Futures and Options are the most popular derivative instruments traded on stock exchanges. 'Derivative' is a broader term that includes forward and swaps as well. But forward & Swaps are not traded on exchanges. These are are traded in the OTC market. However SEBI has recently permitted exchange traded rupee derivatives in addition to stock/index options/futures.

Futures and Options presently constitute the products of exchange-traded-derivatives. Both are traded as standardised contracts in terms of size, maturity and the nature of the underlying assets under stringent financial safeguards. Execution of the contracts are guaranteed by the concerned exchanges. In both cases the contracts are settled in the current period, but intended to be executed at a future date. At the time of entering into a contract in respect of an option deal, the option buyer has to pay a premium to the option seller, while no such payment is required to be made in respect of a future contract. On the other hand execution of the contract is binding on the buyer on the expiry date of a future contract. However in respect of an option contract the buyer has the option to execute the contract but not the obligation.

Following the introduction of index futures (year 2000), the Securities and Exchange Board of India (SEBI) permitted the BSE and the NSE to introduce more derivatives, such as options on indices and individual stocks (year 2001). But an instrument that may be more in line with the domestic market structure -- single-stock futures -- was not under consideration at that time. However futures in single stocks were allowed subsequently in November 2001. This is described/explained in more detail in a subsequent article on futures.

Trading in options products is riskier than futures. This is from the options-writer's perspective. Market-making in Options depends to a great extent on institutions willing to write the contracts. Since the buyer of an option contract is not under any obligation to exercise his right, his risk is limited to the premium paid for purchasing the right.

However, the writer is under an obligation to deliver. This means the risk borne by the option-writer is significant. Exchanges normally guarantee the writer's position. Hence, to limit default in the market, the margin requirements are quite high. For instance, in international markets, while the margin rate for index futures contracts is around 5 per cent, that for index options works out to the commission received plus around 15 per cent of the contract's notional value.

As per Section 18A of the Securities Contract (Regulation) Act, 1956, only exchange-traded derivatives are legal in India. The said Section of SC(R)Act specifically provides-

Notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid if such contracts are -

1. traded on a recognised exchange;

2. Settled on the clearing house of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange

Section 18A was incorporated in S.C(R)Act in the year 1999. Prior to the amendment in the same year RBI has permitted Banks and Financial Institutions and primary dealers to undertake forward rate agreements (FRAs) and interest rate swaps (IRS), which are OTC derivative products, under provisions of Section 6A of the Banking Regulations Act, 1949. However to make the issue clear RBI has proposed to Government to modify the aforesaid Section 18A with additional clause as under:

"if such contracts are of the class and nature as notified by the Reserve Bank of India or the Securities and Exchange Board of India or the Central Government from time to time and entered into by persons or entities as may be authorised as 'eligible persons/entities' by the Reserve Bank of India or the Securities and Exchange Board of India or the Central Government from time to time."

Other than the Institutions under the regulatory control of RBI, no investor can therefore deal with derivative products other than the exchange-traded Options & Futures.

Introduction of Futures & Options in the Capital Market provides better risk management and hedging opportunities. These products may be traded at the level of individual investors, as well as by Institutions like Insurance Companies, Mutual Funds etc. Trading in Futures & Options involve complexities, needing expert knowledge. While they could provide substantial benefits, the attendant risks are also considerable, if the investor acts prompted by blind speculation.

Daily settlement is marking-to-market of futures contracts and is a credit safeguard built into the futures trading system that requires traders to realize any losses in cash on the day of occurrence. Daily settlement is maintained through margin accounts of the traders. Margin accounts are debited for daily losses and credited for daily gains. If the margin account balance falls below the maintenance margin level, the trader receives a "margin call" requiring the deposit of cash or securities to bring the margin account back up to the initial margin balance.

Derivative contracts can be settled in a variety of ways, considering the type of derivative contract. The most common contracts are option and futures contracts, since they are settled on formal exchanges. An option contract that expires out-of-the-money expires worthless with the option contract writer pocketing the premium and no exchange takes place. An option contract that expires in-the-money requires delivery of the stock and payment of the exercise price. If the option is on an index, obviously the index cannot be delivered and settlement is the intrinsic value of the option (the net proceeds between the market price and the exercise price). Futures contracts are generally settled through offset. The investor takes an equal but opposite futures position to close out the contracts. The net gain or loss is then settled on the account. Upon expiration of the futures contract, the margin balance is returned plus any gain credited or the margin is used as a credit against any additional loss. Futures contracts differ from options in that futures are settled daily during the contract period.

While derivatives are contracts that derive their existence from the underlying assets, because of the ease of trade, they have the potential to reach huge proportions. Since derivatives also suffer from risks, as do the underlying securities, derivatives need to be handled cautiously on account of sheer size. These characteristics make derivatives double-edged swords. This drives home the importance of adequate regulation that takes care of the concerns associated with derivatives trading. SEBI has introduced stringent regulatory measures based on recommendations of LC Gupta Committee and subsequently by JR Verma Committee. Salient features of market regulation & Investor protection are also discussed earlier and these may be referred. Margining System relevant to the Derivative Market is also discussed in detail earlier.

Salient futures of these products are discussed in separate pages on futures and options. However it is to be cautioned that this will provide you merely basic or theoretical knowledge. Those who desire to undertake trading in these products are advised to thoroughly study the information and guidance provided in the websites of NSE and BSE, in addition to that in the website of SEBI, including latest press releases and circulars. The trading and settlement procedures, margin requirements, clearing arrangement, obligations and code of conduct binding brokers etc. are available on the websites of SEBI and the two Stock Exchanges. SEBI site also provides investor-guidance and procedure for settlement of grievances. Investors should not blindly be guided by advice of investment consultants and put through these deals, but they must exercise their own sound judgement, perceiving both the benefits and the risks involved in these products of derivative trading.

The measures specified by SEBI for protecting interests of investors are already discussed earlier and these may be referred.