X/(1 + r)^T = p + S

or, equivalently,

c − p = S − X/(1 + r)^T,

where S is the current spot price of the underlying, c and p are the prices of the European call and put respectively, X is the exercise (strike) price, T is time to expiration in years, and r is the (annual) risk‑free interest rate. The term X/(1 + r)^T is the present value of the strike, discounted to today.

Because the two portfolios — (1) long call + present value of X and (2) long underlying + long put — have identical payoffs at expiry, their prices must be equal. If they are not, an arbitrage opportunity exists: an investor can sell the overpriced portfolio and buy the underpriced one, locking in a risk‑free profit.

For example, suppose the Nifty index is at 1065, the annual risk‑free rate is 12%, and we have three‑month (T = 0.25) European 1060 options with a call priced at 290 and a put at 60. The present value of the strike is X/(1 + r)^T = 1060/(1.12)^{0.25} ≈ 1,030.4. Then

c + PV(X) ≈ 290 + 1,030.4 = 1,320.4,
p + S = 60 + 1,065 = 1,125.

Since c + PV(X) > p + S by about 195.4, portfolio A (call + PV(X)) is overpriced relative to portfolio B (stock + put). To arbitrage, sell portfolio A and buy portfolio B — concretely: sell the call and borrow the present value of the strike (i.e., sell the bond), and use the proceeds to buy the stock and buy the put. The initial cash inflow equals the price difference (about 195.4). At expiry the positions offset in every state of the world: if S_T > X the short call is exercised and the long stock supplies the delivery; if S_T < X the long put is exercised and the long stock is sold at X; in both cases the obligation on the borrowed amount is exactly met. The initial cash inflow therefore becomes a risk‑free profit. If the inequality were reversed, the arbitrage would be implemented in the opposite direction (buy the call and lend the PV(X), sell the stock and sell the put).

When the underlying pays known dividends, the parity adjusts by subtracting the present value of expected dividends from the spot price; in other words, replace S by S − PV(dividends) in the parity formula. Finally, this exact equality holds only for European options; American options permit early exercise, so simple put–call parity does not generally hold for them.

Six primary factors determine an option’s value before expiration: the current price of the underlying stock, the option’s exercise (strike) price, the time remaining until expiration, the risk‑free interest rate, the volatility of the underlying asset, and any dividends expected during the option’s life. These elements together set the broad pricing limits for options.

If an option’s market price rises above its theoretical upper bound or falls below its theoretical lower bound, arbitrageurs can exploit the mispricing by constructing offsetting positions in the option and the underlying securities to earn riskless profit. The activity of arbitrageurs tends to correct such discrepancies, bringing option prices back within the established bounds.

A call option gives its holder the right to buy an underlying stock or index at a specified strike price. Because owning the stock directly can always replicate or exceed the payoffs of a call, the market price of a call can never exceed the current stock (or index) price. In symbols, C ≤ S, where C is the call price and S the current stock/index level. If this relationship were violated (C > S), an arbitrageur could sell the call and simultaneously buy the stock, pocket the immediate difference C − S and face no future loss: if the option is exercised the arbitrageur delivers the stock, and if it is not exercised the arbitrageur still owns the stock.

A put option gives its holder the right to sell the underlying at the strike price X. The maximum payoff from a put is at most X (this occurs only if the underlying falls to zero), so the put’s price cannot exceed the strike: P ≤ X, where P is the put price. If P > X, an arbitrageur can write (sell) the put and set aside X in a risk-free investment to cover any eventual exercise; this produces a riskless profit equal to the premium received in excess of the cost of the precaution.

The no-arbitrage lower bound for a European call option is given by C ≥ S − X/(1 + r)^t, where S is the current spot price of the underlying, X the strike, r the risk-free rate and t the time to expiry in years. If the call trades below this value, an arbitrageur can construct a riskless profit by buying the call and shorting the underlying.

For example, consider a three‑month Nifty call with strike 1,060 when the spot index is 1,150 and the risk‑free rate is 12% p.a. Discount the strike for three months: X/(1 + r)^t = 1,060/(1.12)^(0.25) ≈ 1,030.40. The lower bound is therefore 1,150 − 1,030.40 = 119.60. If the call were quoted at, say, 115 (below the bound), an arbitrageur could buy the call for 115 and short the index for 1,150, receiving a net cash inflow of 1,035 which is invested at the risk‑free rate. After three months that amount grows to about 1,064.73. At expiry two cases arise. If the index is above 1,060 the arbitrageur exercises the call, buys the index at 1,060 to cover the short and is left with a riskless profit of about 4.73. If the index is below 1,060 the option is allowed to expire and the arbitrageur buys the index in the market at the lower price, earning an even larger profit (for example, if the index is 1,050 the profit is about 14.73). Thus, any call priced below the lower bound permits a guaranteed profit.

Similarly, the no‑arbitrage lower bound for a put is P ≥ X/(1 + r)^t − S. If a put trades below this value, one can buy the put and the underlying financed by borrowing to lock in a riskless gain.

