Derivatives

160 terms · each links to a full explanation with a worked example and the exam traps

American optionAn option whose holder may exercise it at any time on or before expiry. All exchange-traded index and stock options in India are European style instead — exercisable only on expiry.
ArbitrageSimultaneously buying and selling an asset, or a replica of it, in different markets to profit from a price discrepancy — a trade that aims to lock in a profit rather than bet on direction.
ArbitragerA participant who locks a profit by entering opposite transactions in two markets at once — carrying no exposure and taking no view, and in the process pulling the two prices back together.
AssignmentThe allocation of exercised options to one or more option sellers — the moment the writer's obligation becomes a real cash outflow, decided by the exchange and not by the writer.
Assignment marginA margin collected on an option position for its final settlement obligation, on top of the initial, exposure and premium margins, levied until the pay-in towards exercise settlement is complete.
Asymmetric payoffA payoff where gains when the underlying moves one way differ sharply from losses when it moves the other — the defining feature of options, as against the symmetric, linear payoff of futures.
Asymmetric risk exposureThe defining pay-off feature of options: gains when the underlying moves one way differ sharply from losses when it moves the other way. Futures, by contrast, have symmetric exposure.
At-the-moneyAn option whose strike price is closest to the spot price, so exercising it immediately would produce neither a gain nor a loss — the strike where the whole premium is time value and uncertainty peaks.
Automatic exerciseThe rule that every in-the-money Exchange Traded Interest Rate Option is exercised by the clearing corporation itself at expiry, at the final settlement price, with no action needed from the buyer.
Ban periodThe state a derivative security enters once its market-wide Open Interest exceeds 95% of the Market Wide Position Limit, during which members and clients may only trade to reduce their positions.
Base priceThe reference price a contract starts each trading day from — the theoretical futures price on the day it is introduced, and the previous day's daily settlement price on every day after.
BasisThe difference between the spot price and the futures price of an asset — positive when spot exceeds futures, negative when futures exceeds spot, and zero at expiry.
Bermudan optionAn option that can be exercised only on specific dates named in the contract, usually near expiry — more flexible than a European option, less flexible than an American one.
Binomial pricing modelAn option pricing model that maps the underlying's possible prices as a tree of up and down moves at equally spaced time steps — accurate and flexible because it is iterative, but slow to compute.
Black-76 modelThe variant of the Black-Scholes model used to price Options on Futures, which substitutes the futures price F for the spot price and discounts the whole payoff at e^(-rT).
Black-Scholes modelA 1973 closed-form option pricing model using spot, strike, volatility, time to expiry and the risk-free rate; Indian exchanges use it for the theoretical price of exchange-traded currency options.
Bond forwardAn OTC rupee interest rate derivative in which a buyer agrees to buy a specific Government Security from a seller on a future date at a price fixed today — governed by RBI's Directions of 21 February 2025.
Break-even pointThe level of the underlying at which a position makes neither profit nor loss — for a bought call, strike plus premium; for a bought put, strike minus premium.
Butterfly spreadA four-legged position — one option bought at a low strike, two sold at a middle strike and one bought at a high strike, all of the same expiry — that caps the unlimited loss of a short straddle.
Buying a spreadAn intra-commodity spread trade — buying the near-month futures contract and simultaneously selling the far-month contract — taken when the near month looks underpriced or the far month overpriced relative to fair value.
Buy spread orderAn exchange order type that trades a calendar spread as a single instruction: a buy spread order simultaneously sells the near-month leg and buys the far-month leg at the price difference quoted.
Calendar spreadA long position in futures of one maturity and a short position in futures of another maturity on the same underlying. It is a bet on the price gap between the two months, not on market direction.
Call optionA contract giving its buyer the right, but never the obligation, to buy the underlying at a fixed strike price — so the loss is capped at the premium and the gain is not.
Carry costThe interest cost built into the gap between a stock's spot price and its futures price, reflecting the cost of funding a spot purchase until the futures contract's delivery date.
