Derivatives

A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Common underlying
instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks.

Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.

Derivatives are secondary securities whose value is solely based (derived) on the value of the
primary security that they are linked to–called the underlying. Typically, derivatives are considered
advanced investing.

Short Call
A short call is a strategy involving a call option, which obligates the call seller to sell a security to
the call buyer at the strike price if the call is exercised. A short call is a bearish trading strategy,
reflecting a bet that the security underlying the option will fall in price.

If the price of the underlying security falls, a short call strategy profits. If the price rises, there’s
unlimited exposure during the length of time the option is viable, which is known as a naked
short call. To limit losses, some traders will exercise a short call while owning the underlying
security, which is known as a covered call.

Rho
Rho is the rate at which the price of a derivative changes relative to a change in the risk-free rate of
interest. Rho measures the sensitivity of an option or options portfolio to a change in interest rate.
Rho may also refer to the aggregated risk exposure to interest rate changes that exist for a book of
several options positions.

For example, if an option or options portfolio has a rho of 1.0, then for every 1 percentage-point
increase in interest rates, the value of the option (or portfolio) increases 1 percent. Options that are
most sensitive to changes in interest rates are those that are at-the-money and with the longest time
to expiration.

Speculator and Arbritageurs

Arbitage

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small
differences in price. Arbitrage is possible because of inefficiencies in the market.

Arbitrageurs—those who use arbitrage as a strategy—often buy stock on one market such as
a financial market in the U.S. like the New York Stock Exchange (NYSE) while simultaneously selling
the same stock on a different market like the London Stock Exchange (LSE). The stock would be
traded in U.S. dollars in the United States, while in London, the stock would be traded in pounds.
This usually happens very quickly, and once acted upon, the opportunity is gone.

Speculation

Speculation is a short-term buying and selling strategy. It involves a significant amount of risk of loss
or gains. The reward is the main driver, so if there wasn't any expectation of gain, there would be no
use for speculation. This strategy is generally driven by assumptions or hunches on the part of the
trader, who attempts to profit from rising and falling prices.

Speculation is a very important part of the market. Without it, there would be no liquidity. Participants
would be limited to just those producers and companies. This would widen the bid-ask spread,
making it harder to find buyers and sellers in the market.

Theta
The term theta refers to the rate of decline in the value of an option due to the passage of time. It
can also be referred to as the time decay of an option. This means an option loses value as time
moves closer to its maturity, as long as everything is held constant. Theta is generally expressed as
a negative number and can be thought of as the amount by which an option's value declines every
day.

 Theta, usually expressed as a negative number, indicates how much the option's value will
decline every day up to maturity.
 Because theta represents the risk of time and the loss of value of an option, it is always
expressed as a negative figure. The value of the option diminishes as time passes until the
expiration date. Since theta is always negative for long options, there will always be a zero
time value when the option expires. This is why theta is a good thing for sellers but not for
buyers—value decreases from the buyer's side as time goes by, but increases for the seller.
That's why selling an option is also known as a positive theta trade—as theta accelerates,
the seller's earnings on their options increase.

What is bond?

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower

(typically corporate or governmental). A bond could be thought of as an I.O.U. between
the lender and borrower that includes the details of the loan and its payments. Bonds are used by
companies, municipalities, states, and sovereign governments to finance projects and operations.
Owners of bonds are debtholders, or creditors, of the issuer.

Bond details include the end date when the principal of the loan is due to be paid to the bond owner
and usually include the terms for variable or fixed interest payments made by the borrower.

In simple terms, a bond is loan from an investor to a borrower such as a company or

government. The borrower uses the money to fund its operations, and the investor receives interest
on the investment. The market value of a bond can change over time. ... If stock markets plummet,
bonds can help cushion the blow.

American Vs European options

The key difference between American and European options relates to when the options can be
exercised:

 A European option may be exercised only at the expiration date of the option, i.e. at a

single pre-defined point in time.
 An American option on the other hand may be exercised at any time before the expiration
date.

 American and European options have similar characteristics but the differences are

important. For instance, owners of American-style options may exercise at any time before
the option expires.1 On the other hand, European-style options may exercise only
at expiration.

 Most stocks and exchange-traded funds have American-style options while equity indices,
including the S&P 500, have European-style options.

