A reference guide for technical terms in derivatives and the Malaysian derivatives market, including key concepts and terminology
A
American option
An option that may be exercised at any time prior to expiration
Anticipatory hedge
A hedging strategy that involves taking a futures position in anticipation of a later cash transaction.
Arbitrage
The simultaneous purchase and sale of same or similar products indifferent markets for a minimum risk.
Assignment
The process by which the seller of an option is notified of the buyer’s intention to exercise.
At-the-market
Where the underlying asset is trading at the same level as the strike or exercise price of the option.
Automatic Exercise
The exercise by a clearing house of an “in-the-money” option at expiration, unless the holder of the option submits specific instructions to the contrary.
B
Basis
The difference between the actual or spot price and the futures price.
Bear
One who expects a decline in prices (the opposite of “bull”).
Bearish
When conditions suggest lower prices, a bearish situation is said to exist.
Bearish put spread
The simultaneous purchase of one “at-the-money” put and sale of one “out-of-the money” put.
Bid
An offer to buy, subject to immediate acceptance unless otherwise indicated, a definite quantity of a contract at the price stated
Black-Scholes
Equation used to calculate a theoretical call price using the five key determinants of an option’s price price of the underlying, strike price, implied volatility, time to expiration, and risk free interest rate
Break down
A sharp decline in price below support area.
Break up
A sharp increase in price above resistance area.
Bull
One who expects a rise in prices (the opposite of “bear”).
Bullish
If higher prices appear warranted, the situation is said to be bullish.
Bullish call spread
The simultaneous purchase of one “at-the-money” call and sale of one “out-of-the money” call.
Butterfly
The sale (purchase) of two identical options, together with the purchase (sale) of one option with an immediately higher exercise price and one option with an immediately lower exercise price. All options must be of the same type, have the same underlying asset and expire at the same time.
Buy/write
The purchase of an underlying contract and the simultaneous sale of a call.
C
Call option
A contract between a buyer and a seller whereby the buyer acquires the right, but not the obligation, to purchase a specified share, commodity, futures contract or cash index, at a fixed price on or before a specified date. The seller of the call option assumes the obligation of delivering the share, commodity, futures contract or cash index, should the buyer wishes to exercise the option.
Capitalisation weighted index
A stock market index which is weighted according to the market capitalisation of the constituent stocks. Thus, those companies with higher market capitalisation have a larger weighting in the index.
Capital markets
Securities markets for medium to long-term investments and fundraising, as distinct from the money markets which focus on the short term (usually up to one year).
Carrying charge
The expense, such as storage charges, insurance, interest charge and other incidental costs involved in ownership of stored physical commodities over a period of time. May be reflected in futures contracts by successively high prices for each succeeding future periods in so-called “normal” markets
Cash commodity
Actual physical commodities as distinguished from futures contracts. Sometimes called “spot commodity”.
Cash market
Market for immediate delivery of and payment for commodities or financial instruments
Cash settlement
A procedure for settlement of contracts by automatic close out at a cash price designated by the clearing house in futures markets which make no provision for delivery, e.g. KLIBOR futures and FBM KLCI futures.
Charting
The use of graphs and charts in the technical analysis of futures markets toplot trends in price, volume and open interest. See also technical analysis
Clearing contracts
The process of substituting principals to transactions through the operation of the clearing house
Clearing house
An independent body which guarantees the fulfilment between clearing members of all contracts traded on the exchange. The clearing house holds all margin requirements of the clearing members who have to cover their commitments with the clearing house on a day-to-day basis. The clearing house handles all cash settlement within the market and provides the documentation necessary to record all business.
Clearing participant
A participants of the clearing house
Close out
To trade an equal and opposite futures transaction to that already held. See also offset
Combination
A two-sided option spread that does not fall into any well defined category of spreads. More specifically, the term is often used to refer to a long call and short put or a short call and long put, which together make up a synthetic position in the underlying asset.
Contract
A term of reference describing a unit of trading for futures or options. A legal agreement that details a futures or options transaction.
Contract grade
The grade of a commodity which has been officially approved by the exchange as deliverable in settlement of a futures or option contract.
Contract month
The month in which delivery is to be made in accordance with a futures or option contract.
Contract size
The amount of the underlying instrument that is covered by the futures or option contract.
Convergence
The coming together of the underlying cash price and the futures price as the expiry date approaches.
Cost-of-carry
The cost built-in to the price of a forward or futures contract – it includes the interest rate and any other receipts built-in to a forward or futures price. Also known as the “carrying charge”.
