Derivatives are contracts that derive their price or value from an underlying asset. The underlying asset may be a bond, stock, currency, debt instrument, interest rate, commodity, or market index. There may be two or more parties to a derivative contract.
While different types of financial derivatives exist in the market, you can broadly classify them into four major categories – forwards, swaps, futures & options.
Standard derivative market terms you must know
- Futures contract: This is an agreement between two entities to buy or sell an underlying asset. The sale/purchase is undertaken at a specified price, however, on a future date. Both the parties to a futures contract are obligated to execute the contract on the stipulated date. Like any other transaction involving financial instruments, the buyer holds a long position while the seller holds a short position. Futures contracts are generalised exchange-traded contracts. As the futures exchange is the counterparty to every transaction, default risk is eliminated. Futures on interest rates, forex, and stock indices are primarily popular.
- Forwards contracts: It is a promise to deliver an underlying asset at a predetermined price at a stipulated date in the future. These tailor-made contracts are executed in the OTC (Over-The-Counter) market and not via an exchange. Hence, they suffer from counterparty risk, as an exchange’s rules and regulations do not govern them.
- Options: These are derivative finance contracts wherein the option holder/buyer has the right, but not the obligation, to purchase or sell the underlying asset at a prescribed price on a future date. If the buyer exercises the option, the seller must fulfil the contract.
- Call option: It is an option contract wherein the buyer has the option to buy the underlying asset at a stipulated price on the exercise date.
- Put option: It is an option contract wherein the holder has the option to sell the underlying asset at a predetermined price on the exercise date.
- Exercise date: The date on which the option holder exercises the option contract is known as the exercise date. American options can be exercised on or before the option expiry date, while European options can be executed only on the option expiry date.
- Exercise/Strike price: The exercise price is the price at which the underlying asset can be bought or sold by the option holder on the exercise date.
- Option premium: It is the present market value of an option contract. It is incurred by the option buyer and is an income for the seller.
- Equity derivatives: They derive their value partly or wholly from underlying equities or stocks. Equity futures and options are the most sought-after derivatives in the stock market.
- Swaps: It is an agreement between two entities to exchange predetermined cash flows for a given period. Popular swaps are interest rate and currency swaps.
These are some derivative market terms you should know before you engage in derivative trading. Derivative trading is a suitable hedging mechanism as you can take simultaneous positions in the spot and derivative markets and mitigate your losses. You can consider taking expert assistance to master derivative trading.