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To enable you to easily understand important terms, frequently used in derivatives trading, we have a few phrases listed below. Click on any of them to get an explanation:
A trader expects to make a spot transaction at a future date and opens a futures position now to protect against a change in the spot price.
The simultaneous purchase of one asset against the sale of the same or equivalent asset in two different markets to create a riskless profit due to price discrepancies.
The band around the no-arbitrage price within which arbitrage transactions are not worthwhile.
See arbitrage band.
While the arbitrage transaction is riskless in theory, in practice, some risks may be present.
The price at which the market maker is willing to sell. Also called the offer price.
See deferred contract.
This occurs when the spot price exceeds the current price of a futures contract. The opposite of contango.
The difference between the cash price of a financial instrument and the price of a particular futures contract relating to that instrument. Also known as a crude basis or simple basis.
The possibility that the value of the basis will change over time.
A market in which prices are falling.
A calendar spread designed to profit in a bear market.
A measure of responsiveness of a security or portfolio to movements in the stock market as a whole. Measures systematic risk.
In the absence of new information, the transaction prices for a security will fluctuate between the bid and the ask price, depending on whether the trade was initiated by a buyer or a seller.
The difference between the ask price and bid price.
The price at which a market maker is willing to buy.
A person who acts as an agent for others in buying and selling futures contracts in return for a commission.
A market in which prices are rising.
A calendar spread designed to profit from a bull market.
A passive strategy in which a trader buys a security (or portfolio), which is then held for a period of time without revision.
The simultaneous purchase and sale of futures contracts for different delivery months of the same financial instrument. Also called an intracommodity spread, a horizontal spread or a time spread.
Capital Assets Pricing Model. The equilibrium expected return on an asset depends on the riskless interest rate, the expected return on the market and the asset’s beta (B) value.
See carrying charges.
The total cost of carrying an asset forwards in time, including storage, insurance and financing costs.
The stock market crash of October 1987 was caused by a fall in stock market price, which led portfolio insurers to sell index futures, resulting in a drop in their price, and, via index arbitrage, a further fall in stock market prices, etc.
An arbitrage transaction where the trader holds a long position in the underlying asset and a short position in the corresponding futures contract.
In commodities markets this term is used to refer to the market in a particular grade and location of the underlying asset. For index futures there is only one underlying grade and location, and so the cash market is synonymous with the spot market.
See spot price.
At delivery time, instead of the physical transfer of the underlying asset, there is a final marking to the market at the EDSP and the positions are closed out.
Commodity Futures Trading Commission. An independent US federal agency which has regulated futures trading in the United States since 21st April 1975.
A trading halt when the price movement exceeds some present limit.
An organisation connected with futures exchange through which all contracts are reconciled, settled, guaranteed and later either offset or fulfilled through delivery or cash settlement. Its function is to manage the margin and delivery systems, as well as to guarantee performance of exchange traded contracts.
A member of the clearing house.
The time period at the end of the trading session during which that day’s settlement price is determined.
The last price of the trading period for a security.
A fee charged by a broker to a customer when a position is liquidated. See round trip.
See future fund.
Commodity pool operator
The firm managing a commodity pool. This terminology is common in the U.S.
Commodity trading adviser
Professional traders who conduct individually managed accounts on behalf of investors. This terminology is common in the U.S.
A single spot position is hedged using a number of different futures.
A customer’s open positions in futures contracts are sqaured-up by the member firm holding the account or the Clearing House, usually after the customer fails to meet margin calls. Also see Forced liquidation.
A bull (bear) calendar spread in two different maturities is matched by a bear (bull) calendar spread in another two maturities. This requires there to be at least four outstanding maturities.
Mistakes in setting prices in one market are transmitted to another.
This exists when the spot price is less than the current price of a futures contract. The opposite of backwardation.
Interest is accurued continuously rather than at discrete intervals. The interest is assumed to be added to the capital sum and so interest is then also payable on the interest received.
The standard unit of trading for futures markets.
See delivery month.
The monetary value that is multiplied by the index value to determine the market value of the futures contract.
The standard terms of the futures contract to be traded.e g. size of the contract, tick size, settlement and margining methodology, trading times, delivery procedures.
The movement to equality of the spot and futures prices as the delivery date approaches.
A few people gain control of all available supplies of the underlying asset.
Cost of carry
The cost of holding a stock of the underlying e g the costs of storing, insuring and financing the asset.
Cost of carry price
The futures prices given by the cost of carrying an equivalent spot position until delivery.
The other party (buyer or seller ) to a transaction.