As an illustration, take a two‑month Nifty put with strike 1,260 while the spot is 1,185 and r = 12% p.a. Discount the strike for two months: 1,260/(1.12)^(1/6) ≈ 1,236.48, so the lower bound for the put is about 1,236.48 − 1,185 = 51.48 (≈ 51.50). If the put is offered at 40, an arbitrageur can borrow 1,225 to buy the index (1,185) and the put (40). After two months the loan grows to roughly 1,248.36. If the index finishes below 1,260 the arbitrageur exercises the put, sells the index at 1,260, repays the loan and earns a riskless profit (about 11.64 in this example). If the index finishes above 1,260 the put is ignored, the arbitrageur sells the held index at the market price and still makes a higher profit (for example, if the index is 1,270 the profit is about 21.64). In either case, a put priced below X/(1 + r)^t − S allows arbitrage.

Options Hedging Strategies

Options are financial contracts used to hedge against adverse price movements without taking a directional position in the underlying asset. A call option guarantees a purchaser the right to buy at a predetermined maximum price, while a put option guarantees a minimum selling price. Thus, buying a put (or alternatively writing a call) protects against a fall in price, and buying a call (or alternatively writing a put) provides protection against a rise in price.

Choosing between buying and writing options depends on the expected magnitude of price movement. Writing options can be preferable when only a small or modest change is anticipated because the writer receives the option premium as income and may not face large losses if the market remains relatively stable. Buying options is usually a better choice when a substantial price movement is expected, since the buyer’s loss is limited to the premium paid while the potential gain from a large favorable move can be significant. Writing, however, creates an obligation to the counterparty, whereas buying limits the buyer’s downside to the premium.

Covered writing describes selling options against a position you already have the capacity to meet. Most commonly it means selling a call option when you own the underlying asset, or selling a put option when you hold the cash or liquidity required to buy the underlying if assigned. When you write a call while owning the shares, you can deliver those shares if the buyer exercises the option.

A covered call therefore pairs a long position in the underlying with a short call on that same asset. For example, an investor who holds Infosys shares and sells a call on Infosys can fulfil the seller’s delivery obligation by handing over the shares he already owns. This contrasts with a naked call, where the writer does not own the underlying. If a naked call is exercised, the writer must buy the asset at the prevailing market price to deliver it, exposing them to potentially unlimited loss equal to the excess of the market purchase price over the strike price, offset only by the premium received.

Covered calls are less risky than naked calls because the worst outcome is having to sell shares you already own at the strike price, possibly below current market value. Investors typically use the strategy when they expect the stock to remain flat or rise only modestly. The premium earned reduces the effective acquisition cost of the shares and provides income while holding the position, but it also caps the upside because gains above the strike price accrue to the option buyer. Economically, this approach resembles selling a put in that both collect premium and reflect a mildly bullish or neutral outlook.

The mirror image of writing a covered call is holding a short position in the stock while owning a call option on it—a combination that offsets the payoff pattern of long stock plus short call.

A covered call is an options strategy in which an investor who already owns the underlying stock sells a call option on that stock. Because the seller owns the shares, any obligation to deliver the stock if the option is exercised is covered, so the position avoids the potentially unlimited risk associated with a naked call. The seller receives a premium for writing the call, which provides immediate income and partially offsets downside in the underlying, while capping upside because any rise above the strike will be surrendered at exercise.

The maximum profit from a covered call equals the gain on the stock up to the strike price plus the premium received—effectively (strike price − purchase price) + premium. Sellers must also meet margin requirements for the option position until it is closed or expires.

For example, suppose an investor owns Reliance shares quoted at ₹280 and is mildly bearish, expecting the price to fall to about ₹250 over the next month. He sells a call with a strike of ₹270 and receives a premium of ₹25. If, contrary to his expectation, the price rises to ₹300 at expiry, the call buyer will exercise, and the seller will effectively pay the option payout of ₹30 (₹300 − ₹270). That payout is offset by the appreciation in the seller’s holdings (₹20, from ₹280 to ₹300) plus the ₹25 premium received. Net result: ₹25 + ₹20 − ₹30 = ₹15 profit.

The covered call can also be used when an investor is moderately bullish but believes the stock will not rise beyond a certain level. For instance, if Reliance trades at ₹285 and the investor thinks it will stay below ₹300, he can buy the shares (or futures) at ₹285 and simultaneously sell a ₹300 call for ₹15. The premium lowers his effective acquisition cost to ₹270 (₹285 − ₹15). The trade reduces cost and generates income, but it also means the investor gives up any upside beyond the ₹300 strike, creating an opportunity cost if the market rallies strongly.

A protective put is an hedging strategy in which an investor holds a long position in a stock and simultaneously buys a put option on that same stock. The put gives the holder the right to sell the stock at a predetermined strike price, so owning the option acts like an insurance policy: it preserves the stock’s upside while limiting potential losses below the strike. By put–call parity, a long stock plus a long put is economically equivalent to a long call plus a certain amount of cash (the present value of the strike), which highlights how the put provides downside protection without eliminating upside participation. The main trade-off is cost: the put’s premium raises the effective acquisition price of the position, but that extra expense is the price paid to cap downside risk and reduce portfolio volatility.