Cash and carry arbitrageBuying the underlying in the cash market and simultaneously selling futures when futures trade above their fair price, carrying the asset to expiry to lock in the mispricing.
Cash and carry pricingThe no-arbitrage model for bond futures: theoretical futures price = cash (dirty) price + financing cost − income on the cash position, which is accrued interest to the futures settlement date.
Cash settlementSettling a derivative on expiry or exercise by exchanging the price difference, without delivering the underlying asset. SEBI mandates physical settlement for stock derivatives, not index derivatives.
Close to the moneyThe band of option strikes clustered around the at-the-money strike which, in Options on Goods, lapse unless the buyer gives an explicit instruction to exercise them.
Closing transactionAn options trade that reduces or eliminates an existing position by an offsetting purchase or sale of a contract with the same strike price and expiry — also called squaring off.
CollarAn options strategy extending a covered call: hold the stock, sell a call above the price and buy a put below it, putting a floor under losses in exchange for a lower cap on profits.
Commodity OptionsAn options contract in which the underlying is the right to enter a commodity futures contract — a second-order derivative that a Category III AIF may trade up to 10% of its funds in one commodity.
Contingent cash flowA foreign currency receipt or payment that may not happen at all — an unconfirmed order or an unsuccessful bid — for which the workbook prefers bought options to futures, because the loss is capped at the premium.
Contract cycleThe period over which a derivative contract trades, and the set of expiries available at once — for NSE stock and index futures, a three-month cycle of near, next and far months.
Contract specificationsThe terms of an exchange-traded derivative that the exchange fixes in advance — underlying, lot size, contract cycle, expiry day, tick size, settlement prices, trading hours — everything except the price.
Contract valuePrice or rate multiplied by the lot size or contract multiplier — the number margins, brokerage, transaction charges and regulatory fees are all computed from, and different for every contract.
Contrarian indicatorA market signal read against the crowd — an extreme reading is treated as a sign of an imminent reversal rather than as confirmation of the trend, the way the workbook reads an extreme put-call ratio.
Contrary instructionAn instruction from the holder of an in-the-money option telling the exchange **not** to exercise it — the only way to stop an ITM contract being exercised automatically at expiry.
ConvergenceThe certainty that a futures price and the spot price of its underlying meet at expiry — because on the last trading day the contract settles at the cash market price, leaving no room for a difference.
Corporate Bond Index FuturesCash-settled futures on an index of corporate debt rated AA+ and above, permitted by SEBI in January 2023 to give the corporate bond market a hedge of its own.
Cost of arbitrageThe financing cost an arbitrageur incurs while holding a cash-and-carry position until expiry, which reduces the gross arbitrage profit to the net gain actually earned.
Cost of carryThe cost of holding an asset until a future date — financing interest plus storage, less any income it pays. It links spot to futures: fair futures price = spot + cost of carry − inflows.
Cost of futures and optionsWhat holding a futures or options position actually costs, as the workbook frames it when comparing derivatives to a direct index or gold investment — largely an interest cost, plus a premium for options.
Covered callHolding the underlying in the cash market and writing a call against it — a way of earning premium income from a holding, at the cost of capping the gain above the strike.
Covered short putWriting a put option while holding enough funds to buy the commodity if the put is exercised — a premium-earning strategy, as opposed to a naked short put written without the funds.
Crack spreadAn inter-commodity spread strategy in the energy complex — trading crude oil futures against futures on the petroleum products refined from it — used to lock in a refiner's margin.
Credit Default SwapA contract in which a protection buyer pays a regular premium to a protection seller, who agrees to pay any loss in value on a specified reference obligation if a credit event such as default occurs.
Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.
Crush spreadAn inter-commodity spread specific to the soyabean complex — buying soyabean futures and selling soyabean meal and soyabean oil futures in a set proportion — used to lock in a processor's crushing margin.
DeltaThe change in an option's premium for a one-rupee change in the underlying — the first and most used Greek, and the hedge ratio that says how much underlying to hold against an option position.
Delta hedgingOffsetting an option position's delta with the underlying or futures so the combined delta is zero, then buying or selling as delta changes to keep it there — the option trader's way of managing risk.