D
Daily price limit
A limit imposed by the exchange on the range within which prices of futures or options can fluctuate within one day’s trading session.
Day orders
Orders which automatically expire at the close of the day’s trading if not filled during the day on which they are received.
Day trading
Establishing and liquidating the same futures market position within one day.
Default
Failure to perform on a futures contract as required by the exchange’s rules, such as failure to meet a margin call or to make or take delivery.
Deliverable
A deliverable contract is one which allows the physical commodity or instrument described in the contract to be tendered or received in settlement of the contract.
Delivery
The tender and receipt of the actual commodity or financial instruments, in settlement of a futures contract. Note that for many futures contracts, no delivery position exists but settlement is made in cash.
Delivery month
A specified month during which actual delivery of the commodity may be made under the terms of a futures or option contract.
Delta
The sensitivity of an option’s value to a change in the price of the underlying. All else being equal, an option delta of 0.4 would indicate that, if the underlying asset were to rise by RM1.00, a call option’s premium would rise by 40 cent.
Delta neutral spread
A spread where the total delta position on the long side and the total delta position on the short side add up to approximately zero.
Derivatives
A financial instrument whose value is completely derived from the price or value of some other instrument or commodity.
Downtrend
Succession of lower highs and lower lows.
Dynamic hedging
A hedging strategy that is actively adjusted to reflect the changing prices of the underlying asset.
E
Eurodollar
US dollar deposits placed with banks outside the US. Holders may include individuals, companies, banks and central banks. Other currencies deposited include the euroyen, euroswiss etc.
European option
An option which may be exercised only on the expiration date
Exchange rate
The “price” of one currency stated in terms of another currency.
Exchange-traded option
An option traded on an approved exchange. This type of option has standardised exercise prices set by the exchange, enabling transfer of option positions to third parties. See option
Exercise (or strike) price
The price at which the buyer of a call can purchase the commodity during the life of the option and the price at which the buyer of a put can sell the commodity during the life of the option.
Exercise
The process by which the holder of an option notifies the seller of the intention to take delivery of the underlying asset, in the case of a call or make delivery, in the case of a put, at the specified exercise price
Expiry
The date and time after which a futures or option contract ceases to exist and may no longer be exercised.
F
Fair value
Theoretical value of a derivative.
First notice day
The first day on which notices of intention to deliver actual commodities against futures market positions can be received. First notice day will vary with each commodity and exchange
Forward contract
A legally binding contract between a buyer and a seller for a specific quantity of a commodity at a specific price at a specific time in the future.
Forward purchase or sale
A purchase or sale of an actual commodity for deferred delivery.
Fundamental analysis
Study of economic factors and policy decisions which will affect the supply and demand of the commodity being traded in futures contracts. See also technical analysis.
Futures contract
A contract between a buyer and a seller whereby the buyer is obligated to take delivery and the seller is obligated to make delivery of a fixed amount of an underlying asset/security at a predetermined price on a specified future date. Futures contracts are usually traded on an exchange and are settled daily on the basis of their current value in the marketplace.
G
Gamma
The sensitivity of an option’s delta to a change in the price of the underlying asset.
Good-till-cancelled
An order designation which tells the broker to keep the order in effect until executed or cancelled.
H
Hedge
Use of futures or option contracts to reduce risk to current holdings from market fluctuations.
Hedge ratio
A calculation of the number of futures contract required to hedge an underlying instrument so that the gains or losses from the futures position will offset the losses or gains in the underlying instrument.
Hedger
A trader who enters the market with the specific intent of protecting an existing position in an underlying asset.
I
In-the-money
A call option with a strike price lower (or a put option with a strike price higher) than the current market value of the underlying commodity.
Initial margin
The clearing house determines a minimum initial margin (or deposit) on all contracts traded on the market. This deposit must be paid by the trader to the clearing participant and is then lodged by the clearing participant with the clearing house.
Inter-commodity spread
A form of speculative trade that comprises a long position in one futures contract and a short position in a different but economically related futures contract, e.g. a long position in KLIBOR futures and a short position in Eurodollar futures.
Interest Rate Swap
An agreement to exchange a stream of interest payments for another, over an agreed period of time.
Intra-commodity spread
A form of speculative trade that is based on the same futures contract but different delivery months. It consists of a long position in one contract month and a short position in another contract month for the same commodity on the same exchange. This sometimes called calendar spread.
