Key Terminology and Concepts in Derivatives

Rajesh was becoming increasingly familiar with derivatives, but he realised that to fully understand them, he needed to grasp the key terms used in trading. His cousin Priya, a financial analyst in Mumbai, visited him again and offered to explain these concepts in a simple way.

“Rajesh,” Priya began, “understanding derivatives is like learning a new language. If you know the key terms, navigating this world becomes much easier.” She started with the basics.

Underlying Asset

“First, we have the underlying asset,” Priya explained. “This is the asset on which the derivative is based. It could be wheat, like in your case, or commodities such as gold, silver, and crude oil, or even stocks. The value of a derivative depends on the price of this underlying asset.”

Strike Price

Next, Priya moved on to the strike price. “If you’re dealing with options, the strike price is the price at which you can buy or sell the asset. Think of it as an agreed price—like fixing a price for your wheat before harvest. If the market price goes above the strike price and you hold a call option, you benefit by buying at the lower price.”

“But what if I don’t want to buy?” Rajesh asked, recalling his earlier experience with options.

Premium

“That’s where the premium comes in,” Priya said. “In options, the premium is the price you pay for the right to act if market conditions are favourable. It’s like an insurance premium—you pay upfront for protection. If things don’t go as planned, you only lose the premium.”

Rajesh nodded thoughtfully. “So, options are like insurance for me?”

“Exactly,” Priya replied. “There are two types of options:

• Call options, which give you the right to buy the asset, and
• Put options, which give you the right to sell it.”

Expiration Date

She then explained the expiration date. “Every derivative contract has a deadline—the expiration date—by which you decide to act. For example, if you buy a call option on wheat, you must decide whether to exercise it before it expires.”

Margin

“When you trade futures contracts, you don’t pay the entire value upfront. Instead, you pay a margin, which is a fraction of the contract’s value. This allows you to control a larger position with less money.”

Leverage

“This brings us to leverage,” Priya continued. “Leverage allows you to amplify your returns by using less money than the asset’s full value. In futures, the margin is a form of leverage. While it can boost profits, it also magnifies losses.”

Mark-to-Market

“In futures contracts, we adjust the value daily based on current market prices,” Priya explained. “This process is called mark-to-market. If wheat prices go up today, the gain is credited to your account immediately. If prices fall, you’ll need to pay the difference.”

Hedging and Speculation

Finally, Priya introduced the concepts of hedging and speculation. “When you use derivatives, you’re either hedging or speculating.

• Hedging is about reducing risk, like how you protect yourself from wheat price fluctuations.
  
• Speculation is betting on price movements to make a profit. Speculators take on risk, hoping that prices will move in their favour.”
  

Pulling It All Together

With Priya’s explanations, Rajesh now understood the key terms like underlying asset, strike price, premium, expiration date, margin, leverage, mark-to-market, hedging, and speculation. Each concept was like a piece of a puzzle, helping him see the bigger picture of how derivatives worked.

Conclusion

Rajesh felt confident that he could now navigate the world of derivatives with ease. In the next chapter, we’ll explore futures contracts in greater detail, so you can learn how to use them effectively to manage risks and take advantage of market opportunities.