Some terms you need to know to navigate derivatives

 

Dorothy Zhang/MEDILL

Derivatives can seem intimidating, but with a little bit of knowledge you can begin to navigate this important corner of the investment world. Here are some common terms in the futures and options markets to help get you going.

 

Futures contract

Agreement to buy or sell a commodity on a particular date in the future, at a price agreed upon by the buyer and seller, typically through an exchange. Futures contracts exist on everything from wheat and crude oil to government securities and stock indexes.

Going long

One who has bought a futures contract to establish a market position and who has not yet closed out this position through an offsetting sale.

Going short

One who has sold a contract to establish a market position and who has not yet closed out this position through an offsetting purchase.

Arbitrage

The simultaneous buying and selling of a commodity or index in two different markets at two different prices to profit from price discrepancies. Most commonly, arbitrage trading is between the cash market and the futures market of a given commodity or index.

Limit-up and limit-down

The maximum amount by which the price of a commodity futures contract may advance or decline in one trading day. For example, the CME Group currently has a 30-cent-per-bushel daily price limit on the nearby corn futures contract. Exchanges’ maximum price limits apply to a futures contract in both directions – up or down.

Margin call

A demand for additional funds because of adverse price movement that would result in a loss if the investor were to close out his futures contract that day.

Volume

Daily turnover in a listed contract. This includes positions that are closed out by the end of the trading day and positions that are held overnight.

Open interest

Exchanges are required to post the number of outstanding long and short positions in their listed contracts. The amount of open interest gives an indication of the level of institutional participation in a market.

Options contract

A financial contract giving the investor the right, but not the obligation, to buy or sell an underlying instrument, typically shares of stock, at a pre-set price for delivery in the future.

Strike Price/Exercise Price

The stated price per share for which underlying stock may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.

Put option

A bet that the underlying stock will decline. For example, if an investor thinks Google shares are going to drop to $480 by September 11, she can purchase a put option with a strike price of $500, due to expire three months from now.

Call option

A bet that the underlying stock will rise. For example, if an investor thinks Google shares are going to advance to $560 by September 11, she can purchase a call option with a strike price of $550 due to expire three months from now.

In-the-money

In the case of a call option, the market price of the stock is higher than the strike price, meaning the buyer may now exercise the option. For example, if Google is trading at $523, a $500 call option is in-the-money. A put option is in-the-money if the market price of the stock is lower than the strike price.

Out-of-the-money

The opposite of in-the-money. If Google is trading at $470, a call option with a strike price of $500 is out-of-the-money. The buyer of the option may not exercise it and the option expires worthless.

Over-the-counter

Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.

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