American Options

Options are contracts that derive their value from an underlying asset or investment. Options give the
owner the right to buy or sell the underlying asset (such as a stock), at a fixed price (called the strike
price), on or before a specific expiration date in the future. A call option gives the owner the right to
buy a stock, for example, while a put option gives the owner the right to sell the stock. The up-front
fee (called the premium) is what the investor pays to purchase the option.
European options

European index options stop trading one day earlier, at the close of business on the Thursday
preceding the third Friday of the expiration month.

Initial Margin vs. Maintaince Margin

 The initial margin is the amount a trader must deposit with their broker to initiate a trading
position.
 The maintenance margin is the amount of money a trader must have on deposit in their
account to continue holding their position, which is typically 50% to 75% of the initial margin.
 The initial margin requirement is the amount a trader must deposit to initiate a trading
position. For futures contracts, the clearinghouse sets the initial margin amount. Brokers,
however, may require traders to deposit additional funds beyond the initial margin
requirement in order to establish and maintain the account.

 Once a futures trading position is established, a trader must maintain a certain balance
established by the broker—typically 50% to 75% of the initial margin—to continue holding
the position.

Maintenance Margin

In futures trading, if the account falls below the specified maintenance margin level, then the broker
sends the trader a margin call. This informs the trader that they must immediately deposit sufficient
funds to bring the account back up to the initial margin level. If the trader fails to do so promptly, the
broker will close out the trader's market position.

Call vs put

Put options explained

Put options are investments that traders will buy if they expect the price of the underlying asset to fall
within a specific timeframe.

In this case, the strike price is the price at which traders can sell the underlying asset. For example,
buyers of a stock put option with a strike price of £100 can use their option to sell the stock for £100
before the expiration date.

Buyers need to pay a premium for the right to sell the stock at the strike price for a given period. This
premium goes to the put seller, which is why writing put options can be an effective means of
generating income.

Calculating the cost of the put option is relatively simple. Put options represent 100 shares of the
underlying stock. So, to determine the price of the option, simply multiply the underlying share price
by a factor of 100.

Call options explained

Call options are investments that traders will buy if they expect the price of the underlying asset to rise
within a certain timeframe.
For call options, the strike price is the predetermined price at which the buyer can purchase the
underlying asset. For example, traders who have purchased a stock call option with a strike price of
£100 can use the option to buy the stock at £100 before the expiration date.

It’s important to remember that unless the current price of the underlying asset is below the strike
price, then it isn’t worth using the option, as you could simply make more money by buying the asset
on the market.

Just as with put options, buyers of call options need to pay a premium for the right to purchase the
stock at the strike price. This premium goes to the call seller.

Long call

 A long call option gives you the right to buy stock at a preset price in the future. A long put
option lets you sell it.
 Long call means buying a call option. This means the trader has the right to buy a security
at a future date at a predefined price. The term long itself means buying security or buying an
option.
 The long call option strategy is the most basic option trading strategy whereby the options
trader buy call options with the belief that the price of the underlying security will rise
significantly beyond the strike price before the option expiration date.

Short put

A short put refers to when a trader opens an options trade by selling or writing a put option. ... The
writer (short) of the put option receives the premium (option cost), and the profit on the trade is limited
to that premium.

Selling the put obligates you to buy stock at strike price A if the option is assigned.

When selling puts with no intention of buying the stock, you want the puts you sell to expire worthless.
This strategy has a low profit potential if the stock remains above strike A at expiration, but substantial
potential risk if the stock goes down. The reason some traders run this strategy is that there is a high
probability for success when selling very out-of-the-money puts. If the market moves against you, then
you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.

Gamma

Gamma is the rate of change in an option's delta per 1-point move in the underlying asset's price.
Gamma is an important measure of the convexity of a derivative's value, in relation to the underlying.
A delta hedge strategy seeks to reduce gamma in order to maintain a hedge over a wider price
range. A consequence of reducing gamma, however, is that alpha will also be reduced.

Gamma is the first derivative of delta and is used when trying to gauge the price movement of an
option, relative to the amount it is in or out of the money. In that same regard, gamma is the second
derivative of an option's price with respect to the underlying's price. When the option being measured
is deep in or out-of-the-money, gamma is small. When the option is near or at the money, gamma is
at its largest. All options that are a long position have a positive gamma, while all short options have
a negative gamma.