Intrinsic value
The in-the-money portion of the option’s premium. For call options, this is the difference between the underlying stock’s price and the strike price. For put options, it is the difference between the strike price and the underlying stock’s price. In the case of both puts and calls, if the respective difference value is negative, the intrinsic value is given as zero.
L
Last trading day
The final day under an exchange’s rules during which trading may take place in a particular delivery contract month. Futures or option contracts outstanding at the end of the last trading day must be settled by delivery of physicals or by cash settlement. See Expiry
Leg
One side of a spread position.
Leverage
Also known as “gearing”, it is the amount of assets under the control of a person using a small outlay. Because the margin for futures trading is usually only a few per cent of the notional amount, there is the existent of leverage. Leverage magnifies gains or losses from trading futures contracts.
Life of contract
The period of time from the first day of trading in a futures contract month through to the last trading day.
Limit price (daily)
The maximum price advance or decline from the previous day’s settlement price permitted in one trading session for a commodity. Not all commodities have daily trading limits.
Limit order
An order given to a broker by a client which has some restriction upon its execution, such as price or time.
Liquidation
The sale of a previously held long position or the repurchase of an earlier established short position. The former is also called long liquidation, while the latter is referred to as short covering.
Liquidity
The ability of an asset to be converted to cash quickly and easily with little impact on price.
Long
A trader who has bought futures contracts or who owns the underlying which is unhedged. “Net long” refers to a trader whose total purchases exceed total short sales in their open futures contracts.
Long hedge
A long hedge is to take a long position in the futures contract. A long hedge is primarily used by end users of the commodity.
M
Margin
A deposit made by a client/trader with a clearing house to ensure the fulfilment of any future financial obligations resulting from trades
Margin call
A communication to a trader asking him to cover an adverse price movement on a futures position by topping up on his margins or liquidating his position.
Mark to market
The process by which margin deposit with the clearing house is calculated daily according to the daily settlement price. If the initial deposit falls below the margin requirement, a margin call will be made.
Market maker
An independent trader or trading firm that is prepared to both buy and sell contracts in a designated market. Market makers must make a two-sided(bid and ask) market.
Market order
An order to buy or sell futures contracts for immediate execution at best available price.
Market-on-close (MOC)
An order to be filled at the current market price as close as possible to the close of that day’s trading.
Market risk
In the share market, market risk refers to the risk that the overall market will rise or fall.
Minimum price fluctuation
Smallest increment of price movement possible in trading a given futures contract.
N
Naked
A long (short) market position with no offsetting short (long) market position. A trader who executes one side of a two sided spread is said to be naked until the other side is executed.
Net position
The difference between the open contracts long and the open contracts short, held in any one commodity by an individual or group.
Novation
Novation is the substitution of the clearing house for the opposite contracting party in a futures or options contract. The clearing house becomes the buyer to every seller and the seller to every buyer. Such a facility allows complete flexibility to enter or leave the market at will.
O
Offer
A communication indicating a willingness to sell at a given price. Opposite to bid.
Offset
The procedure by which the long or short position of an individual is liquidated or closed-out by an opposite transaction.
Open interest
The number of open contracts on a particular future/option – shows whether a particular future/option is liquid
Open position
The total number of futures contracts entered into a particular delivery month or futures market which have not been liquidated by an off setting futures transaction or by actual delivery.
Option
The right, but not the obligation, to buy or sell a specific asset at a predetermined price (the exercise price) at or before a specific date (expiry date), for which the buyer pays a premium, limiting the potential loss in the market to the total amount of the premium.
Out-of-the-money (OTM)
A call option with a strike price higher (or a put option with a strike price lower) than the current market value of the underlying commodity. Out-of-the money options have no intrinsic value.
Overbought
A situation in which the demand and incessant buying of a certain asset unjustifiably pushes the price of an underlying asset up to levels that do not support the fundamentals.
Oversold
A situation in which the supply and incessant selling of a certain asset unjustifiably pushes the price of an underlying asset down to levels that do not support the fundamentals.
Over-the-counter (OTC)
The market in derivatives where transactions are tailored to the requirements of the users and do not occur on an organised exchange.
P
Physical delivery
Where the underlying commodity is tendered or accepted in fulfilment of a futures contract.
Position
The total of a trader’s open contracts in a particular underlying asset.
Position limit
A limit imposed by the exchange, on the total number of futures/options positions that may be held by a single account so that no single buyer or seller can unduly influence the price of the contract.