Evolution of India's Derivatives Market

The derivatives market in India has deep roots in commodity trading, with futures contracts traced back to 1875. Despite this long tradition, the central government progressively restricted forward and futures trading in many commodities during the 1960s and 1970s. Forward trading in securities was formally prohibited by a 1969 notification issued under Section 16 of the Securities Contracts (Regulation) Act (SC(R)A), although forward contracts in the rupee–dollar exchange rate continued to be permitted and widely used under Reserve Bank of India rules. Today futures trading is allowed in a range of agricultural and non‑agricultural commodities; at the time there were 41 permitted commodity contracts traded on 18 commodity exchanges regulated by the Forward Markets Commission under the Ministry of Food and Consumer Affairs.

In capital markets, a longstanding indigenous mechanism known as the badla system—popular for over a century—came under pressure in the 1990s as foreign institutional investors entered the market and a series of scandals exposed serious market risks. FIIs were uncomfortable with the opaque risk profile of badla and pushed for formal risk‑management tools. SEBI therefore moved to introduce financial derivatives, but legal barriers in the SC(R)A had to be removed first. The Act’s preamble and Section 20 had effectively prohibited options and related transactions; to clear the way, the Securities Laws (Amendment) Ordinance, 1995, promulgated on 25 January 1995, repealed Section 20 and amended the preamble.

Recognizing the need for a comprehensive regulatory framework, SEBI set up a committee chaired by Dr L. C. Gupta on 18 November 1996 to design rules for derivative trading; the committee reported on 17 March 1998. A key recommendation was to expand the statutory definition of “securities” to encompass derivatives so they could be brought within the SC(R)A’s regulatory ambit. Legislative efforts followed: a Securities Contracts (Regulation) Amendment Bill was introduced in July 1998 but lapsed with the dissolution of the 12th Lok Sabha. A revised Securities Laws (Amendment) Bill, introduced in October 1999, incorporated the earlier proposals and the Standing Committee on Finance’s suggestions. The resulting legislation inserted a definition of “derivatives” to include instruments that derive their value from debt instruments, shares, loans, risk instruments, contracts for differences or from the prices or indices of underlying securities, and it brought derivatives within the statutory meaning of “securities.” The law allowed only exchange‑traded derivatives and prohibited over‑the‑counter derivative trading.

Parallel to legislative change, SEBI moved to address market risk. In June 1998 it constituted a committee under Professor J. R. Verma to recommend risk‑containment measures; the committee’s October 1998 report was largely accepted by SEBI in March 1999. With legal and regulatory groundwork in place, the government rescinded the 1969 notification on 1 March 2000, lifting the long-standing ban on forward trading in securities.

Derivatives trading formally began in June 2000 on India’s two major stock exchanges. The BSE launched futures based on the Sensex on 9 June 2000, and the NSE introduced futures on the S&P CNX Nifty on 12 June 2000. SEBI subsequently established a technical group to frame risk‑management norms for index options; trading in index options started in June 2001, options on individual securities followed in July 2001, and stock futures commenced in January 2002. Further product innovation continued: interest‑rate futures were introduced in June 2003, with additional futures-and-options contracts added in August 2003.

Regulatory liberalization also widened access. FIIs and NRIs were permitted to invest in all exchange‑traded derivative contracts, exchange‑traded contracts referencing a notional 10‑year government bond were allowed, and stock brokers were authorised to deal in derivatives. The National Stock Exchange emerged as the dominant trading venue for both equity and derivatives, hosting more than 99 percent of exchange‑traded derivative contracts and undertaking extensive investor education—training over 11,200 market participants in derivatives trading. Together, these legal, regulatory and infrastructure changes transformed India’s derivatives landscape from a restricted, informal practice into a formally regulated, exchange‑based market.

NSE Derivatives: Trading, Clearing and Regulation

The NSE’s futures and options platform operates on the fully automated NEAT‑F&O screen-based trading system, which offers nationwide order‑driven trading in the S&P CNX Nifty futures together with online monitoring and surveillance. Access is provided to two user categories: trading members (TMs) and clearing members (CMs). Trading members handle order entry, matching and trade management, while clearing members use a trader workstation to monitor the trading members whose trades they clear; CMs can also set position limits for those trading members.

An investor wishing to trade derivatives must sign a client‑broker agreement with a member of the derivatives segment; a separate agreement is not required for options trading if one already exists for index futures. Brokers charge a commission on the contract value (strike price plus premium), typically between 0.1 and 0.2 percent, though some brokers instead levy small per‑share rates (commonly 5–25 paise) depending on the broker and the volume of business.