Open Interest
 Open interest is the total number of outstanding derivative contracts, such as options or futures
that have not been settled. ... Increasing open interest represents new or additional money coming
into the market while decreasing open interest indicates money flowing out of the market.

 Open interest equals the total number of bought or sold contracts, not the total of both added
together.
 Open interest is commonly associated with the futures and options markets.

Options

Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an
underlying asset at an agreed-upon price and date. Call options and put options form the basis for a
wide range of option strategies designed for hedging, income, or speculation.

1. Call options. Calls give the buyer the right, but not the obligation, to buy the underlying asset. ...
2. Put options. Puts give the buyer the right, but not the obligation, to sell the underlying asset at the
strike price specified in the contract.

long put

A long put refers to buying a put option, typically in anticipation of a decline in the underlying asset. ...
A trader could buy a put for speculative reasons, betting that the underlying asset will fall which
increases the value of the long put option.

The term "long" here has nothing to do with the length of time before expiration but rather refers to
the trader's action of having bought the option with the hope of selling it at a higher price at a later
point in time.

A long put has a strike price, which is the price at which the put buyer has the right to sell the
underlying asset. Assume the underlying asset is a stock and the option’s strike price is $50. That
means the put option entitles that trader to sell the stock at $50, even if the stock drops to $20, for
example. On the other hand, if the stock rises and remains above $50, the option is worthless
because it is not useful to sell at $50 when the stock is trading at $60 and can be sold there (without
the use of an option).

If a trader wishes to utilize their right to sell the underlying at the strike price, they will exercise the
option. Exercising is not required. Instead, the trader can simply exit the option at any time prior
to expiration by selling it.

Delta.

Delta expresses the amount of price change a derivative will see based on the price of the
underlying security (e.g., stock). Delta can be positive or negative, being between 0 and 1 for a call
option and negative 1 to 0 for a put option.

The ratio of the change in price of an option to the change in price of the underlying asset. Also
called the hedge ratio. Applies to derivative products. For a call option on a stock, a delta of 0.50
means that for every $1.00 that the stock goes up, the option price rises by $0.50.

Vega
Vega is the Greek that measures an option's sensitivity to implied volatility. It is the change in the
option's price for a one-point change in implied volatility. Traders usually refer to the volatility without
the decimal point.

Vega is the measurement of an option's price sensitivity to changes in the volatility of the

underlying asset. Vega represents the amount that an option contract's price changes in reaction to
a 1% change in the implied volatility of the underlying asset.
A high vega option -- if you want one -- generally costs a little more than an out-of-the-money
option, and has a higher-than-average theta (or time decay).

Lower-vega options that are out of the money are dirt cheap, but not all that responsive to price
changes in the underlying stock or index

Futures

Futures are derivative financial contracts that obligate the parties to transact an asset at a
predetermined future date and price. The buyer must purchase or the seller must sell the
underlying asset at the set price, regardless of the current market price at the expiration date.

Futures—also called futures contracts—allow traders to lock in the price of the underlying asset
or commodity. These contracts have expiration dates and set prices that are known upfront. Futures
are identified by their expiration month

 Commodity futures such as crude oil, natural gas, corn, and wheat
 Stock index futures such as the S&P 500 Index
 Currency futures including those for the euro and the British pound
 Precious metal futures for gold and silver
 U.S. Treasury futures for bonds and other products

Forward Vs Future

Comparison Chart
BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON

Meaning Forward Contract is an agreement A contract in which the parties agree to

between parties to buy and sell the exchange the asset for cash at a fixed
underlying asset at a specified date price and at a future specified date, is
and agreed rate in future. known as future contract.

What is it? It is a tailor made contract. It is a standardized contract.

Traded on Over the counter, i.e. there is no Organized stock exchange.

secondary market.

Settlement On maturity date. On a daily basis.

Risk High Low

 BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON

Default As they are private agreement, the No such probability.

chances of default are relatively high.

Size of contract Depends on the contract terms. Fixed

Collateral Not required Initial margin required.

