New to derivatives (futures & options)? 10 terms to learn before starting out!

The first and foremost thing to understand, before you step into the complex and fast-paced world of derivatives (futures and options), is risk management. Dealing in futures and options segments is not just about managing your buy or sell orders, but rather collating valuable market data to devise your actionable strategy in a risk-hedged manner. Whether you are considering the Sensex option chain, the commodity option chain, or stock-specific data, being efficient in the language of derivatives is essential before you execute your first trade in this segment.

Capital market regulator SEBI has, over time, released data collated in several studies and surveys highlighting the risk associated with fast-paced financial products such as derivatives, in order to protect the small investor.

Now, first things first, what are derivatives really? Well, these are financial contracts that derive their value from the price moves in an underlying asset, which can be a stock, an index, a commodity or even a currency pair. In a nutshell, derivatives use these underlying values for speculation, risk management or arbitrage opportunities.

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For someone standing at the entry gate of this vast segment, the overwhelmingly large number of new terms and endless graphs can seem overwhelming at once. Whether you’re studying the contours of an option chain, exploring the Sensex option chain, or learning about commodity option chains, the right understanding of the basic concepts can make a big difference.

Here’s a guide to 10 key terms that will help you make sense of this fast-moving segment.

1. What is an option chain?

An option chain is basically information laid out in a specific tabular format that lists the available options contracts of an underlying asset at a time against details such as strike price and open interest levels, volumes, and premiums. Traders use this information meticulously to assess market sentiment.

2. Greeks

This is an important data set that captures the disk associated with a derivative. There are five types of greeks, sometimes also known as 'option greeks': Delta, gamma, theta, vega, and rho. The Greeks take into account important information such as time, volatility and underlying movement.

Greeks offer a crucial viewpoint that helps in both gauging and managing the risk involved in an option.

3. Call Option

A call option gives the buyer the right -- but not the obligation -- to buy an asset at a predetermined strike price on or before the expiry date. In an option chain, increasing open interest in call options often suggests a bullish market outlook. Traders make use of these options when they expect the underlying's price to increase.

4. Put Option

A put option gives the buyer the right to sell the underlying at a certain strike price before expiry. Traders opt for these options when they expect the underlying's price to decrease, using them to hedge against possible market price falls.

5. Strike

A strike -- as it is popularly known -- or 'strike price' is the agreed-upon price at which an asset can be traded if the option is exercised.

For instance, in the Sensex option chain, strikes are arranged in ascending order.

6. Premium

It is the price that an options buyer pays to purchase an option. This price is paid to the option seller -- also known as options writer. In a live option chain, the premium keeping fluctuates throughout the trading hours.

7. In the money (ITM), out of the money (OTM) and at the money (ATM) options

Precisely, these terms describe whether exercising an option would currently be profitable. A call is said to be 'in the money' when the market price is above the strike price, and 'out of money' when it is below the mark. Additionally, 'at the money' options are ones wherein the current market price is not far from the strike price.

8. Open Interest

It is the total number of active outstanding derivative contracts -- such as futures and options (F&O) -- yet to be settled. Simply put, OI gives the measure of market activity and liquidity in a contract at any given point in time.

9. Implied Volatility (IV)

A key measure indicating expected volatility, IV measures how much movement (regardless of direction) that the market expects the price of an underlying asset will move in the future. This data point is used by traders to project future moves and supply and demand.

10. Expiry Date

Every option contract comes with an expiry date. It is the day by which all open positions must be settled. In case traders fail to initiate a settlement themselves, the bourse does this automatically at the market price. Traders must close, roll over or let their positions expire before that date.

The final word:

Understanding futures and options begins with mastering their vocabulary. Only once a market participant is well versed with these terms can they start to interpret real-time data on their own.

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