Margins and contract mechanics are determined by the prescribed market lot. The market lot is set so that the contract value meets the exchange’s minimum contract size, and investors may trade only in whole multiples of that lot. The NSE adjusted lot sizes for 24 stocks on 1 April 2005 because rising share prices had pushed many contract values above the exchange’s prescribed minimum, excluding smaller investors. Where contract values exceeded the ceiling, lot sizes were halved so that the revised market lot brought the contract value back within acceptable limits. Current market lots include: S&P CNX Nifty — 50; S&P CNX Mini Nifty — 20; Nifty Midcap 300 — 300; CNX IT — 100; and Bank Nifty — 50.

Initial deposits with a broker are required to start trading in derivatives; these funds are collected to meet initial and mark‑to‑market margin obligations. Margins must be posted for all futures positions (long and short) and for short option positions; option buyers are not required to post margins but must pay the upfront premium. Margins for index derivatives tend to be lower than for stock derivatives because indices are generally less volatile than individual stocks. Brokers are obliged to issue a contract note for every options and futures trade an investor executes, normally within 48 hours of the transaction.

The National Securities Clearing Corporation Limited (NSCCL) handles clearing and settlement for all trades executed on the NSE’s derivatives segment. Acting as the legal counterparty to every transaction, it guarantees settlement and thereby significantly reduces counterparty credit risk among market participants. To contain risks in the derivatives market, NSCCL has put in place a comprehensive risk-management framework, centered on daily margining of positions and continuous online intra-day monitoring of exposures to ensure timely collateral collection and rapid detection of concentration or volatility-driven buildups.

The Nifty contracts are cash-settled. For Nifty Index futures, settlement is carried out daily by marking all open positions to the daily settlement price; this process computes the gains and losses that arise each trading day. Clearing members must pay any mark-to-market losses by T+1 (the next settlement day), and the contracts receive their final settlement on the contract expiry date.

Index options on the Nifty are European-style, meaning they can be exercised only at maturity. These options also undergo a daily premium settlement to reflect movements in option value, with a formal cash settlement occurring if the option is exercised on the expiry day.

The Securities and Exchange Board of India (SEBI) allows mutual funds to operate in the derivatives market, but only with strict limits. Mutual funds may use derivatives solely for hedging and portfolio rebalancing; they are required to maintain cash or the underlying securities equal to the total exposure created by those derivative positions. Because exposures must be fully covered, there is no room for speculative bets or the use of leverage by mutual funds.

SEBI’s rules also impose clear disclosure and governance obligations. A fund’s offer document must explicitly state that it may use derivatives, trustees must be kept informed of derivative activity on a regular basis, and shareholder approval is required before the fund takes positions in the derivatives market. These measures are designed to contain risk and safeguard investor interests while permitting prudent use of derivatives for risk management.

Equity Derivatives Market in India

Equity derivatives trading in India began in June 2000 with stock index futures. The Bombay Stock Exchange (BSE) led the start of derivatives trading on June 9, 2000, and the National Stock Exchange (NSE) followed on June 12. Over the next year the market expanded: index options were introduced in June 2001, individual stock options in July 2001, and futures on individual stocks were permitted from November 2001. These steps established four principal equity-derivative products in India—index futures, index options, stock futures and stock options.

Globally, index futures have been the most successful equity-derivative contracts, followed by index options and then stock options. On the NSE, index futures and index options are written on the S&P CNX Nifty, CNX IT and CNX Bank indices, while stock futures and options are available on 123 underlying securities. Index options traded on the exchange are European-style, exercisable only at expiry, whereas stock options are American-style, exercisable any time up to expiry.

Equity Derivatives in India

Stock index options are derivatives whose underlying asset is a stock index—examples being the S&P CNX Nifty or the BSE Sensex. Introduced by the Chicago Board Options Exchange (CBOE) in 1983 on the S&P 100, index options let an investor take a position on the value of an entire market or market segment in a single trade rather than buying individual shares. This consolidated exposure reduces transaction costs and generally requires a smaller premium relative to taking equivalent positions in many individual stocks.

Both retail investors and professionals use index options. Retail investors employ them to express a view on the broad market (bullish, bearish or neutral) without selecting individual stocks, while fund managers and other professionals use them to fine-tune asset allocation, improve market timing or hedge portfolio risk. In India, index options are exercised only on the expiry date—this is known as a European-style option—and they are settled in cash rather than by delivery of the underlying securities.

Typical contract specifications on Indian exchanges include a minimum contract value (often stated in lakhs), a maximum maturity of 12 months, and at least three strike categories: in-the-money, near-the-money and out-of-the-money. Both the NSE and the BSE offer multiple strike prices (seven strikes are commonly available), with standard lot sizes—currently 200 units for Nifty and 100 units for Sensex. Exchanges apply a portfolio-based margining approach so clearing members and brokers can assess the net risk of a client’s entire derivatives portfolio rather than treating each position in isolation.