Maturity As per the terms of contract. Predetermined date

Regulation Self regulated By stock exchange

Liquidity Low High

long strangle

A long strangle consists of one long call with a higher strike price and one long put with a lower
strike. ... A long strangle is established for a net debit (or net cost) and profits if the underlying stock
rises above the upper break-even point or falls below the lower break-even point.

A strangle is a good strategy if you think the underlying security will experience a large price
movement in the near future but are unsure of the direction. However, it is profitable mainly if the
asset does swing sharply in price.

Equity

Equity represents the value that would be returned to a company's shareholders if all of the assets
were liquidated and all of the company's debts were paid off. ... The calculation of equity is a
company's total assets minus its total liabilities, and is used in several key financial ratios such as
ROE.

Equity, typically referred to as shareholders' equity (or owners' equity for privately held companies),
represents the amount of money that would be returned to a company's shareholders if all of the
assets were liquidated and all of the company's debt was paid off in the case of liquidation. In the
case of acquisition, it is the value of company sales minus any liabilities owed by the company not
transferred with the sale.

Moneyness in option

 Moneyness is a term to describe whether a contract is either “in the money”, “out of the
money”, or “at the money”. A call option is said to be “in the money” when the future contract
price is above the strike price. A call option is “out of the money” when the future contract
price is below the strike price.

 To calculate moneyness
  The intrinsic value involves a straightforward calculation - simply subtract the market price
from the strike price - representing the profit the holder of the option would book if they
exercised the option, took delivery of the underlying asset, and sold it in the current
marketplace.

Short Strangle

A short strangle consists of one short call with a higher strike price and one short put with a lower
strike. Both options have the same underlying stock and the same expiration date, but they have
different strike prices. A short strangle is established for a net credit (or net receipt) and profits if the
underlying stock trades in a narrow range between the break-even points. Profit potential is limited to
the total premiums received less commissions. Potential loss is unlimited if the stock price rises and
substantial if the stock price falls.

Goal
To profit from little or no price movement in the underlying stock.

Long Put

A put option is a contract that gives an investor the right, but not the obligation, to sell shares of an
underlying security at a set price at a certain time. Unlike a call option, a put option is typically a
bearish bet on the market, meaning that it profits when the price of an underlying security goes down. 

a put option is a contract that gives investors the right to sell shares at a later time at a specified price
(the strike price), 

A long put refers to buying a put option, typically in anticipation of a decline in the underlying
asset. ... A trader could buy a put for speculative reasons, betting that the underlying asset will fall
which increases the value of the long put option.

Type of risk

Market Risk
This is also called systematic risk and is based on the day-to-day price fluctuation in the market.
Business Risk
The second type of stock risk comes from the business. This risk can be escalated if the business is
not doing well. Reasons like the failure of management, poor quarter-by-quarter results, or your
misjudgment in picking a company come under business risk
Liquidity Risk
Before investing in a stock, you should definitely check how solvent the company is? Companies with
high debts may find it hard to pay their bills. Many times, they might even cut the dividends or in the
worst case, may go bankrupt. Liquidity risks are involved in all businesses.
Taxability Risk
The government changes taxes all the time and hence taxes may increase or decrease in the
particular industry where you invested. The change in taxation can affect the stock price.
 Interest Rate Risk.
Interest rate risk is the potential for investment losses that result from a change in interest rates. If
interest rates rise, for instance, the value of a bond or other fixed-income investment will decline.
The change in a bond's price given a change in interest rates is known as its duration.

 Regulatory Risks.

Regulatory risk is the risk that a change in regulations or legislation will affect a security,
company. ... Companies must abide by regulations set by governing bodies that oversee their
industry. Therefore, any change in regulations can cause a rippling effect across an industry.

 Inflationary Risk:
Inflation Risk commonly refers to how the prices of goods and services increase more than
expected or inversely, such situation results in the same amount of money resulting in less
purchasing power. Inflation Risk is also known as Purchasing Power Risk. An example of Inflation
Risk is Bond Markets.

Systematic Risk vs. Unsystematic Risk

SYSTEMATIC RISK UNSYSTEMATIC RISK

Meaning Systematic risk refers to the hazard which is Unsystematic risk refers to the risk
associated with the market or market associated with a particular security,
segment as a whole. company or industry.

