This post would contain the definitions of several terms used in Finance and Stock Markets, which I learnt as an intro for my internship. These are mainly from the book, Option Volatility and Princing: Advance Trading Strategies and Techniques by Sheldon Natenberg. Let’s get started:
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Spot or Cash Transaction : Two individuals have said to have entered into a spot if, one agrees two pay another cash, in return for something, ownership of land, raw materials, goods anything. Same holds for stock. Since, stock prices are always fluctuating, and as a result the stock prices may change during the time when the prices are agreed and when the payment is made followed by stock delivery. This period is known as the settlement period, and it is small enough to be considered this process as a cash transaction.
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Forward Contract : In a forward contract, the parties agree on the terms now, but the actual payment and the exchange of goods doesn’t take place until some later date, which is referred as the maturity or expiration date. Also, the party which would be receiving the cash would face loss of interest earnings, which won’t be there if the transaction gets completed now, and thereby a reasonable forward price might get negotiated between the parties.
For the buyer, the advantages of a forward contract is to prevent the purchase in future at higher prices, and similarly, for the seller, the incentive is to prevent the selling of goods, at potentially lower prices in the future.
- Futures Contract : An alternative reference for the Forward Contract, but here, there is an organized exchange as an entity. The contract specifications of a forward contract are standardized in order to facilitate trading. The exchange specifies the quantity and quality of goods to be delivered, the data and place of delivery, and method of payment. The exchange also guarantees integrity of the contract, i.e if the contract is defaulted either by the buyer or seller, then the exchange assumes the responsibility of fulfiling the terms of a forward contract.
The earliest futures exchanges enabled producers and users of physical commodities such as grains, precious metals, and energy products to protect themselves from price fluctuations. However, more recently, the exchanges have introduced futures contracts on financial instruments such as stocks, and stock indexes, interest-rate contracts, and foreign currencies. Physical commodities are traded, but not as much as these instruments.
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Commodity : A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services. The quality of commodity may differ slightly, but it is more or less uniform among all the producers. E.g. grains, gold, beef, oil, natural gas. Investors and Traders can buy and sell commodities directly in the spot (cash) market or via derivatives such as options and futures. Owning commodities in a broader portfolio is encouraged as a diversifier and a hedge against inflation. More info. available here
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Option Contract : An Option contract gives a party the right to make a decision, at a later date. For this flexibility (aka call option), the party would have to make a separate payment as a compensation, irrespective of its decision to the seller. Similarly, the sellers can also have some flexibility (aka put option), which would enable them to sell at a later data, however some payment has to be made to the buyers as a compensation. A more concrete example of put option is insurance. The inherent logic is same for both the instruments. Options can also have an expiration date, which is the time period in which the buy/sell decision needs to be made. An exercise price could be specified as well, which would denote the different payments for different situations/events. Traders generate profits, by using probabilities to calculate the fair value of a contract, and ultimately selling the contract at a price higher than it’s fair value.
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Derivatives: It is a broad term which refers to contracts, whose values are derived from the value of some underlying asset. For example, higher the value of the asset for which the transaction would be made, higher would be the compensation. For this reason, forwards, futures, and options are referred to as derivatives.
Profits can be generated either by buying at a low price, and selling at a higher price, and also (in stock markets), selling initially at a higher price (we don’t own in first place!) and then buying at a later instance.
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Opening Trade : Opening Trade is the first trade which takes place, irrespective of whether it’s a buy or sell transaction. This results in an open position. A subsequent trade, which reverses the initial trade is called a closing trade. Open Interest refers to the number of contracts which have been opened, and aren’t closed yet. It is widely used as a measure of trading activity. If a trader buys the contract, he is said to have long the contract. However, if the seller first sells a contract, then he is said to have short the contract. Long and Short describe positions, and are also used to describe the actions. A long position would result in debit (payment of money), whereas a short position would lead to credit. These terms might be misleading, as a trader who has acquired a long position would want the market to rise, whereas the trader who has acquired a short position would want the market to fall. But, a trader who is long a derivative, would want a market to fall. So, beware!
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Notional or Nominal Value of a Forward Contract: If a contract specifies delivery of 1000 units, at a price of $75 a unit, then the nominal value of that contract would be $7500. However, for contracts on stock indexes, the number of units isn’t clearly specified as it might be a fraction as well, therefore the exchange then introduces a point value which when multiplied by the price, results in the notional value of that contract.
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Unrealized and Realized Profit : Profits, which are on paper, i.e. you own some stocks, the stock price goes up, then you’d have an unrealized profit, it’s only when you sell the stocks, you’d have realized profit.
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Margin Deposit : This is a security amount collected by the exchange from the buyer and seller, in case any of them fails to fulfil the futures contract. It depends on the notional value of the contract as well as price fluctuations which may happen over time. The exchange also debits/credits amounts to the parties in order to maintain the price mentioned in the futures contract. These credits and debits are collectively known as variation.
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Stock -type Settlement : Suppose there is a transaction involving a trader buying stocks, and then selling them. The unrealized profits in this transaction can only be realized after the position is closed. During the open position, no credits/debits take place.
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Futures -type Settlement : When there are futures involved in transactions, their value might get changed due to the fluctuations in price. But since, the price is agreed in advance, the exchange is responsible for transfering funds from the party at profit at the moment to the party at loss. These payments take place either until the maturity period, or unless another transaction involving this futures contract takes place in other words, during open position. Such settlements are referred to as futures-type settlements.