Delta neutral positionA combined options-and-futures position whose net delta is zero, so a small move in the underlying causes an equal and offsetting gain and loss across the two legs — built and maintained by delta hedging.
DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
Diagonal spreadTwo options of the same type on the same underlying with both a different strike and a different expiry — the most complicated of the three spread families, and the only one that varies on both axes.
Duration-based hedge ratioThe number of interest rate futures that drives a bond portfolio's duration to zero — portfolio modified duration times market value, divided by futures modified duration times futures price over par.
Effective priceThe rate a hedger actually ends up with: the price realised or paid in the spot market, adjusted by the payoff on the hedge — added for a receiver, subtracted for a payer.
European optionAn option that can be exercised only on its expiry date. Indian equity options are European — coded CE for calls and PE for puts — unlike American options, exercisable any time up to expiry.
European-style optionAn option that can be exercised only on its expiry day; the only style permitted for commodity options on Indian exchanges, including options on futures, options on goods and index options.
Exchange traded derivativeA derivative traded on an organised exchange on standardised terms, with prices set by anonymous auction and performance guaranteed by a clearing corporation — as against a bilateral, customised OTC contract.
ExercisePutting an option's right into effect: a call holder buys the underlying at the strike, a put holder sells at the strike. In cash settled IRD options the holder simply receives the difference.
Expectancy modelThe view that a futures price is simply the market's expected spot price at expiry, so futures can trade at a premium or discount to spot and signal the expected direction of prices.
Expectations modelA futures pricing theory holding that the futures price is the market's expectation of the future spot price — unlike the cost-of-carry model, which prices futures off today's spot price plus financing cost.
Expiration dayThe last trading day of a derivative contract, on which it ceases to exist and all open positions are compulsorily settled — the last Tuesday of the month for NSE contracts, the last Thursday for BSE.
Explicit instructionThe instruction an option buyer must actively give to exercise a close-to-the-money or at-the-money commodity option — without it, the option simply expires, unlike an in-the-money option, which exercises automatically.
Fair valueThe theoretical futures price — spot plus the cost of carrying the commodity to expiry — at which a buyer is indifferent between buying today and buying forward.
Financial futuresFutures on currency rates, interest rates (bond futures) and equity prices (stock or index futures) — grouped together in the workbook as distinct from commodity futures, and without a delivery notice period.
Fixed-for-floating swapA commodity swap in which one side pays a fixed price agreed at the outset and the other pays a floating price — a spot price, a nearest-futures price, or an average of either — reset each period.
Forward contractA bilateral, over-the-counter agreement between two parties to buy or sell an asset on a fixed future date at a price agreed today — customised to suit them, and binding on both.
Forward Rate AgreementAn OTC contract that locks in an interest rate today for a borrowing or lending period starting later; only the rate difference on a notional principal is settled, in cash.
Futures bear spreadAn intra-commodity futures spread taken when the actual gap between two calendar months is narrower than the fundamental average difference — sell the near month, buy the far month, and wait for the gap to widen.
Futures bull spreadAn intra-commodity futures spread taken when the actual gap between two calendar months is wider than the fundamental average difference — buy the near month, sell the far month, and wait for the gap to narrow.
Futures carry effectThe reason a call on futures carries more intrinsic value than a call on goods, while a put on goods carries more than a put on futures — because before expiry the futures price sits above the spot price.
Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
GammaThe rate at which an option's delta changes for a one-unit change in the underlying — the second-order Greek, and the reason a delta hedge stops working as soon as the market moves.
Hedge contract monthThe futures contract month chosen for a hedge — the thumb rule is to pick the contract expiring just after the date the hedger plans to unwind the underlying exposure.
HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
Hedge ratioThe number of futures (or options) needed to hedge a position. For one stock with its own futures it is 1:1; for a portfolio against index futures it is portfolio value × beta ÷ contract value.
HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
Historical volatilityVolatility measured backwards — the standard deviation of the underlying's past percentage price changes, as against implied volatility, which is worked out forwards from the option price.
