NCFM Derivatives Market (Dealers) cheat sheet

A derivative is a contract whose value derives from an underlying (equity, index, currency, commodity, interest rate); no principal need change hands at inception.

Forwards are OTC, customizable, and carry counterparty credit risk; futures are exchange-traded, standardized, daily-marked-to-market, and cleared through a clearing corporation.

Options grant a right, not an obligation: buyer pays premium; call buyer profits when underlying rises above strike plus premium, put buyer when it falls below strike minus premium.

Payoff at expiry: long call = max(S − K, 0); long put = max(K − S, 0); short positions are the negatives of these payoffs.

Put-call parity for European options on a non-dividend stock: C − P = S − K·e^(−rT); violations permit arbitrage.

Index futures fair value = Spot × e^((r − q)T), where q is dividend yield; the basis = futures price − spot price, and it converges to zero at expiry.

Open interest counts outstanding contracts; volume counts contracts traded in a period. Rising open interest with rising price signals new long positioning.

In-the-money, at-the-money and out-of-the-money are defined relative to spot versus strike, not to the premium paid or profit/loss.

Order types: market order executes immediately at best available price; limit order executes only at the limit or better; stop order becomes a market order when the trigger is hit.

A stop-limit order converts to a limit order at the trigger, so it may remain unfilled if price gaps through the limit.

Tick size is the minimum price increment; a narrower tick generally reduces the cost of crossing the spread and can improve liquidity.

Market makers quote two-way prices and earn the bid-ask spread while bearing inventory risk; they hedge delta exposure from option positions.

Delta measures change in option price per one-unit change in underlying; gamma is the change in delta; vega is sensitivity to implied volatility; theta is time decay; rho is sensitivity to interest rates.

Implied volatility is the volatility that equates the model price to the market price; volatility smiles/skews reflect demand for downside or upside protection.

Circuit breakers and price bands halt or limit trading after preset moves; trading halts suspend a contract pending information dissemination.

Trade confirmation matches buyer and seller details (contract, price, quantity, counterparty) before the trade proceeds to clearing.

Clearing corporations interpose themselves as central counterparty (CCP) to every trade, becoming buyer to every seller and seller to every buyer (novation).

Daily mark-to-market: gains are credited and losses debited to the margin account; variation margin settles the daily profit or loss.

Initial margin covers potential future exposure over the margin period of risk; maintenance margin is the minimum equity level before a margin call is triggered.

SPAN or similar portfolio margining recognizes offsets between related positions, so a hedged portfolio requires less margin than the sum of its legs.

Settlement may be physical delivery of the underlying or cash settlement of the final difference; index derivatives are typically cash-settled.

T+1 or T+2 settlement cycles define when cash and securities/underlying obligations are exchanged after trade execution.

Segregation of client collateral from proprietary funds protects clients if the member defaults; client assets are not available to general creditors.

A default waterfall typically applies defaulter's margin, then a default fund contribution, then CCP capital and, in some structures, assessment powers on surviving members.

SEBI regulates Indian securities and derivatives markets; exchanges (NSE, BSE) operate under SEBI-recognized rules and their clearing corporations clear trades.

Eligibility criteria for derivatives trading include minimum net worth, net tangible assets, and a deposit with the clearing corporation/member; failure can lead to disablement.

Position limits cap open interest per client, per trading member, and per FII/FPI category to contain concentration and manipulation risk.

Disclosures and reporting: large open positions, client margin reporting, and daily margin reporting to the exchange/clearing corporation are mandatory.

Insider trading and front-running prohibitions apply to derivatives; trading on unpublished price-sensitive information or misusing client order flow is prohibited.

KYC/AML rules require client identification, risk profiling, and ongoing monitoring; suspicious transaction reports go to the Financial Intelligence Unit.

Grievance redressal runs through the member, then the exchange's investor grievance cell, then SEBI's SCORES platform; arbitration is available for disputes.

Record-keeping: order logs, trade confirmations, and margin records must be retained for the prescribed period and produced on regulatory demand.

Value at Risk (VaR) estimates the maximum loss over a horizon at a confidence level; it says nothing about the size of losses beyond that threshold (tail risk).

Expected shortfall (CVaR) is the average loss conditional on exceeding VaR and is more sensitive to tail events than VaR.

Delta hedging neutralizes first-order price exposure; gamma measures how quickly that hedge must be rebalanced as the underlying moves.

Stress testing applies extreme but plausible scenarios (index −10%, volatility doubling, rate shock) and complements statistical VaR.

Leverage magnifies both gains and losses; a futures position requires only margin, so percentage losses on capital can exceed the underlying's move.

Concentration risk: a large position in a single underlying or expiry can be hard to liquidate and may breach position limits.

Liquidity risk has two forms: market liquidity (inability to exit at quoted prices) and funding liquidity (inability to meet margin calls).

Counterparty credit risk is the risk that the other side defaults before settlement; central clearing reduces it but concentrates it in the CCP.

Suitability: a product must match the client's investment objective, risk tolerance, horizon, and experience; derivatives are not suitable for every investor.

Risk disclosure: the client must receive and acknowledge the risk disclosure document before trading derivatives; margin and leverage risks must be explained.

Know-your-client (KYC) is a precondition to executing orders; no order may be accepted without completed onboarding and a client agreement.

Churning and excessive trading to generate commissions violate fiduciary duties; commissions must be disclosed and not drive unsuitable recommendations.

Conflicts of interest must be disclosed and managed: proprietary trading, market making, and research functions should be separated from client advice.

Misrepresentation of returns, guaranteed-return claims, or omitting the risk of loss is a prohibited sales practice.

Client funds and securities must be segregated from the member's own accounts; commingling and unauthorized use of client collateral are prohibited.

Sensitive client information must be kept confidential and used only for the purpose for which it was collected, subject to regulatory disclosure requirements.