Navigating the world of crypto derivatives can sometimes appear too technical especially as derivatives are not as straightforward financial tools compared to spot trading. The market is so large and divergent from other markets that it has its own terms. A person new to trying to trade derivatives without familiarising themselves with the terms may find it difficult to even understand the products offered to them. It is, therefore, necessary to understand the vocabulary of this market before making any trades. This article will discuss the terminologies used in derivatives trading and their meanings.
Understanding the terminologies used and their meanings can help make investing in derivatives easier.
A derivative is a contract between two parties that derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps.
Option: The right but not the obligation to buy (sell) some underlying cash instrument at a specific rate on a particular expiration date.
Premium: The cost associated with a derivative contract, referring to the combination of intrinsic value and time value.
Strike Price: The price at which the holder of a derivative contract exercises their right.
Call Option: It is the right to buy a particular stock, crypto or index at a future date, i.e. a settlement date, at a pre-fixed price (strike price). The market price for the call option is called premium.
Put Option: It is the right to sell a particular stock, crypto or index at a future settlement date at the pre-fixed strike price. The market price for the put option is also called the premium.
Option Writing: While the option buyer gets the right to buy or sell a security, they are not obligated to do so. The option writer, on the other hand, has an obligation to trade and their reward is only the premium. So, option writers take unlimited risks for limited rewards.
At the Money Options: This is the type of option where the strike price is the same as the price of the underlying security.
In the Money Options: Put options are where the strike price is above the price of the underlying security. Call options on the other hand are where the strike price is below the price of the underlying security. For this, premiums are higher.
Out of the Money Option: Put options are where the strike price is below the price of the underlying security or call options where the strike price is above the underlying security. Here the premiums will be lower.
Market Lot: You can’t buy one share in the Futures & Options segment, and the minimum number of shares you can buy is called market lot.
Time Decay: As derivatives contracts are for specific time periods, their value keeps reducing each day. This is technically referred to as time decay.
At-the-Market: A kind of financial transaction where the order to buy or sell is executed at the current market price.
At-the-Money Spot: This is a type of option whose strike price is equal to the current market price in the cash spot market.
At-the-Money Forward: An option whose strike price is equal to the current market price in the forward market.
Commodity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of which is a commodity index.
Currency Swap: A currency swap involves the exchange of an interest in one currency for the same in another currency.
Delta: This is the ratio that compares the change in a financial instrument’s price to the change in the price of the underlying cash index.
Equity Swap: A contract in which counterparties agree to exchange payments related to indices, at least one of which is an equity index.
Forward Contracts: An over-the-counter obligation to buy or sell a financial instrument that is settled privately between the two counterparties.
Futures Contracts: An exchange-traded obligation to buy or sell a financial instrument.
Gamma: The degree of curvature in the financial contract’s price curve to its underlying price.
Theta: The sensitivity of a derivative product’s value to changes in the date, all other factors staying the same.
Hedge: A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk.
In-The-Money Spot: An option with positive intrinsic value with respect to the current market spot rate.
In-The-Money-Forward: An option with positive intrinsic value with respect to the current market forward rate.
Spot: The price in the cash market for delivery using the standard market convention.
Long Position: When a derivative trader trades financial instruments and is on the buying side, it is referred to as going long. For example, if the trader buys a BTC contract and agrees to exchange at a higher strike price, that is a long contract.
Short Position: This is the exact opposite of going long, it is also called shorting. By implication, it means that the derivative trader is the seller of a contract. In the derivatives market, being a seller means having a short-term horizon and therefore you are shorting the underlying financial instrument.
Spot Contract: A spot contract offers immediate delivery. As derivatives only deliver at a future date, spot contracts usually do not form part of the derivatives market. However, they do form the basis for the pricing of futures, forwards and options. If a certain financial asset is being sold for X amount in the spot market and the future expectations are known, then the price of the derivative can be derived.
Expiration: Derivatives are time-bound financial instruments. This means that they come with an expiration date. They have intrinsic worth only up till that date and post that date, they are worthless. Expiration date is a term usually used when we refer to options in particular. When we talk about forwards, swaps or futures, the expiration date is replaced by the settlement date. However, the idea remains the same. Expiration date is when the contract is finally unwound and the profits and losses due become a reality. Simply put, that is the end of the agreement.