Horizontal spreadTwo options of the same type and the same strike but different expiries — a position whose entire value is the difference between the two legs' time values, not a view on direction.
Implied volatilityThe volatility figure that, put into an option pricing model, reproduces the option's actual market price — the market's consensus forecast of how much the underlying will move.
Index derivativesDerivative contracts — chiefly index futures and index options — that have a stock index as the underlying asset. In India they are cash settled and used to hedge market risk.
Inter-bond spreadA long-short position in futures on two different GOI bonds, usually of the same expiry, taken to express a view on how the yield curve will steepen or flatten.
Interest Rate CapA series of interest rate call options, called caplets, that pays the buyer at the end of each period in which the underlying interest rate is above the strike rate agreed in advance.
Interest Rate CollarBuying an interest rate cap and selling an interest rate floor on the same rate, maturity and notional — capping borrowing cost from above while giving up the benefit of rates falling below the floor.
Interest-rate derivativesContracts that let borrowers and investors hedge adverse interest-rate movements — interest-rate futures, interest-rate swaps, interest-rate options (caps and floors) and forward rate agreements.
Interest Rate FloorA series of interest rate put options that pays the buyer at the end of each period in which the underlying interest rate is below the strike rate — protection against falling rates.
Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.
Interest rate swapAn agreement to exchange streams of interest payments on a notional principal for a set period — typically fixed against floating — where only the net difference ever changes hands.
Intrinsic and time valueThe two components of an option's premium — intrinsic value, the amount the option is currently in the money by, and time value, the extra a buyer pays for the chance the option becomes more valuable before expiry.
Law of one priceThe principle that identical assets cannot trade at different prices in two markets, beyond the transaction costs between them — because arbitrageurs would close the gap.
LeverageControl of a large contract value for a small upfront outlay — premium for an option buyer, margin for a futures position — which multiplies percentage gains and percentage losses by the same factor.
Long hedgeA hedge made by buying futures to protect against a price rise before a planned future purchase — the gain on futures offsets the higher cash price, locking in roughly the futures price.
Long positionAn outstanding, unsettled buy position in a derivatives contract — the buyer of a futures contract, or the buyer (holder) of an option, is said to be long.
Long speculatorA trader who buys first and expects the price to rise — a long futures or option position taken with no corresponding short position in the spot market and no intention of using the commodity.
Long straddleBuying a call and a put at the same strike and the same expiry — a bet that the underlying moves a long way in either direction, with two break-even points and a maximum loss equal to both premiums.
Long strangleBuying an out-of-the-money call and an out-of-the-money put with the same expiry but different strikes — the cheaper cousin of the straddle, with a wider band of loss between two break-even points.
Lot sizeThe minimum quantity that must be traded and, on a delivery contract, actually delivered at expiry — equal to or higher than both the trading unit and the minimum order quantity.
Market side ruleThe rule that ties a market participant's buy-or-sell decision in interest rate futures and options to their expectation of rate direction, since bond prices and interest rates move inversely.
Mark to MarketThe daily settlement of a futures position at that day's closing price, so gains and losses are paid in cash every evening instead of accumulating until expiry.
MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
Naked positionA long or short position in a futures contract held without any position in the underlying asset or an offsetting contract — fully exposed to price moves in one direction.
Naked putIn this workbook, a put option taken for trading or speculation with no portfolio behind it — the counterpart of a protective put, which insures holdings the investor already owns.
No-arbitrage boundsThe band around the fair futures price, created by transaction costs, taxes and margins, within which a mispricing is too small to arbitrage profitably — so prices can sit there undisturbed.
Notional bondA theoretical bond with a fixed coupon and maturity that no one has issued — used as a futures underlying so the contract does not depend on the liquidity of any single security.
Notional principalThe reference amount interest is computed on in a swap, FRA or money market futures contract — it sizes the exposure and the settlement, but it is never exchanged.
Offsetting hedgeA hedge undertaken to offset price risk that has arisen from a physical market activity already carried out — one of the workbook’s two basic hedging strategies, the other being locking in a price.
