Commonly Used Terms in Derivative Market
The derivative market can seem like a world unto itself. The market is so large and so different from the other markets that it has its own language. A new person trying to trade derivatives may not even understand the information that is being offered to them. It is therefore necessary to understand the vocabulary of this market before making any trades. This article will explain some of the basic terms used in the derivatives market. The list of these terms is in no way exhaustive. These terms are the most frequently used ones and are therefore used for illustration purpose.
Long Position: When we trade stocks or bonds, we are either on the buying side or on the selling side. However, the terminology used in the derivatives market is markedly different. Here if you are the person buying a derivative contract, then you are on the long side of the contract. In the market, this is simply referred to as going long.
Hence, for example if you buy a contract wherein you agree to exchange $1000 for 900 Euros, you are going long on the dollar.
Short Position: The opposite of going long is called going short. In simple words, this means that you are the seller of a derivative contract. In the derivatives market being a seller means having a short term horizon and therefore you are shorting the underlying financial instrument.
Hence, in the same example, if you agree to exchange $1000 for 900 Euros, then you are going long on the dollar but short on the Euro. Similarly, if you agree to deliver 100 bushels of wheat to someone at a later date for a fixed price, you are going short on the wheat.
Spot Contract: A spot contract is a contract for immediate delivery. Since derivatives, by definition include delivery 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.
Market Maker: A market maker is someone who provides both buy and sell quotes for financial assets.
In case of derivatives market, these assets are derivatives. The purpose of the market maker is to provide liquidity to the market. Lets say that you wanted to sell off a derivative security that you had and you go to the market. Now, it is a real task to find another buyer when you want to sell. Hence, instead there is one party that is always willing to both buy as well as sell.
Hence, if you want to sell you go to the market maker and also if you want to guy to buy, you go to the same market maker.
The market maker never holds the other side of the bet. If they go long on a certain trade with you, they will immediately find someone with whom they can go short with. This cuts them out of the trade and in the end you are holding the long end of the deal whereas the other party is holding the short end.
This creates liquidity in the market as the market maker is always available to take the other side of the trade with you.
Bid Ask Spread: In derivatives markets, market makers will always give you two sets of prices. In set it called the bid price whereas the other set is called the ask price. The difference between the two is known as the bid ask spread.
The bid price is the highest price which the bidder would agree to pay you in case the transaction for a particular security would go through. Hence, for you, this is a selling price.
The ask price on the other hand the minimum price which the market maker expects from you when they transact with you. Since you have to pay this money to the dealer, this can be thought of as the buying price for you.
However, there is always a small difference between the bid price and the ask price. This might seem like an arbitrage opportunity for the market maker since they can make a risk free profit. However, it isnt.
The market maker has to hold the security for a few minutes before they can make an opposite bet and move out of the trade. However, since securities are volatile, they could drastically change value within these few minutes.
The bid ask spread is therefore a compensation provided to the market maker to help them offset the risk that they undertake when they enter into open ended transactions.
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