To illustrate the payoff mechanics: suppose the Nifty stands at 1,550 and an investor buys one call contract (lot size 200) with a premium of 20 per unit, paying 20 × 200 = 4,000 as the total premium. If the strike equals 1,550, the break-even level at expiry is 1,570 (strike + premium per unit). If the index settles at 1,575 at expiry, the option’s intrinsic gain is 5 points per unit, yielding a profit of 5 × 200 = 1,000 after recovering the premium. If the index is at or below the break-even level at expiry, the option will not be exercised and the investor’s loss is limited to the premium paid.

By contrast with index contracts, individual stock futures and options in India are generally American-style (allowing exercise any time up to expiry). Regardless of style, both index and stock options in the current market framework are settled in cash.

Individual stock options are contracts whose underlying asset is a single equity share. In India these are generally American-style options, meaning they can be exercised on any trading day during their life. Option prices are quoted as a premium per share, although each contract covers multiple shares.

For example, consider a put option (the right to sell) on Infosys. Suppose an investor buys a June put on April 3 with a strike price of Rs 23,800 and pays a premium of Rs 650, while the spot price that day is Rs 23,300. The option is “in the money” because the strike exceeds the spot by Rs 500; exercising immediately would yield that intrinsic value of Rs 500, which is still less than the premium paid, so the investor would incur a net loss of Rs 150. The buyer will make a net profit only if the stock falls below the strike less the premium (in this example, below Rs 23,150). In practice, individual stock options are settled using the closing spot price of the underlying stock on the exercise date.

Individual stock options expand the set of strategies available to both hedgers and speculators. A common hedging use is a protective put, where an investor buys puts to insure a portfolio against downside risk. Because options require only a relatively small premium, they provide leverage—large exposure for a limited upfront cost. They are also useful for holders of ESOPs (employee stock options) who face lock-in periods; since ESOPs cannot be sold immediately, buying a put on the underlying stock can protect the employee from losses if the market price falls during the lock-in.

In India, contracts on individual securities have typically been American-style and cash-settled. Cash settlement reduces delivery-related costs and administrative burden, which can encourage greater participation and speculative activity. However, because settlement does not involve actual delivery of shares, large long or short positions can be used to influence spot prices near expiry; manipulators may attempt to push prices up or down to benefit their positions. For this reason, SEBI is moving toward enforcing delivery-based settlement for options on individual stocks to discourage such manipulation.

A stock index measures the change in value of a selected group of stocks relative to a base period; these stocks together form the index. For example, the BSE Sensex is a weighted average of 30 shares, while the S&P CNX Nifty represents a weighted average of 50 shares.

Stock index futures are futures contracts whose underlying asset is such an index. Trading these contracts expresses a view on the direction the entire market (as captured by the index) will move over the life of the contract. Rather than taking positions in individual securities, market participants take exposure to the whole market by buying or selling index futures. These contracts are versatile: they are used for hedging portfolio risk, speculative position-taking, arbitrage between cash and futures markets, managing cash flows, and adjusting asset allocation. Index futures are cash‑settled, and participants are required to post only a fraction of the contract value as margin. This margin arrangement creates leverage (or gearing), allowing a trader to control a larger position than the capital actually invested. Because the exchange’s clearing corporation is counterparty to every trade, the risk of default by the other trading party is removed.

In India, index futures are available on several indices, including the BSE Sensex, S&P CNX Nifty, CNX IT, CNX Nifty Junior, CNX 100, Nifty Midcap 50 and CNX Bank. Contract specifications vary by exchange. On the NSE, the minimum lot size for S&P CNX Nifty futures is 200 units (and multiples thereof), so if the index is around 1,000 points the notional value of one contract is roughly Rs. 2,00,000 (1,000 × 200). On the BSE, Sensex futures use a multiplier of 50, so with the index near 5,000 points a single contract has a notional value of about Rs. 2,50,000 (5,000 × 50). Tick sizes also differ: on the NSE the minimum tick is 0.05 index points, which at a 200‑unit lot equals a Rs. 10 change in contract value; on the BSE the tick is 0.1 Sensex points, and with a multiplier of 50 this corresponds to a Rs. 5 change.

Index futures tend to suit institutional and large equity holders because they provide an efficient way to hedge portfolio risk. Large investors such as pension funds commonly use index futures for risk management. Compared with individual stocks, an index is harder to manipulate and typically exhibits lower volatility; as a result, capital adequacy and margin requirements for index futures are comparatively lower, which encourages broader participation in the market.

Stock futures are standardised contracts on the shares of individual companies. On the NSE they follow specific contract specifications (see Table 9.1). Compared with options, stock futures are conceptually simpler. For example, if an investor is bullish on a stock trading at Rs 290 and expects it to rise to Rs 340 over the next month, buying the share outright and selling later at Rs 340 yields a profit of Rs 50 — roughly a 17% return on the Rs 290 outlay. If instead the investor takes the same bullish position through a stock futures contract, he may be required to post only a margin — say 20% of the spot price, or about Rs 58. The same Rs 50 gain on an initial margin of Rs 58 produces an approximate one‑month return of 86%, illustrating the leverage that futures provide.

