Derivatives Market
What are Derivatives?
A derivative is a financial contract between two parties that derives its value from an underlying asset. This means that they possess no value of their own but are dependent on the asset to which they are linked. The most common types of derivatives are Futures, Options, Forwards & Swaps. Derivatives contracts can be on various asset classes like stocks, bonds, currency, commodities, and interest rates. Derivatives are used by market participants for hedging as well as speculative purposes.
Let’s have a look at some common terminologies related to derivatives:
Forward: It is an agreement for buying or selling an underlying asset at a particular price & a specific date in the future.
A buyer takes a long position on the asset, whereas the seller takes a short position or maybe vice versa. The parties involved in this contract can manage the volatility by locking in the price for the underlying assets. Forward contracts are traded over the counter & are not regulated by the exchanges so, it is possible to customize the agreement between two parties as per requirement. They are mainly used for hedging against market uncertainty. These contracts are prone to default as they are not regulated.
Futures: Futures contracts are similar to forwards contracts. But unlike a forward contract, a futures contract cannot be customized because the exchanges regulate them. Hence futures contracts are standardized agreements between two parties. Futures contracts are less prone to default because they are regulated.
Options: An option is just a contract giving you the right to buy or sell an underlying security at a pre-negotiated price on a specific date. However, when that date arrives, you’re not obligated to buy or sell the underlying. Instead, you have the option to let the contract expire. However, when buying options, you’ll pay what’s known as a “premium” up front, which you’ll lose if you let the contract expire. But when you are selling an option, you receive a premium. Hence on expiry, you get to keep the premium you receive.
There are mainly two options:
- Call option: A call option gives the right to buy an asset at a particular price at a later date.
- Put option: A put option gives the right to sell an asset at a particular price at a later date.
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Swaps: A swap is a derivative contract between two parties that involves exchanging of cash flows, such that one party will receive a fixed interest rate & pay the other party a variable interest rate. The cash flows are derived from an underlying asset; hence swaps are a derivative instrument. Generally, swaps are traded over the counter market so they can be customized as per the needs of the parties in the contract.
Strike: A strike price refers to the predetermined price at which a derivative contract can be bought or sold at a future date. When entering a derivative contract, the strike price is decided at which buyer & seller will execute the contract.
Expiry: This is the date at which a derivative contract comes to an end. The expiry date is essential for both parties of the contract because, before expiration, they have to decide whether to execute the contract or not.
Open Interest (OI): Open interest is the total number of derivatives contracts outstanding in the market on a particular day. Therefore, OI data is beneficial for traders as it measures money flow in the derivative market.
PCR: PCR, also known as Put Call Ratio, is a derivative tool used by many market participants to measure the market's sensitivity. PCR is calculated by the total number of Puts divided by the total number of calls. If PCR>1, we can consider that more market participants are willing to take short positions & the market may fall. On the other hand, if PCR <1, it signifies more market participants are expecting an up move in the market as Calls are more than the puts.
Option Chain: An option chain is known as an Option Matrix is considered another helpful tool for traders. The options chain lists out all option contracts, both puts, and calls for a specific security. It shows a few key information like expiry date, strike prices, and volume and pricing information, etc.
Conclusion
Finally, we came to the end of our journey of learning several common terminologies that are used in the financial systems across different industries. We have focused especially on those terms that are commonly used in the stock market.