Nature Uncontrollable Controllable

Factors External factors Internal factors

Affects Large number of securities in the market. Only particular company.

Types Interest risk, market risk and purchasing Business risk and financial risk
power risk.

Protection Asset allocation Portfolio diversification

Credit Default Swap

A credit default swap (CDS) is a financial derivative that allows an investor to "swap" or offset his or
her credit risk with that of another investor. For example, if a lender is worried that a borrower is
going to default on a loan, the lender could use a CDS to offset or swap that risk.

To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse
the lender in the case the borrower defaults. Most CDS contracts are maintained via an
ongoing premium payment similar to the regular premiums due on an insurance policy.

Interest rate swap

 An interest rate swap occurs when two parties exchange (i.e., swap) future interest payments
based on a specified principal amount. Among the primary reasons why financial institutions
use interest rate swaps are to hedge against losses, manage credit risk, or speculate. Interest
rate swaps are traded on over-the-counter (OTC) markets, designed to suit the needs of each
party, with the most common swap being a fixed exchange rate for a floating rate, also known
as a "vanilla swap".

 With an interest rate swap, the borrower still pays the variable rate interest payment on the
loan each month. ... Then, the borrower makes an additional payment to the lender based on
the swap rate. The swap rate is determined when the swap is set up with the lender and is
unchanging from month to month.

Warrants
  Warrants are a derivative that give the right, but not the obligation, to buy or sell a
security—most commonly an equity—at a certain price before expiration. The price at which
the underlying security can be bought or sold is referred to as the exercise price or strike
price.
 An American warrant can be exercised at any time on or before the expiration date, while
European warrants can only be exercised on the expiration date. Warrants that give the right
to buy a security are known as call warrants; those that give the right to sell a security are
known as put warrants. 

Intrinsic value
 Intrinsic value is a measure of what an asset is worth. This measure is arrived at by
means of an objective calculation or complex financial model, rather than using the
currently trading market price of that asset.
 In financial analysis, intrinsic value is the calculation of an asset's worth based on a
financial model.
 In options trading, intrinsic value is the difference between the current price of an
asset and the strike price of the option.

 Intrinsic value is an umbrella term with useful meanings in several areas. Most often
the term implies the work of a financial analyst who attempts to estimate an asset's
intrinsic value through the use of fundamental and technical analysis.

Galton board
 The Galton board, also known as the Galton box or quincunx or bean
machine, is a device invented by Sir Francis Galton to demonstrate the
central limit theorem, in particular that with sufficient sample size the
binomial distribution approximates a normal distribution.

 The Galton Board is a 7.5” by 4.5” desktop probability machine. This delightful little device
brings to life the statistical concept of normal distribution. ... As the beads accumulate in the
bins, they approximate the bell curve, as shown by the yellow line on the front of the Galton
board.

Implied Volatality Vs. Historical Volatality

 Volatility is a metric that measures the magnitude of the change in prices in a security.
Generally speaking, the higher the volatility—and, therefore, the risk—the greater the
reward. If volatility is low, the premium is low as well. Before making a trade, it's generally a
good idea to know how a security's price will change and how quickly it will do so.

 Implied volatility, as its name suggests, uses supply and demand, and represents the
expected fluctuations of an underlying stock or index over a specific time frame.
 With historical volatility, traders use past trading ranges of underlying securities and indexes
to calculate price changes.
 Implied, or projected, volatility is a forward-looking metric used by options traders to
calculate probability.
 Calculations for historical volatility are generally based on the change from one closing price
to the next. 
 Implied volatility, also known as projected volatility, is one of the most important metrics for
options traders. As the name suggests, it allows them to make a determination of just how
volatile the market will be going forward. This concept also gives traders a way to calculate
probability. One important point to note is that it shouldn't be considered science, so it
doesn't provide a forecast of how the market will move in the future.
 Historical volatility gauges the fluctuations of underlying securities by measuring price
changes over predetermined periods of time. It is the less prevalent metric compared to
implied volatility because it isn't forward-looking.

 When there is a rise in historical volatility, a security's price will also move more than normal.
At this time, there is an expectation that something will or has changed. If the historical
volatility is dropping, on the other hand, it means any uncertainty has been eliminated, so
things return to the way they were.