Investing in the derivatives market may seem overwhelming to a first-time investor. This market has its specific terms and understanding these before you decide to invest is important.
Here are six frequently used terms in the derivatives market.
1. Long position
When you trade in bonds and stocks, you may either be a buyer or a seller. However, when you invest in the derivative market, the terminologies are different. In this market, when you buy a financial derivative, you assume a long position.
2. Short position
The opposite of assuming a long position is taking a short position. In simple words, when you take a short position, you are selling the derivative. In the derivatives market, when you have a short-term duration, you take a short position on the underlying asset.
3. Spot contract
This is a contract that is available for immediate delivery. Generally, the deliveries of contracts in the derivatives market occur at a future date. Therefore, spot contracts are not considered as a component of this market. However, these types of contracts are beneficial to base the prices of different options and futures. For example, if the spot price of an asset is INR X, this may be used to derive the price of the same in the derivatives market.
4. Expiration date
Derivatives are time-bound financial instruments. In other words, these are available with a pre-determined expiration date. The contract has an intrinsic value until this date, after which, it loses its value. Expiration is commonly used for options trading
. Swaps, futures, and forward contracts often use the term settlement date. However, both these have the same meaning. The expiration date is the day on which the contract ends and you know your profit or loss situation.
5. Market maker
A market maker provides buy and sell quotes for the financial asset. The primary role of the market maker is to provide liquidity to the derivatives market
. If you want to sell a derivative contract, you may not always find a buyer. Similarly, finding a seller if you want to buy may also not be possible always. A market maker is helpful in this situation. He will trade with you and immediately find another party to take the other position. Therefore, if you hold a long position, the market maker will find someone who is willing to assume a short position.
6. Bid-ask spread
Market makers always provide two prices. These are known as bid price and ask price. The difference between these two prices is referred to as the spread. The highest amount a buyer is willing to pay to acquire your contract is called the bid price. The ask price is the lowest amount a market maker expects you to pay to complete the transaction. This may provide the market maker with an arbitrage opportunity because of the spread between the bid and ask prices.
The derivative market may seem complicated because of the technical terminologies. There are several underlying assets that may make investing complex. However, understanding the basics will enable you to trade in this market and earn high profits.