by The Derivatives Market is a financial market where contracts derive their value from an underlying asset, security, index, rate or commodity. To understand futures, options and other derivative instruments, students need to know certain basic market terminologies. Terms such as underlying asset, contract size, margin and settlement explain the structure and execution of derivative contracts. Other important terms include expiry date, strike price, premium, spot price, futures price, open interest, mark to market, lot size, long position and short position. Understanding these terms helps investors analyse derivative contracts, calculate obligations and manage market risk effectively.
Basic Terminologies of Derivatives Markets:
1. Underlying Asset
The underlying asset is the financial asset, commodity, security, index or reference variable from which a derivative contract derives its value. The price movement of the underlying directly or indirectly affects the value of the derivative. Underlying assets may include shares, stock indices, commodities, currencies, interest rates and government securities. For example, in a gold futures contract, gold is the underlying asset. In a Nifty futures contract, the Nifty index is the underlying. The underlying asset provides the basis for determining the price, settlement value and risk associated with a derivative contract. In India, derivatives are regulated mainly by SEBI.
2. Contract Size
Contract size refers to the standard quantity of the underlying asset covered by one derivative contract. It determines the total exposure represented by the contract. For example, if one futures contract represents 100 units of an asset, its contract size is 100 units. Contract sizes are generally specified by the relevant stock exchange and may differ between securities and commodities. Standardisation of contract size makes trading easier and improves market transparency. Traders must know the contract size before calculating their total exposure, margin requirements, potential profit or loss and settlement obligations. Contract size is also commonly related to lot size.
3. Margin
Margin is the amount of money or eligible collateral that a trader must deposit to take or maintain a position in certain derivative contracts. It acts as financial security against potential losses and helps reduce default risk. In futures trading, exchanges and clearing corporations may require initial margin, exposure or additional margin and maintenance related requirements, depending on applicable rules. Positions may also be subject to mark to market obligations. Margin is not normally the full value of the underlying contract. Because derivatives involve leverage, a relatively small margin can control a larger contract value, increasing both potential gains and losses.
4. Settlement
Settlement is the process through which the financial obligations arising from a derivative contract are completed. It determines how gains, losses, securities or commodities are transferred between the parties. Derivatives may generally involve cash settlement or physical settlement, depending on the contract specifications and applicable regulations. In cash settlement, the difference between the contract value and settlement value is paid in money. In physical settlement, the underlying asset is delivered according to prescribed conditions. Settlement is facilitated through the clearing corporation, which calculates obligations and manages the settlement process. Proper settlement reduces counterparty risk and supports orderly functioning of derivative markets.
5. Futures Contract
A futures contract is a standardised agreement to buy or sell an underlying asset at a predetermined price on a specified future date or according to the contract’s settlement terms. Futures are traded on recognised exchanges and are subject to margin requirements and daily mark to market. Examples include stock futures, index futures and commodity futures. Both parties have contractual obligations. Futures are commonly used for hedging, speculation and arbitrage. In India, exchange traded futures are regulated within the framework administered by SEBI.
6. Options Contract
An option is a derivative contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within or at a specified period, depending on the contract. A call option provides a right to buy, while a put option provides a right to sell. The option buyer pays a premium for this right. The option seller, or writer, assumes the corresponding obligation if the option is exercised. Options are widely used for hedging, speculation and risk management.
7. Call Option
A call option gives the buyer the right to buy the underlying asset at a predetermined strike price, subject to the terms of the contract. The buyer generally pays a premium for this right and is not obligated to exercise it. A call option may become valuable when the market price of the underlying rises above the relevant strike price, after considering the premium and other costs. Traders may purchase calls when they expect an increase in the underlying price. Call options are also used to manage exposure to potential price increases.
8. Put Option
A put option gives the buyer the right to sell the underlying asset at a predetermined strike price according to the contract terms. The buyer pays a premium for this right but is not required to exercise it. Put options can provide protection against a decline in the value of an underlying asset. For example, an investor holding shares may purchase a put option to reduce the impact of a possible fall in share prices. Traders may also purchase puts when they expect prices to decline. Put options are therefore useful for downside protection and speculation.