Offshore derivative instrumentsInstruments issued by an FPI that reference Indian securities; SEBI bars ODIs referencing derivatives and allows onshore derivative hedging only via a separate Category I registration, within limits.
Open interestThe total number of derivative contracts outstanding and not yet settled in an underlying — counted on one side only, because every long is matched by a short.
Open positionAn outstanding, unsettled long (buy) or short (sell) position in a contract; margins, exposure limits, daily MTM and corporate-action adjustments are all applied to open positions.
OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
Option buyer maximum riskThe workbook's comparison-table rule that an option buyer's maximum possible loss is capped at the premium paid, unlike a futures position, whose risk equals the full swing in the underlying.
Option premiumThe price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
Options on FuturesA European commodity option whose underlying is a futures contract, so exercise devolves into a futures position opened at the strike price rather than into delivery of the goods.
Options on GoodsA European option whose exercise devolves directly into delivery of and payment for the physical commodity, rather than into a futures position.
Option writerThe party who sells an option: receives the premium upfront and takes on the obligation to sell (call) or buy (put) the underlying if the buyer exercises. Gain is capped at the premium.
OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
Out-of-the-moneyAn option that would produce a negative cash flow if exercised immediately — a call with the spot below the strike, or a put with the spot above it. Its intrinsic value is zero and its premium is all time value.
Over-the-counterA bilateral market where two parties negotiate a contract's terms directly, with no exchange or clearing house between them, unlike a standardised, centrally cleared exchange-traded market.
Partial hedgeCovering only a fraction of an exposure with derivatives, leaving the rest open — so the effective rate is a weighted average of the hedged rate and the spot rate.
Pay-offThe profit or loss on a position at expiry, stated as a function of the settlement price — positive when the trade makes money, negative when it loses.
Payoff chartA graph plotting an underlying's expiry price on one axis against a derivative position's profit or loss on the other — a straight, symmetric line for futures, and a kinked, asymmetric one for options.
Premium style optionThe style in which Exchange Traded Interest Rate Options are structured: the buyer pays the full option premium upfront, in cash, to the seller, at the time of the trade.
Price discoveryThe process by which the free interaction of buyers and sellers produces a price that reflects every participant's expectation of what the underlying will be worth at a future date.
Protective callBuying a call option to hedge a foreign currency payable: it caps the purchase rate at strike plus premium, while leaving the importer free to benefit if the currency falls.
Put-call parityThe arbitrage-free relationship binding a European call and put of the same strike and expiry to the spot and the discounted strike: c + X·e^(−rt) = p + S. Deviations create risk-free profit.
Put-Call RatioPut open interest (or volume) divided by call open interest on the same underlying, read as a contrarian sentiment gauge: below 1 is taken as bearish, above 1 as bullish.
Put optionA contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
Reference priceIn an exchange spread order, the last traded price of the near-month (first) leg — the anchor price to which the entered spread difference is added to fix the far-month leg's traded price.
Regular arbitrageBuying a bond in the underlying market and selling futures on the same bond when futures trade above their theoretical price — locking in a pay-off that is the same whether the bond price rises or falls.
Reverse arbitrageSelling a bond, lending in repo and buying futures on the same bond when futures trade below theoretical value — a locked-in pay-off not open to all, as short selling G-Secs is restricted.
Reverse cash and carry arbitrageSelling the underlying in the cash market and simultaneously buying futures when futures trade below their fair price — the mirror image of cash and carry, and it needs stock to sell.
Reverse Interest Rate CollarBuying an interest rate floor and selling an interest rate cap on the same rate, maturity and notional — protecting a floating-rate receiver against falling rates while giving up gains above the cap.
RhoThe option Greek that measures interest rate sensitivity — the change in an option premium for a one percentage point change in the risk-free rate. It is positive for calls and negative for puts.
Risk transferThe economic function by which commodity price risk moves off the hedger, who does not want it, onto the speculator, who is willing to carry it for a return.
RolloverCarrying a derivatives position past expiry by closing the expiring contract and opening the same position in the next series simultaneously — the only way to hold a view longer than one contract cycle.
