“When they are employed wisely, derivatives make the world simpler because they give their buyers an ability to manage and transfer risk.”
-Carol Loomis (Financial Journalist; Rt. Sr. Editor, Fortune Magazine)

The term ‘Derivatives’ is an instrument which derives its value or price from or is dependent upon an underlying asset which can be a financial asset such as currency, stock, market index, commodities etc. According to the Securities Contract Regulation Act, 1956 the term ‘Derivative’ includes:

  1. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; or
  2. a contract which derives its value from the prices or index of prices, of underlying securities.

A derivative can be understood as a future contract for which we enter into an agreement as the present day price. For instance, when you recharge your mobile number with a package that allows you to call at Rs. 0.90/min for a STD call for a period of three months, for which you are charged an amount every month. Even if there is a tariff increase for this package, till the expiry of your plan, you will only need to pay the price fixed earlier. Let’s get to know Derivatives better.

Derivatives that are traded in India and regulated by SEBI are Futures and Options (F&O). These are briefly defined below:

Futures Contracts are standardized exchange traded contracts which is an agreement between two parties to buy or sell an underlying asset at a particular time in the future at a specific price. The underlying asset may be a commodity, stock, currency etc. The buyer of future contract only needs to pay certain percentage of the whole amount, i.e. the margin. Suppose a USD-INR currency futures contract, having a lot size of 1000, the cost would be approximately Rs. 65,000, for which the buyer only needs to pay approximately Rs.1400 as a margin to hold that position. A futures contract may either be squared off prior to maturity, or be marked for delivery upon maturity or be settled in cash upon maturity, depending on the underlying asset.

With the purchase of a futures contract, the holder legally binds himself to buy the underlying asset at a specific price and at some specific time in future.

Options Contract is a contract which gives the holder of the option the right, but not an obligation, to either buy or sell the underlying asset in future. In contrast, in a forward or futures contract, the two parties are legally bound or are obligated to meet their commitments as specified in the contract. The buyer of the option contract is required to pay an upfront fee called option premium (the price to be paid to the seller of the option contract for buying the right). There are two types of options:

  1. Call option: It gives the holder the right to buy an asset by a certain date for a certain price, but not an obligation; and
  2. Put option: It gives the holder the right to sell an asset by a certain date for a certain price, but not an obligation.

Apart from the above two segments, there are two other type of derivatives currently not regulated by SEBI and thus not traded in the exchange. They are Forwards Contracts and Swaps. Forwards Contracts are customized contracts between two parties, where settlement takes place on a specified date in future at a price agreed today. Whereas, Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.

Furthermore, a trader may opt to trade in Equity Derivatives, Commodity Derivatives or Currency Derivatives.

  • Equity Derivatives: F&O in Equity are only available in over 200+ individual securities listed by the NSE, as well as NIFTY 50 Index, NIFTY Bank Index, NIFTY IT Index etc.
  • Commodity Derivatives: Futures are available in all commodities, whereas Options are only available in Gold as of now.
  • Currency Derivatives: F&O are available in all the four currency pairs which are USD-INR, EUR-INR, GBP-INR and JPY-INR.

Maturity of Derivative Contracts refer to the expiry of the contract. Since every derivative contract is based on some future agreement to buy or sell at certain price, every derivative contract has an expiry. It is different for different segments and depends on the underlying asset that the derivative derives its value from. Let’s learn them better.

In case of Equity F&O, when the contract expires, the positions are “closed-out” and will be settled in cash, which is either the liability to pay any loss or eligibility to receive any profits. The expiry of Equity Derivatives is currently fixed on the last Thursday of every month.

In case of Commodity Futures, upon expiry of Contracts (for bullions & spices), they are marked for delivery. During the “delivery period”, the holder pays the remaining amount and receives delivery of the commodity. Whereas in case of other commodities, it is similar to equity futures, it will be settled in cash. Gold is the only commodity currently traded in Options, and upon Expiry it will be settled in cash. Learn More

In case of Currency F&O, when the contracts expire, it will be settled in cash similar to that of equity derivatives. The expiry of Currency Derivatives is currently fixed on 2 days before the last working day of every month. Learn More

As we have seen in Capital Markets Segment, Capital Gains/Losses are taxed based on period of holding (i.e. Short-term or Long-Term). Likewise, Capital Gains/Losses from trading in Derivatives are also obligated to go through the books of accounts of the trader for tax purposes.

Additionally, equity share transactions are also levied STT. Similarly, there exists an STT on Equity Derivatives as well, which is shown below:

Type of Transaction STT Rate Payable By
Sale of an Equity Future 0.010% Seller; on the price at which such futures are traded.
Sale of an Equity Option 0.050% Seller; on the Option premium
Sale of an Equity Option, where option is exercised 0.125% Purchaser; on the settlement price.

In case of Commodity Derivatives, the tax levied is called Commodities Transaction Tax (CTT), on all non-agricultural commodities such as Gold, Silver, Crude, Zinc, Copper, Aluminum etc., which is shown below:

Type of Transaction STT Rate Payable By
Sale of Non-Agri Commodity Future 0.010% Seller; on the price at which such futures are traded.

In case of Currency Derivatives, there is no Tax levied on the transaction. However, any Gains/Losses shall be liable to be taxed based on whether they are Short-Term or Long-Term.

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