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Part 8. Derivatives: The Foundation
Everything up to this point has been about owning shares. From here the guide covers instruments whose price is derived from something else, which is where the word derivative comes from. They are not more advanced in the sense of being cleverer. They are more advanced in the sense that the ways to lose money are more numerous and faster.
Read this before the rest of the derivatives sections SEBI has published repeated studies of individual traders in equity derivatives. The findings have been consistent and stark: roughly nine out of every ten individual traders lose money, and the aggregate losses run into tens of thousands of crores each year. This is not a warning about being careless. It is the base rate. Most of those people were not reckless; they were ordinary people using an instrument whose mechanics they had not understood, in sizes they could not survive. The purpose of these five parts is to put you in the minority who understand what they are holding. It is not to encourage you to trade derivatives at all. |
8.1 What a Derivative Actually Is
A derivative is a contract between two people about the future price of something else. Nobody hands over a share when the contract is created. What is created is an obligation, or a right, that will be settled later.
Think of it like this A farmer expects a mango harvest in June and worries the price will crash. A juice factory needs mangoes in June and worries the price will spike. In February they agree: fifty quintals in June at four thousand rupees a quintal, whatever the market price turns out to be. No mango changes hands in February. Both have removed their uncertainty. If June arrives at five thousand, the factory has done well and the farmer has given up some gain. If June arrives at three thousand, the reverse. Neither was gambling. Both were removing a risk they did not want. That contract is a future. Everything else in derivatives is a variation on it. |
Derivatives exist for hedging, and they are used far more for speculation. Both uses are legitimate, and the instrument does not care which you intend. What matters is knowing which one you are doing.
8.2 The Vocabulary You Cannot Avoid
Term | What it means in plain words |
|---|---|
Underlying | The thing the contract is about: Nifty, Bank Nifty, or a specific share |
Lot size | The fixed bundle you must trade. You cannot buy half a lot. |
Expiry | The date the contract dies and is settled. Every contract has one. |
Contract value | Lot size multiplied by the price. What the position is really worth. |
Margin | The deposit the exchange requires to hold the position |
Mark to market | Daily settlement of gains and losses in cash, every evening |
Open interest | The number of contracts currently alive and unsettled |
Square off | Closing a position by doing the opposite trade |
Rollover | Closing a contract near expiry and opening the same position in the next month |
Lot size, and why the first number to check is not the price
Derivatives trade in fixed bundles. You cannot buy three units of Nifty. You buy one lot. The exchange revises lot sizes periodically so that one contract stays within a range of rupee value that SEBI considers appropriate, which means the lot size for any index or stock changes from time to time and must be checked, not remembered.
The number that catches everyone out Nifty is at 24,000 and the lot size is 75 units. One futures contract is therefore worth 24,000 x 75 = 18,00,000 rupees. The margin to hold it may be around 2,70,000, so that is what leaves your account. But your exposure is eighteen lakh, not two point seven lakh. A one percent move in Nifty is 18,000 rupees to you, which is about 6.7 percent of the money you actually put up. This is the single most important sentence in this part: the contract value is what you are exposed to, and the margin is merely the deposit. |
Careful here A very large number of new derivative traders size their position by asking "how much margin do I have?" rather than "how much am I exposed to?". That is how a person with three lakh rupees ends up controlling fifty four lakh of Nifty across three lots and is wiped out by a two percent gap. |
Expiry, and the fact that these contracts die
A share can be held forever. A derivative cannot. Every contract has an expiry date, after which it does not exist. This changes everything about how you must think, because being right eventually is worth nothing here. You have to be right before the contract expires.
Indian exchanges list monthly contracts and, for index products, weekly ones. The exact expiry days have been changed more than once by the exchanges and by SEBI, including the number of weekly expiries permitted. Do not memorise a day from any guide, this one included. Check the contract specification on the exchange website before you trade, because it does change.
Think of it like this Buying a share is buying a seat in the theatre. You can sit as long as you like and wait for the story to improve. Buying an option is buying a ticket for a specific show on a specific date. If the story improves the following week, your ticket is already worthless. You were right about the story and you still lost your money. |
8.3 Margin, and What Actually Leaves Your Account
When you take a futures position, or sell an option, you are promising to honour a future obligation. The exchange has no way of knowing whether you can, so it demands a deposit that would cover a bad day. That deposit is margin, and it comes in two parts.