Short hedgeA hedge made by selling futures to protect an existing holding or a planned sale against a price fall — the futures gain offsets the lower cash price, locking in roughly the futures price.
Short positionAn outstanding, unsettled sell position in a derivatives contract — the seller of a futures contract, or the seller (writer) of an option, is said to be short.
Short straddleSelling a call and a put with the same strike and same expiry, betting the underlying stays still. Profit is capped at the two premiums; losses grow without limit on a big move either way.
Short strangleSelling an out-of-the-money call and an out-of-the-money put on the same underlying and expiry. It profits if the price stays between the two strikes; losses are unlimited on a large move.
Speculator or traderA derivatives market participant with no real underlying exposure, taking a position purely on a price view, preferring derivatives to the underlying for their leverage, low cost and speed of execution.
Square offClosing an open futures position before expiry by taking the opposite trade — a buyer sells, a seller buys — locking in the profit or loss without waiting for the contract to settle.
Square-off of optionsClosing an open interest rate option position before expiry by selling a bought option, or buying back a written one, realising only the change in premium rather than the payoff the option might have had at expiry.
Strike priceThe price fixed in an option contract at which the buyer may buy (call) or sell (put) the underlying if he chooses to exercise — fixed for the life of the contract, unlike the premium.
Strike price intervalThe fixed gap between consecutive strike prices an exchange lists for an options contract — set at Rs 0.25 for Exchange Traded Interest Rate Options, giving strikes like 99.75, 100.00, 100.25.
SwapA derivative in which two parties agree to a specified exchange on future dates — typically one pays a fixed interest rate and receives a floating one on an agreed principal that never itself changes hands.
SwaptionAn option on a swap — the right, not the obligation, to enter an interest rate swap at a predetermined strike rate on a future date, bought for a premium.
Synthetic long callA protective put position — long the stock plus a long put at the same strike — whose payoff, limited loss with unlimited upside, mimics that of an outright long call option.
Synthetic securityA short-term instrument built by holding a long-maturity bond alongside a short position in its futures, shortening its effective maturity to the futures' expiry — used to enhance yield over a cash security.
ThetaThe option Greek that measures time decay — the change in an option's premium for a one-day decrease in time to expiry. It is negative for a long option, call or put alike.
Tick sizeThe smallest price change a contract may be quoted in — prices move only in whole multiples of it, and it differs from one commodity to another.
Tick valueThe rupee profit or loss on one contract when the price moves by a single tick — lot size divided by the quotation factor, multiplied by the tick size.
Time decayThe steady loss of an option's time value as expiry approaches — the reason options are called wasting assets and the reason the workbook says option sellers hold a structural advantage.
Time valueThe part of an option premium that is not intrinsic value — what the buyer pays for the possibility that the underlying moves further in his favour before expiry. It falls to zero on expiry day.
True hedgeAn instrument that genuinely matches the exposure it protects — single-bond GOI futures for GOI security risk, in the workbook's example, unlike the Overnight Index Swap, which is successful but does not qualify.
UnderlyingThe asset a derivative contract derives its value from — the index, stock, bond or currency whose spot price drives the contract. The derivative has no value of its own without it.
Unit of tradingThe quantity in one contract — for Indian bond and T-Bill futures, notional bonds of Rs 2 lakh face value, which is 2,000 units of Rs 100 — and the reason exposures round rather than match.
VegaThe option Greek that measures sensitivity to volatility — how much an option premium changes for a one per cent change in the implied volatility of the underlying. It is positive for a long call and a long put alike.
Vertical spreadTwo options of the same type and the same expiry but different strikes, one bought and one sold — a limited-profit, limited-loss position that trades away part of the upside to cut the cost or cap the risk.
Wasting assetAn option, whose time value shrinks towards zero every day it is held and is worth nothing at expiry — so an option buyer loses money simply from the passage of time.
Zero sum gameThe principle that every derivative long has a matching short, so one side's gain is exactly the other side's loss and the net value of all derivative positions is zero.