Put option
A contract between a buyer and a seller whereby the buyer acquires the right, but 0 not the obligation, to sell a specified share, commodity, futures contract or cash index, at a fixed price on or before a specified date. The seller of the put option assumes the obligation of taking delivery of the shares, commodity, futures contract or cash index should the buyer wish to exercise the option.
R
Range
(i) The difference between the highest and the lowest price at which a given futures contract has traded during a particular period of time; and
(ii) an area in the price chart between support and resistance.
Replicating portfolio
The combination of various cash and derivative positions to replicate a cash position.
Round turn
A completed transaction involving both a purchase and a subsequent sale or a sale followed by a liquidating purchase.
S
Settlement day
The maturity day of a futures or options contract – the time at which money and securities are exchanged
Settle-to-market
The procedure by which the clearing house revalues each open position to the settlement value and calls (or pays) a variation loss (or gain). It is the daily realisation of profits/losses on open contracts.
Settlement value
The price used by the clearing house to settle-to-market all open futures positions.
Short
The selling side of an open futures contract.
Short covering
See cover, liquidation.
Short hedge
Selling futures contracts to protect against possible fall in prices of commodities. Also called a “selling hedge”. See also hedging.
Short selling
Selling a contract with the idea of buying to offset it at a later date.
Speculator
A person entering into futures or options contracts for any purpose other than hedging. One who attempts on the basis of existing conditions to anticipate price changes and to trade accordingly in order to make capital gains.
Spot price
The price quoted for actual physical commodity. It is the same as the cash price.
Spread
(i) A market position which is simultaneously long and short an equivalent amount of the same or related commodities; and
(ii) The difference between the buying and selling rates.
Stop order
An order to buy or sell at a definite price either above or below the price prevailing at the time the order is given. Used at time to (1) initiate a position or (2) limit losses by placing the order for the protection of open commodity commitments. A buy stop order becomes a market order when a sale is made or is bid at or above the stop price whereas a sell stop order becomes a market order when a sale is made or is offered at or below the stop price. A stop order need not be filled at the specified price, but will be filled as a market order once the price is traded or bid/offered, depending whether the stop is a “buy stop” or a “sell stop”.
Stop-loss order
See stop orders. A stop order is often referred to as a stop-loss order when it is used to offset a long or short position in the futures market when its purpose is to protect a profit or to limit a loss.
Straddle
Is an option strategy where a call and a put with the same exercise price is purchased by a speculator who is betting that the range implied by the options that he has purchased will turn out to be wider. Buying a straddle is buying volatility.
Strangle
A position consisting of a long (short) call and a long (short) put, where both options have the same underlying asset and the same expiration date, but different exercise prices. The speculator makes money when the range of the underlying asset ends up wider than that implied by the option premiums.
Strike price
The price, specified in the option contract, at which the underlying futures contract or commodity will move from seller to buyer. Also called “exercise price” or “contract price”.
Swaption
Option to enter into an interest rate swap or some other types of swaps.
Synthetic call
A long underlying position together with a long put.
Synthetic put
A short underlying position together with a long call.
Systemic risk
The risk that a disruption, whether at a firm, market segment or across markets, will cause widespread difficulties at other firms, in other market segments or in the financial system as a whole.
T
Technical analysis
Technical analysis is a method of forecasting the future direction of prices through the study of past market data primarily through price and volume charts.
Theoretical value
An option value generated by a mathematical model given certain prior assumptions about the terms of the option, the characteristics of the underlying and prevailing interest rates.
Theta
The sensitivity of an option’s value to a change in the amount of time to expiration. In other words it measures the time decay of an option.
Time decay
See Theta.
U
Underlying instrument
The share, commodity, futures contract or cash index to be delivered in the event that an option is exercised or a futures contract is held until expiry.
Uptrend
Succession of higher highs and higher lows.
V
Vega
The sensitivity of an option’s value to a change in volatility.
Volatility
The degree to which the price tends to fluctuate over time.
Volume
The total number of contracts traded in a commodity or commodity delivery month during a specified period of time.
W
Warrants
Listed stock options that provide the holder with the right but not the obligation to buy or sell shares in the underlying company
Writer
The seller of an option.
Y
Yield
The income of an investment (usually as a per cent per year).
Yield curve
A graph showing the relationship between the yield to maturity and the term to maturity of a group of similar securities
Source
Securities Commission Malaysia (SC) Licensing Examination (SCLE) eGuide Module 14 – Derivatives