The risk the counterparty will not fulfil the terms of the contract. Also called default risk.
Hedging a risk is one asset by initiating a position in a different but related asset.
A situation where the broker acts for both the buyer and seller. All cross trades must be transacted on the trading floor, or through the screen market. This is currently not allowed by SEBI in India.
The group of people standing in the futures pit.
A share is cum dividend when the purchaser receives the next dividend payment.
An order to trade futures contracts that automatically expires at the end of that day’s trading session.
Trades that are opened and closed on the same day.
The risk that the counterparty will fail to meet their obligations under a contract.
Futures contracts other than the near contract.
The transfer of ownership of an actual financial instrument, or final cash payment inlieu thereof, in settlement of a futures contract under the specific terms and procedures established by the exchange. Also see settlement.
The day on which the futures contract matures. Also known as expiry day.
The calendar month on which the futures contract matures, resulting in delivery or cash settlement of the specified financial instrument. Also known as expiration month.
The price fixed by the clearing house at which deliveries on futures contracts are invoiced. Also known as the expiry price or the settlement price.
A financial instrument designed to replicate an underlying security for the purpose of transferring risk.
Interest payments are made periodically. The interest is assumed to be added to the capital sum and so interest is then payable on the interest received.
Double auction market
This occurs when the price is determined by competitive bidding between both buyer and sellers, as in futures markets.
A floor trader is allowed to trade on his or her own behalf, as well as an agent for others.
Futures contracts on the same underlying asset are traded on more than one exchange.
An investment strategy in which a long position in shares is hedged by selling futures. The futures position is adjusted frequently so that it replicates a purchased put option.
Feasible combinations of expected profit and risk which, for each level of risk, have maximum profit.
The cash or other collateral which may be accepted as cover for margin obligations.
Exchange Delivery Settlement Price. This is the price at which the delivery or cash settlement takes place, expressed in index points. This terminology is common in the U.S.
A contract between two parties by which they swap the returns from an equity portfolio and an investment at a fixed or variable interest rate.
The return on a security beyond that which could have been earned on riskless asset.
A share is ex-dividend when the purchaser does not receive the next dividend payment.
The risk that prices may move between the time an order is initiated and executed.
The date that any futures contract (or option) ceases to exist.
See delivery month.
The no-arbitrage price of a futures contract. Also known as theoretical value.
Fair value range
See arbitrage band.
The future that is furthest from its delivery month i. e. has the longest maturity.
Fill or kill order
An order to trade futures contracts which must be executed immediately. If not it is cancelled.
The process of designing new financial instruments, especially derivative securities.
The value of that portion of the firm’s equity that is available for trading, and so excludes shares in the hands of controlling investors.
A person on the floor of an exchange who executes orders in the open outcry system.
A customer’s open positions in futures contracts are offset by the brokerage firm holding the account, usually after the customer fails to meet margin calls. Also called compulsory close-out.
An agreement between two parties to trade an asset at a specified future date and price. This is an OTC product.
Futures contracts other than the near contract.
See near contract.
Brokers trade on their own behalf, ahead of their customers order’s. This was only banned in Japan in December 1992.
The application of economic analysis to publicly available information to predict price movements.
A legal, transferable standardised contract that represents an agreement to buy or sell a quantity of a standardised asset at a predetermined delivery date. This is an exchange traded product.
They raise money from investors and pool this capital into a fund which is invested in futures contracts. A popular form is a 90/10 fund.
Futures and options fund
U K unit trusts that can invest up to 10 percent of their funds in futures and options.
An option written on a futures contract.
Geared futures and options fund
U K unit trusts that can invest up to 20 percent of their funds in futures and options and have the potential to lose all the money in the fund.
A number of different spot positions are hedged using a variety of different futures.
A spread between a spot asset and a futures position that reduces risk.
The portfolio of shares whose risk is being hedged away.
The number of futures contracts bought or sold divided by the number of spot contracts whose risk is being hedged.
The purchase or sale of futures contracts to offset possible changes in the value of assets or cost of liabilities currently held, or expected to be held at some future date.
The time period over which an investment is held.
See calendar spread.
The risk that new information may arrive after an investors has decided to trade and before the order is submitted.
The variance of returns on an asset that is implied by equating the observed and theoretical prices of an option on that asset.
An institutional investment portfolio that aims to replicate the performance of a chosen market index.
An option written on a stock index.
The trading of baskets of shares corresponding to those in some specified market index. The buyer of the index participation pays immediately in exchange for a promise by the seller to deliver the shares (or their cash equivalent) at one of a number of subsequent dates, chosen by the buyer. Also know as an Exchange Traded Fund (ETF).