In India, stock futures are generally not intended for physical delivery; investors use them to express views on future price movements. If one expects prices to rise, one goes long in futures; if one expects prices to fall, one goes short. The principal attraction is leverage: traders can initiate or carry forward positions by paying a relatively small margin. The flip side is that losses are also magnified. A prudent approach is to go long when futures trade at a premium that reflects the known cost of carry, and to short when the cost of carrying a position is negative. (The cost of carry captures financing costs, dividends and other carrying expenses that affect fair futures pricing.)

Stock futures are often more effective than index futures for hedging a position in a particular share, because it is easier to match and arbitrage differences between a single stock’s cash and futures prices than to do the same for an entire index. Historically in India, stock futures replaced the older badla carryover mechanism. Under badla, brokers rolled over positions by financing purchases at rates that varied with demand and were settled periodically; by contrast, futures disclose the carrying cost (interest or premium) at the time the contract is entered, making pricing and risk assessment more transparent. As with any derivative, investors can combine futures with options to design strategies that capture upside while limiting downside exposure.

The number and spacing of strike prices for index options on the NSE depend on the previous day’s closing level of the underlying index. As per the exchange parameters (NSE Factbook, 2008–09), strike intervals are 50 points for index levels up to 2,000 and 100 points for higher index levels; the same strike-interval rules apply to long-term contracts as well.

Individual stock futures are sometimes less active in other markets because single-stock volatility tends to be higher than index volatility, creating greater risk for clearinghouses and necessitating higher margin requirements — which can reduce market depth. In India, however, the historical continuity with badla-style trading helped stock futures gain popularity: they account for around 32% of the derivatives segment’s total turnover. Since January 2008, by the number of contracts traded on the NSE, average daily volumes in stock futures have been among the highest in the world.

Equity Derivatives Lot-Size Framework

Review of minimum contract size in the equity derivatives segment

The minimum contract size in the equity derivatives segment has been raised from 2 lakhs to 5 lakhs. The lot-size framework that governs derivatives contracts has been prescribed to ensure contract values remain within a defined band and to promote uniformity across exchanges.

Lot sizes must be set so that the contract value, measured on the day of review, lies between 75 lakhs and 710 lakhs. For stock derivatives, the lot size (measured in units of the underlying security) should normally be fixed as a multiple of 25, subject to a minimum lot of 50 units. If, however, the contract value at the minimum lot of 50 units exceeds 10 lakhs, the lot size may instead be fixed as a multiple of 5, with a floor of 10 units. For index derivatives, the lot size should be fixed as a multiple of 5, with a minimum of 10 units.

Stock exchanges are required to ensure that the lot size for a given underlying is identical across all exchanges where it trades. Exchanges must review lot sizes every six months, using the average closing price of the underlying over the preceding month, and publish any revision with at least two weeks’ advance notice. If the revised lot size is higher than the existing one, the change will apply only to newly initiated contracts.

Equity Derivatives: Products and Eligibility

The equity derivatives segment offers four principal products: index futures (cash-settled), index options (cash-settled, European style), stock futures (cash or physical settlement) and stock options (cash or physical settlement, European style).

Presently the minimum contract size in the equity derivatives segment is ₹5 lakhs. Consequently, lot sizes are determined so that the contract value on the review date lies between ₹25 lakhs and ₹210 lakhs.

SEBI has prescribed eligibility criteria for introducing derivatives on stocks and indices. A stock must be among the top 500 measured by average daily market capitalization and average daily traded value over the preceding six months on a rolling basis; its median quarter‑sigma order size over the last six months must meet a prescribed minimum (reported as ₹710 lakh); and the market‑wide position limit (MWPL) for the stock must be at least ₹300 crores.

Indian Equity Derivatives Market Overview

Mutual funds whose Scheme Information Documents (SIDs) do not envisage investments in derivatives must secure affirmative consent from a majority of unit‑holders before entering the derivatives market. Dissenting investors must be offered an exit option at the prevailing NAV, without charge of exit load, and this option must remain open for at least 30 days prior to the scheme commencing derivative trading. The funds are also required to disclose the extent and manner of proposed derivative participation and to explain the associated risks with suitable numerical examples. Compliance with Regulation 18(15A) of the SEBI (Mutual Funds) Regulations, 1996 is mandatory before such participation begins.

Equity derivatives constitute the most active and liquid segment of the Indian securities market, and they hold a significant place in global derivatives trading by number of contracts, products and traded value. On the exchange front, the National Stock Exchange (NSE) offered futures and options on 176 stocks while the Bombay Stock Exchange (BSE) offered them on 173 stocks. At the NSE, index futures and options are permitted on ten and eight indices respectively; at the BSE, they are allowed on nine and five indices respectively. The NSE’s index derivatives include Nifty, Nifty Midcap 50, Nifty Bank, Nifty Infra, Nifty IT and Nifty PSE, and also permit contracts linked to three foreign indices: the Dow Jones, S&P 500 and FTSE 100. The BSE offers derivatives on indices such as the S&P BSE Sensex, Bankex, Oil & Gas, Teck and BSE100, and provides futures on several foreign indices including the HSI, MICEX, FTSE/JSE Top 40 and Bovespa.