9. Strike Price
The strike price, also called the exercise price, is the predetermined price at which the buyer of an option has the right to buy or sell the underlying asset, depending on whether it is a call or put option. For a call option, the strike price is the price at which the underlying can be purchased. For a put option, it is the price at which the underlying can be sold. The relationship between the strike price and market price helps determine whether an option is in the money, at the money or out of the money.
10. Premium
Premium is the price paid by an option buyer to the option seller for obtaining the rights provided by the option contract. It is determined by several factors, including the underlying asset price, strike price, time remaining to expiry, volatility, interest rates and market expectations. Unlike the option buyer, the option seller receives the premium but assumes an obligation if the option is exercised or settled according to its terms. Premium is therefore an important component of option pricing and represents the cost of obtaining option protection or exposure.
11. Expiry Date
The expiry date is the date on which a derivative contract reaches the end of its specified contractual life. After expiry, the contract is settled or otherwise dealt with according to its terms and applicable exchange rules. Futures contracts have specified expiry dates, while options also have defined expiry dates. Traders must close, roll over or settle their positions before or at expiry as permitted by the contract. The time remaining until expiry is important in option pricing, because the value of time generally decreases as an option approaches its expiry date.
12. Spot Price
The spot price is the current market price of the underlying asset for immediate purchase or sale. It is different from the futures price, which relates to a future settlement obligation. The relationship between spot price and futures price is important for understanding derivative pricing and arbitrage opportunities. For example, the current market price of gold is its spot price, while the price quoted for a gold futures contract represents the futures price. Changes in the spot price can significantly influence the value of related futures and options contracts.
13. Futures Price
The futures price is the price agreed or quoted for the underlying asset under a futures contract for its specified future settlement. It may differ from the current spot price because of factors such as interest costs, storage costs, dividends, convenience yield and market expectations, depending on the underlying. Futures prices continuously change during trading hours in response to demand and supply. Traders analyse futures prices to take hedging, speculative or arbitrage positions. The difference between spot and futures prices is also important for understanding the relationship between the cash and derivatives markets.
14. Long Position
A long position in derivatives generally means that a trader has purchased a futures contract or has taken a position that benefits from an increase in the underlying price. In futures, a buyer has an obligation according to the contract terms. A trader may take a long position when expecting the underlying asset’s price to rise. For example, purchasing a stock futures contract creates a long futures position. If the price increases favourably, the position may generate a profit, subject to transaction costs, margins and settlement adjustments.
15. Short Position
A short position generally refers to selling a futures contract or taking a derivative position that benefits from a decline in the underlying price. In futures, the seller has contractual obligations according to the contract terms. A trader may take a short position when expecting prices to fall. For example, selling a stock futures contract creates a short futures position. If the underlying price declines as expected, the position may generate a profit. Short positions are also important for hedging, particularly when a producer or investor wants protection against falling prices.
16. Open Interest
Open interest represents the total number of outstanding derivative contracts that remain open and have not been closed, exercised or settled. It provides information about the level of market participation and outstanding positions. Open interest is different from trading volume, which measures contracts traded during a particular period. An increase in open interest may indicate that new positions are being created, while a decrease may indicate positions being closed. Traders and analysts use open interest along with price and volume data to understand market activity and assess trading trends.
17. Mark to Market
Mark to market, commonly called MTM, is the process of adjusting the value of an open futures position based on its current market price. In exchange traded futures, daily gains and losses are generally calculated and settled according to applicable clearing and exchange procedures. If the market moves against a trader, funds may be required to meet the resulting obligation or margin requirement. MTM helps control counterparty and settlement risk by recognising losses regularly instead of allowing them to accumulate until final expiry. It is an important feature of futures markets.
18. Lot Size
Lot size refers to the standard number of units of the underlying asset represented by one derivative contract. It determines the quantity that a trader buys or sells through a single contract. For example, if the specified lot size is 50 units, trading one contract represents exposure to 50 units of the underlying. Lot sizes are determined according to applicable exchange specifications and may vary between contracts. Understanding lot size is essential for calculating total contract value, margin requirements, profit and loss, and market exposure. In many contexts, contract size and lot size are used interchangeably.