If trading is not continuous it is infrequent, infrequent trading may be either non-synchronous trading or non-trading.
The ‘good faith’ deposit of the cash or securities which a user of futures market must make with his or her broker when purchasing or selling futures contracts, as a guarantee of contract fulfilment.
Private and confidential information, usually acquired through a position of trust, that is likely to have an impact on security prices when made public.
Dealing on the basis of inside information.
The simultaneous purchase and sale of futures contracts in different financial instruments.
See calendar spread.
A spread involving futures contracts traded on different exchanges.
See calendar spread.
See calendar spread.
A spread involving future contracts traded on the same exchange.
A market in which the price of a stock index futures is higher the closer is the contract to delivery.
Unofficial trading when the market has closed.
One of the two positions constituting a spread.
When the price of a share rises and the value of the firm’s outstanding debt is fixed, the ratio of debt to equity falls, i.e. its leverage (or gearing) falls. This makes return on the share less risky. A reverse argument applies for price falls.
Lifting a leg
Liquidating one side of a spread or arbitrage position prior to liquidating the other side. Also called ‘legging out’.
This occurs when the futures price has moved down to the lower price limit.
The price has increased or decreased by the maximum amount permitted by the price limits.
An order to buy or sell at a specific price (or better), to be executed when and if the market price reaches the specified price.
Limit order book
A list of the outstanding limit orders.
See price limit.
This occurs when the price has moved up to the upper price limit.
Any transaction that offsets or closes out a previously established long or short position; also known as buying in or covering.
The degree to which a market can accommodate a large volume of business without moving the price, i.e. market impact.
A floor trader who executes trades on his or her own account in the open outcry system.
A market position established by buying one or more futures contracts not yet close out through an offsetting sale; the opposite of shot.
A hedge involving a long futures position and a short spot position.
Long the basic
The purchase of the underlying asset and sale of contracts in the corresponding futures contract.
A firm hedges the combined exposure of all its assets and liabilities. See also micro hedging.
The minimum amount which a person is required to keep in their margin account.
A deposit of funds to provide collateral for an investment position. See also initial margin, variation margin and maintenance margin.
A request for the payment of additional funds into a person’s margin account.
This is calculated by multiplying the number of a company’s shares issued by the share price.
The degree to which current prices reflect a set of information.
An order to buy futures contracts which becomes a market order if the market reaches a specified price below the current price, or to sell if the market price reaches a specific level above the current price. Opposite of a s order.
A dealer who makes firm bids and offers at which he or she will trade.
An order to buy or sell at a price as close as possible to the closing price for that day.
A market order to be executed during the opening.
An order to buy or sell for immediate execution at the best obtainable price.
A market value weighted portfolio consisting of every share traded on the exchange.
The possibility of gain or loss due to movements in the general level of the stock market. Also see systemic risk.
Marking to the market
The daily revaluation of open positions to reflect profits and losses based on closing market prices at the end of the trading day.
The process by which buy and sell transactions are reconciled, before being passed to the clearing house.
The length of time before delivery.
A firm hedges only specific transactions rather than all its assets and liabilities. See also macro hedging.
Minimum price movement
The smallest possible price change. See also point and tick size.
It usually refers to the actual less the no-arbitrage futures price, and may be deflated by either the spot price or the no-arbitrage futures price. In a few cases the mispricing incorporates transactions costs.
A trader who sells when the market falls and buys when the market rises. This behaviour tends to amplify price movements. Also known as a positive feedback trader.
This is a type investment company that sells its shares (called units) to the public and uses the proceeds to invest in other companies.
National futures Association
A self-regulating US body which registers and regulates those employed in the futures brokerage industry.
Naïve hedge ratio
A one-for-one hedge ratio.
The future that is nearest to its delivery month i.e. has the shortest maturity.
The difference between the long and short open positions in any one future held by an individual or group.
Non – Synchronicity
The stock trades at least once every interval, but not necessarily at the close of each interval. See non-trading.
The stock does not trade during every interval. See non-synchronicity.
This occurs when the expected price of a futures contract at delivery exceeds the current price of the future.
A market in which the price of a stock index futures contract is lower the closer is the contract to delivery.
The legal word for the conversion of a futures contract between a buyer and seller into two separate contracts, each with the clearing house as counterparty.
A quantity of shares that does not correspond to that in which trading normally takes place.
See ask price.
The cumulative number of either long or short contracts which have been initiated on an exchange, and have not been offset.