In a notable product innovation, NSE launched futures on India VIX on 26 February 2014. India VIX is a volatility index derived from NIFTY option prices and reflects the market’s expectation of volatility over the next 30 calendar days. The contract (INDIAVIX) was introduced as three weekly futures contracts expiring every Tuesday; tick size was set at 0.25 and lot size at 550.

Participant composition in the NSE F&O market is skewed towards proprietary trading, which accounts for roughly half of total turnover. Foreign portfolio investors (FPIs) contribute about 12 per cent, the residual “others” category—which includes retail investors, high‑net‑worth individuals and corporates—accounts for about 38 per cent, while mutual funds form a very small share, around 0.5 per cent. The 2015 World Federation of Exchanges report noted that NSE handled nearly 50 per cent of global volumes in stock index options; its turnover‑to‑GDP ratio for 2015–16 stood at 511, underlining the market’s depth and liquidity.

Trading intensity in derivatives has grown rapidly. By February 2017, equity derivatives turnover was roughly twelve times that of the equity cash segment. Index options have become the dominant product, accounting for about 79 per cent of F&O turnover on the NSE; combined, index and stock options made up approximately 83.61 per cent of total derivatives trading. Several factors explain this preference for options: Security Transaction Tax (STT) on options is levied on the option premium rather than on notional value as in futures, which can make the tax cost relatively lower; in addition, options give market participants flexibility to construct hedges and income strategies, including earning upfront premium by writing options.

Between FY 2004–05 and FY 2016–17, turnover in the cash market grew at a compounded annual growth rate (CAGR) of 11.39 per cent, while equity derivatives turnover expanded at a much faster CAGR of 35.10 per cent. Market capitalisation of listed BSE companies rose at a CAGR of 17.82 per cent over the same period. The ratio of equity derivatives turnover to equity cash turnover climbed from 1.54 to 15.59. This expansion reflects a combination of higher index levels and stock prices, tax changes such as the reduction in STT on equity futures from 0.017 per cent to 0.01 per cent, and the introduction in the 2013 Budget of a commodity transaction tax (0.01 per cent) on non‑agricultural commodity futures. Over the years, more than 95 per cent of equity derivatives trading in India has taken place on the NSE.

Indian index contracts, particularly on NIFTY and SENSEX, are also traded abroad. Futures and options on NIFTY are available on exchanges such as Singapore Exchange (SGX), Osaka Exchange (OSE), Chicago Mercantile Exchange (CME) and the London Stock Exchange, while SENSEX‑linked products trade on platforms including Hong Kong Exchange and Clearing Ltd, BM&FBOVESPA (Brazil), Johannesburg Stock Exchange, MICEX‑RTS (Moscow), Korea Exchange and Dubai Gold & Commodities Exchange.

On the investor side, individual participation in the equity derivatives segment has ranged between 26 and 33 per cent of total turnover. Proprietary trading dominates activity in index options, and the combined contribution of proprietary and non‑institutional non‑proprietary participants has been substantial—together accounting for roughly 85 per cent of index options volume. Foreign investors typically contribute between 15 and 20 per cent of total volumes across product categories.

SEBI has actively sought to strengthen the cash market alongside derivatives by introducing new products, redesigning existing ones and running investor‑awareness initiatives. It has also revised margin trading norms—rationalising initial margin requirements—and permitted stocks to be used as collateral for funding from stock brokers, measures intended to improve access to finance and market functioning.

Derivatives Market Risks and Safeguards

The derivatives market has expanded rapidly around the world, becoming an integral part of modern finance. Like any market, however, it is vulnerable to severe failures when risk is misjudged or controls are weak. Excessive speculation and inadequate risk management have precipitated some high-profile collapses: the fall of Barings Bank and the troubles at Germany’s Metallgesellschaft illustrated how concentrated positions and flawed hedging can destroy long-established firms, and the near-collapse of Long Term Capital Management — an institution with very large notional derivatives exposures — showed how leverage and complex strategies can threaten broader financial stability and invite official intervention.

India’s derivatives market is relatively young but growing quickly. To ensure it develops resiliently, robust checks and controls are essential: effective regulation, sound risk-management practices by market participants, strong market infrastructure, and investor education. These measures will help contain excessive speculation, reduce the risk of scams, and support stable, orderly market development.

Overview of Financial Derivatives

A derivative is a financial contract whose value depends on the price of another asset, called the underlying — for example, a share, a stock‑market index, an interest rate, a commodity or a currency. The modern expansion of derivative markets, especially in developed economies, has been driven by greater volatility in global markets, advances in technology and financial theory, political developments, and the increasing integration of domestic markets with international capital flows.