Component | What it covers |
|---|---|
SPAN margin | The exchange’s calculation of the worst plausible one day loss on your position |
Exposure margin | An additional cushion on top, in case the worst plausible day is worse than plausible |
Two rules follow, and they surprise people.
- Buying an option requires no margin. You pay the full premium up front and that is the most you can lose, so the exchange needs no further security from you.
- Selling an option requires substantial margin, because your possible loss is not capped. Selling one Nifty option can require a similar deposit to holding a futures contract.
Careful here Margin is not fixed. When volatility rises, the exchange raises margin requirements, and it does so on exactly the day the market is falling and your position is already losing. If you are fully deployed, you will get a margin call demanding more money at the worst possible moment, and if you cannot pay, your broker will square off your position at whatever price is available. This is the mechanism by which people lose more than they expected. Keep a genuine cash buffer, not a theoretical one. |
Mark to market: your losses are settled every evening
In shares, a loss is on paper until you sell. In futures, it is not. Every evening the exchange values your position at the closing price and moves cash between the two sides. If you are down, money leaves your account that night.
Three days of mark to market on one Nifty futures lot Day 0: You buy one lot at 24,000. Margin blocked, roughly 2,70,000. Day 1: Nifty closes at 23,850. You are down 150 points x 75 = 11,250, and that amount is debited from your account that evening. Day 2: Nifty closes at 23,700. Another 150 points, another 11,250 debited. You are now 22,500 down in cash, not on paper. Day 3: Nifty recovers to 24,100. You are credited 400 points x 75 = 30,000 that evening, and are now 7,500 ahead overall. Nothing about the total profit or loss changed. What changed is that you needed the cash to survive days 1 and 2 without being squared off. |
8.4 Cash Settled and Physically Settled
This distinction has caught out a great many people in India, and it is worth being precise about.
Contract | How it settles at expiry | |
|---|---|---|
Index futures and options (Nifty, Bank Nifty) | Cash. The difference is paid in rupees. No shares change hands, because you cannot deliver an index. | |
Stock futures and options (Reliance, HDFC Bank) | Physical delivery. Actual shares must be delivered or received. | |
Careful here If you hold a stock option that finishes even slightly in the money at expiry, it is exercised and you must settle in shares. A single lot of a large stock can mean a delivery obligation of several lakh rupees appearing in your account, along with the margin demand that comes with it. People have bought a cheap out of the money stock option for a few thousand rupees, watched it drift into the money on expiry day, and found themselves owing a delivery worth far more than their entire account. Close stock option positions before expiry unless you specifically intend to take or give delivery, and know the value of what you would owe. | ||
8.5 Who Is On the Other Side
Every derivative contract has two sides, and unlike shares, it is created rather than transferred. When you buy a Nifty future, someone simultaneously sold one, and that contract did not exist a moment earlier. Knowing who these counterparties usually are helps you understand the price.
Participant | Usual purpose | |
|---|---|---|
Hedgers | A fund holding shares buys index puts as insurance; an exporter hedges currency. They accept a cost to remove a risk. | |
Speculators | Taking a view on direction, with no underlying position to protect. Most individual traders are here. | |
Arbitrageurs | Exploiting small differences between spot and futures prices. They are the reason those differences stay small. | |
Option writers | Usually institutions and professional desks with the capital to absorb tail risk. They are on the other side of most retail option buying. | |
The uncomfortable arithmetic Derivatives are a zero sum transfer before costs, and a negative sum game after them. For every rupee an option buyer gains, an option seller loses that rupee, and both pay brokerage, exchange fees, stamp duty, securities transaction tax and GST on top. In shares, everyone can profit together over decades, because the companies underneath actually create value. In derivatives, nothing is created. The money simply moves, minus friction. That is the structural reason the SEBI loss figures look the way they do. | ||
© Vipin Nair. This guide is for reading online only. Copying, downloading, printing and redistribution are not permitted. For study and general reference; not legal, tax or investment advice.