The method trading on many futures exchanges whereby bids and offers are audible to all other participants on the floor of the exchange (or pit) in a competitive public action.
Contracts which have been initiated and are not yet offset by a subsequent sale of purchase, or by making or taking delivery.
The initial margin required to cover a new futures position.
A trade for which there is not a matching record by the two parties. This may be because the price, quantity, maturity, counter party or side (long – short) fail to match.
A view that the market price has risen too strictly in relation to the underline fundamental factors.
A trade which is not liquidated on the same day in which it was established.
The actual futures price exceeds the no-arbitrage futures price.
A view that the market price has declined too steeply in relation to the underlying fundamental factors.
A market where dealing does not take place at an organised exchange.
A hedge where the change in the value of the future contracts is identical to the change in the value of the other asset or liability.
Settlement of a futures contract by the supply or receipt of the asset underlying the contract.
An octagonal or hexagonal area on the trading floor of an exchange, surrounded by a tier of steps upon which traders and brokers stand while executing futures trades in the open outcry system.
This can mean the minimum permissable price change, or it can mean a price change of 100 basis points. For index point are simply the units of measurement of the index. Currently for the FT-SE 100 the minimum price movements is 0.5 index points.
An investment strategy employing various combinations of shares, options, futures and debt that is designed to provide a minimum or floor value to the portfolio.
A market commitment. Also see net position.
A restriction on the maximum number of contracts that can be held by a single trader at any one time.
A trading strategy in which a position is held for longer than one day.
Positive feedback tader
See momentum trader.
The process by which a market (usually the futures market) reflects new information before another related market (usually the spot mrket).
The maximum and minimum prices, as specified by the exchange, between which transactions may take place during a single trading session.
The difference between the highest and lowest pricing during a given period.
The price at time t + l divided by the price at time t.
The simultaneous trading of a basket of shares as part of a plane or strategy. The NYSE definition require the simultaneous trading of at least fifteen stocks with a total value of over $1 million.
Punching and settlement price
A manipulator first establishes a long (short) position in index futures, and then buys (sells) shares to push the final settlement price up (down).
The use of profits on a previously established position as margin for adding to that position.
This is the same as a futures contract, except that the payments of variation margin do not involve the full daily price change. Instead, the traders pays(or receives) each day the present value of the daily price change if it were paid on delivery day; a smaller sum.
The sequence of potential arbitrageurs, in order of increasing transactions costs.
The theory that changes in the variable (for example, share returns) are at random; that is, they are independently and identically distributed over time.
Realised bid-ask price
The difference between the prices at which scalpers have bought and sold.
The number of futures contracts above which one must report daily to the exchange or the CFTC the size of the position by delivery month and purpose of trading.
Reserve cash and carry
An arbitrage transaction where the trader holds a short position in the underlying asset and a long position in the corresponding futures contract.
The additional return risk-averse investors require for assuming risk.
Liquidation for a futures position, and the establishment of a similar position in a more distant delivery month. This is also called a switch. When a hedger switches their futures position to a more distant delivery month this can be called ‘rolling the hedge forwards’.
A quantity of shares that corresponds to that in which trading normally takes place.
The purchase (sale) of a futures contract and the subsequent offsetting sale (purchase). Transactions costs are normally quted on a ‘round trip’ basis.
See round trip.
Rule 80a in U.S.
When the NYSE moves down (up) by more than some preset limit, selling (buying) shares (not just short selling) as part of an index arbitrage transaction can be execute only if the last price movement was up (down). This rule was introduced in 1990.
To trade for small gains, normally by establishing and liquidating a futures position quickly, often within minutes, but always within the same day.
The largest price movement in the underlying security for which the clearing house requires cover.
SEBI Securities and Exchange Board of India
The regulatory body for all participants in the securities and derivatives markets in India.
Securities and Exchange Commission. A federal agency charged with the regulation of all US equity and options markets.
Security market line
A line showing the relationship between a security’s beta and its expected return.
The process by which clearing members close positions.
See delivery date.
The price which the clearing house uses to determine the daily variation margin payments. It may differ from the price of the last transaction.
A measure of the risk adjusted performance of an investment. It is calculated as the excess return on the investment divided by the standard deviation of investment returns.
A market position established by selling one or more futures contracts not yet closed out through an offsetting purchase in anticipation of falling prices; the opposite of long.
A hedge involving a short futures position and a long spot position.
A trader sells shares he or she does not own This is equivalent to a negative holding of the share.
Short the basis
The purchase of a futures contract as a hedge against a commitment to sell the underlying asset.