Derivatives serve several economic functions. They allow market participants to transfer or reduce risk, improve liquidity, lower transaction costs, and support more efficient price discovery. By permitting investors to modify the risk‑return profile of a portfolio, derivatives also convey forward information about expected magnitudes and directions of market moves.

Indian law recognises derivatives under the Securities Contracts (Regulation) Act, 1956, defining them to include securities derived from debt instruments, shares, loans, or contracts for differences, and any contract whose value is tied to prices or price indices of underlying securities. The principal financial derivative forms are forwards, futures, options, warrants, swaps and swaptions, and the principal market participants are hedgers, speculators and arbitrageurs.

Formal derivatives trading in India began in June 2000 on the BSE and NSE: Sensex futures started on the BSE on 9 June 2000, and S&P CNX Nifty futures began on the NSE on 12 June 2000. A forward contract is an over‑the‑counter, customised agreement between two parties to buy or sell an asset at a specified future date and price agreed today. By contrast, a futures contract is a standardised, exchange‑traded agreement to buy or sell a specified quantity of an instrument or commodity in a designated future month at a price determined at the time of the trade. Futures facilitate hedging against adverse price changes, improve price discovery, reduce the cost and time of intertemporal transactions, and help resource allocation.

Investors can hold one of four broad views about market movement — bullish, bearish, volatile or neutral — and different derivative strategies match these views. Strategies fall into three categories: hedging strategies (to reduce risk), speculative trading strategies (to profit from directional or volatility views) and arbitrage strategies (to exploit pricing inconsistencies).

The cost‑of‑carry model links futures and spot prices. In general terms the futures price equals the spot price plus carry costs (financing costs, storage, insurance, less any income from the asset). For simple discrete financing, F = S + C; if financing is expressed as a rate r over the period, the relationship can be written in compounded form. For stock‑index futures, the cost of carry is the financing cost minus expected dividends, often expressed as F = S[1 + (r − d)] for a given holding period and dividend yield d. Hedging with index futures can be done in several ways — for example, long stocks with short index futures, short stocks with long index futures, hedging a portfolio with short index futures, or protecting a portfolio with long index futures. Speculative approaches include taking long or short positions in index futures and engaging in basis trading.

Options give the holder the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a predetermined strike price on or before a stated date. A call gives the right to buy; a put gives the right to sell. Options can be in‑the‑money (immediate exercise would be profitable), at‑the‑money (spot equals strike) or out‑of‑the‑money (immediate exercise would not be profitable). Intrinsic value is the immediate exercise value — for a call, max(0, S − K); for a put, max(0, K − S). The option premium exceeds intrinsic value by the time value, which reflects the possibility that favourable price moves before expiration may make the option profitable.

Option prices are sensitive to several factors captured by the “Greeks.” Delta measures the change in option price for a small change in the underlying price; Gamma measures the rate of change of Delta; Theta measures time decay — how the option premium erodes as expiration approaches; Rho measures sensitivity to interest rates; and Vega measures sensitivity to changes in implied volatility. These sensitivities underpin many trading and hedging decisions.

Options strategies are numerous and flexible. Spreads combine buying and selling options to shape payoff and risk: vertical spreads use the same expiry but different strikes; calendar (horizontal) spreads use the same strike but different expiries; diagonal spreads mix different strikes and expiries. Volatility strategies include straddles (buying a call and put at the same strike and expiry), strangles (buying out‑of‑the‑money call and put with same expiry but different strikes) and butterfly spreads (combining bull and bear spreads to profit from little expected movement). Covered writing, put‑call parity and arbitrage around theoretical upper and lower price bounds are further tools traders use to exploit or manage pricing relationships.

The Black–Scholes model, developed by Fischer Black and Myron Scholes, provides a closed‑form formula for pricing European options on non‑dividend‑paying stocks. In that framework the call price can be expressed as C = S N(d1) − K e^{−rT} N(d2) and the put price as P = K e^{−rT} N(−d2) − S N(−d1), where d1 and d2 are functions of S, K, r, volatility and time to maturity, and N(·) denotes the standard normal cumulative distribution. For non‑dividend‑paying stocks the put‑call parity relationship is C + K e^{−rT} = P + S; if this equality is violated, arbitrage opportunities exist. When the underlying pays dividends, the parity adjusts for the present value of expected dividends.

Several practical bounds follow from arbitrage logic. A European call can never be worth more than the stock itself, so C < S. A lower bound for the call is C ≥ S − K e^{−rT}; if the market price were below this level, a riskless profit could be constructed.

Options can be used as insurance: buying a put or selling a call protects against price declines, while buying a call or selling a put limits downside in exchange for upside exposure. Writing options can be attractive when price changes are expected to be small; buying options is preferable when large or uncertain moves are anticipated.

In the Indian equity derivatives market the principal products are stock index options (underlying: an index), individual stock options (underlying: a single equity), stock index futures (underlying: an index) and stock futures (underlying: individual company shares). These instruments together provide investors and institutions the means to hedge, speculate and discover prices in a regulated exchange environment.