This exists when the return of small firms exceed the risk adjusted returns predicted by the CAPM.
Standard Portfolio Analysis of Risk. This is a system for calculating initial margins on portfolios of options and futures developed by the CME, and used by them since 16 December 1988, and by LIFFE from 2 April 1991.
A floor trader charged with the making of a fair and orderly market in particular shares or options.
Trading on anticipated price changes, where the trader does not hold another position which will offset any such price movements.
An example of an ETF, Standard and Poor’s Depositary Receipts (SPDRs) were introduced on 29 January 1993 by AMEX. They represent shares in a trust consisting of a basket of shares that is designed to track the S&P500 index. The trust has a life of 25 years, at which point it will be distributed to share holders.
The market in which the asset underlying the futures contract is traded e.g. the stock market.
See delivery month.
A derivation of ‘on the spot’ usually referring to the cash market price of a financial instrument available for immediate delivery.
The simultaneous purchase of one futures contract and sale of another, in the expectation that the price relationship between the two will change so that the subsequent offsetting sale and purchase will yield a net profit.
The difference in the prices of the near and far contracts in a spread.
A reduced margin payment for the holder of a spread position.
The number of futures contracts bought, divided by the number of futures contracts sold.
A large position in an existing futures contract is partly rolled over into a later contract month, possibly several times. This procedure may be used to hedge a series of payments or receipts.
A price is stale if it refers to the price of a trade that took place some time ago. See infrequent trading.
A market order to buy when the market price has touched a specified level above the current price, or a market order to sell when the market price has touched a specified level below the current price. Also known as a s-loss order. Opposite of a market-if-touched order.
For futures contracts, this is a synonym for a spread.
Strengthening of the basis
This occurs when the futures price declines relative to the spot price.
See exercise price.
A trader takes the same position (long or short) in a future for a series of delivery dares. This may be used to hedge a series of payments or receipts.
See roll over.
A combination of a long call option and a short put option, or debt and the underlying asset, that replicates the behaviour of a long futures contract.
Risk inherent in the market as a whole which cannot be diversified away. It is measured for each firm by a ‘beta’ value. Also known as market risk.
The risk created by marking to the market.
The correction factor by which the hedge ratio is multiplied to allow for tail risk.
Tailing the hedge
Correcting the size of hedge to allow for the risks of marking to the market.
Tax timing option
Capital gain (losses) on shares are taxable when realised. The tax timing option refers to the fact that the owner can choose when to liquidate his or her position in the shares, and hence when the tax liability (or loss) occurs.
The prediction of prices by examining past prices, volume and open interest .
Term structure of futures prices
The relationship between futures prices on the same underlying asset, but with a different time to maturity.
See fair value.
A market with few trades.
Theoritical Intermarket Margining System. This another system for calculating performance bond (initial margin) requirements for options. It is developed by the Options Clearing Corporation OCC).
Minimum permitted movement in the quotation. Measured in index points.
See minimum price movement.
See calendar spread.
The deviations between a portfolio’s performance and that of the portfolio whose performance it is desired to mimic.
The time delay between when an order is initiated and executed.
The maximum number of contracts that a person can trade in a single day.
Triple witching hour
That time every 3 months when four different contracts reach maturity – stock index futures contracts, stock index options on index futures and some options on index futures and some options on individual stocks.
The security, stock, commodity or index on which a futures contract is based.
The actual futures price is less than the no-arbitrage futures price.
Risk due to event which affect individual companies, not the market as whole. It can be removed by holding a well diversified portfolio.
An increase of one tick in the price of a security.
Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on a particular position, with a specified level of certainty or confidence.
The actual futures price less the no-arbitrage futures price.
A trader who buys when assets look underpriced, and sells when assets look overpriced. Such a trader tends to buy when there is a large drop in prices, and sell when there is a large rise, and so tends to stabilise prices.
The gain or losses on open contracts, which are calculated by reference to the settlement price at the end of each trading day and are credited or debited by the clearing house to the clearing member’s margin accounts and by those members to or from the appropriate customers margin accounts.
A market is volatile when it is prices fluctuate a lot. Academics often choose to measure the volatility of a variable by its variance.
The number of transactions in a futures contract during a specified period of time.
Weakening of the basis
This occurs when the futures price rises relative to the spot price.est of the week.
This is when the gains (losses) of the long positions are exactly equal to the losses (gains) of the short positions. This is true for the market as a whole for all futures products.
A sum is invested in fixed interest securities to guarantee the initial investment at a specified date (e.g. 90 percent of the money), and the remainder (e.g. 10 percent) is used to trade futures.