The world of trading is full of jargon, and in an already complicated industry this can leave those wanting to find out more about the market feeling despondent. In this blog, we will take you through some of the main terms used in trading and explain what they mean.
For more information about trading with derivatives, you can watch our explanation here:
Accumulator – A structure which uses a combination of options to leverage your position, giving the ability to secure a market price more favourable than currently trading
Arbitrage – This is a means of profiting from a difference in price by simultaneously buying and selling an asset.
At the money – Also known as ATM, this is a term used to describe an options contract with a strike price that is identical to the underlying market price.
Backwardation – This is when the price of a futures contract is trading lower than the spot price. This is most commonly seen when the market becomes undersupplied
Bearish – No, it’s nothing to do with bears…this means expecting that a market will experience a downward trend, and acting accordingly.
Bear call spread – A trading strategyconstructed by combining a short call option and a long call option with a higher strike. You would use this to use the advantage of downward market movement by limiting profit and loss.
Bid-Ask Spread –The difference in price between the best buy (bid) and best sell (offer) price for an asset.
Broker – An independent person or company who organises and executes a financial transaction on behalf of another party.
Bullish – Nothing to do with bulls…this means expecting a market to have an upward trend, and acting accordingly. The exact opposite of being bearish.
Bull call spread – A trading strategy constructed by combining a long call and a short call with a higher strike. It takes advantage of upward market movements while limiting profit and loss. It can be traded at 0 cost initially, making it attractive.
Blue chip – This is a term often used to describe stocks and shares that are reputable, stable and long-established. The companies considered to hold this status can change over time, though it tends to be companies at the top of the sector.
Calendar Spread – A calendar spread is the difference in the price of the same asset from one futures contract to another. For example, if the price for white sugar was $5/MT higher against the March futures contract than the May futures contract, this would be the value of the March May calendar spread.
Call Option – A contract giving the buyer the right, but not the obligation, to BUY a specific amount of an underlying contract (e.g No. 11 Futures) at a specific price (strike price) at a specific time (Option expiration date).
Cash Price – Not to be confused with Prompt or Spot price, the cash price refers to the current price being traded for a commodity for immediate delivery off the exchange. The cash price and spot futures price should converge the closer you get to the spot futures contract expiry.
Contango – When the price of a futures contract is higher than the spot price. This is typically seen when the market is well supplied. Here we would expect the higher price of the futures contract to reflect the commodity cost of carry.
Cost of Carry – This is the cost to hold a physical commodity over time. This has a number of components including interest charges, forex costs and physical storage. It can vary greatly between firms.
Day order – This is an instruction to buy or sell an asset at a specific limit. The order will remain valid for the course of the day, and will either fill at the target or expire unfilled if the market does not reach the target. A day order will not continue working after the market close.
Exchange – the exchange is an open, organised marketplace for financial instruments including stocks, shares, commodities and derivatives. Sometimes, this term is used interchangeably with ‘the market.’
Expiry (of a futures contract) – This is the date, explicitly communicated by the respective exchange, when a trading position automatically closes down, or expires. If a position is not closed out before expiry then a physical delivery, physical receipt or a cash settlement will be triggered, depending on exchange rules.
Forex – Often knows as foreign exchange, it is the rate at which you can convert one currency into another. The rate may vary depending on the value date at which the forex transaction is booked for.
Forward contract – This is a contract with a defined date of expiry. It can be customised to include stipulations of a specific amount of the asset being traded.
Futures contract – A futures contract is an agreement to buy or sell a particular asset at a predetermined price at a specified time in the future.
GTC order – This stands for `good `till cancelled` and is an instruction to buy or sell an asset at a specific limit. The order will remain valid and working in the market until it is either filled or cancelled.
Hedge – Not the green garden kind, this is a term to describe an investment or trade that is made to reduce your existing exposure to risk.
Historical simulation method – This is an approach to measuring VAR that uses analysis to predict price.
Iceberg order – When executing large futures orders in times of lower liquidity, it can be preferable to work the order slowly to ensure the best result is obtained by the client. An Iceberg order divides this large order into smaller segments, automatically working each segment in the market when the previous one has been filled.
In the money – Also known as ITM, this phrase refers to an option whose strike price is currently profitable. For example, a long call option where the market price is higher than the option strike, or vice versa for a long put option.
Leverage – This is where a market participant amplifies their exposure to the market. An example of this would be an option position, where more risk can be taken on, compared to an outright futures position. This can amplify profits, however also increases the risk of large losses.
Limit orders – These are most common type of order, and are instructions to buy or sell at a specific price or better. The priority is therefore price and not immediate execution.Limit orders carry the risk of not filling if the market trades further away from the limit. Limit orders are either `day` or `GTC` orders.
Long – This refers to a position that makes a profit if the assets market price increases – for example buying the underlying asset. Often referred to as ‘going long’ or ‘taking a long position’.
Long Butterfly Spread – This is a more complex trading strategy combining 4 options. 1 long ITM call, 2 short ATM calls and 1 long OTM call.This is equivalent to a short straddle, but losses are limited. The profit however, is unable to be as large as with a simple short straddle. We would be selling volatility in this scenario.
Long and short straddle – When going long on a call and long on a put with identical strikes, the trader will make profit if the market moves either way. The loss is therefore whatever was paid as a premium to gain the position.Here, the trader is expressing a view on volatility – executing a long straddle if they believe the market will trade higher or lower, and a short straddle if they believe it will remain rangebound.
Lot – A group of assets that is traded instead of a single asset. For example, lots of sugar come in standardised sizes, according to the market. 1 lot of white sugar amounts to 50 metric tonnes.
Margin call – These can be broken down into initial and variation margin calls:
Margin calls are charged by the exchange in order to limit exposure to the participants executing futures, mitigating risk of counterparty default. An initial margin is charged as a percentage of the notional commodity value, and protects the exchange from one day of market movement risk.
The variation margin is charged at the day to day change in value of the position, and must be settled the next working day by the participant. If you have bought futures and the price on the market rises, you will receive a cash call. If the market falls, you will pay a cash call. This ensures counterparty performance on the exchange.
Market order – This is the most basic order. It instructs the broker to buy or sell a security at best price currently available. The priority here is on execution, not price. This type of order is typically used for smaller orders in more liquid markets, where the participant wishes to execute their position without delay.
Monte Carlo – This is a method of measuring risk by developing a model and using it to predict future investment prices. This data is then used to predict the worst-case loss on the investment.
OCO (one cancels the other) or stop-limit order – This allows many orders to be placed at once. Whichever order is filled first will cancel the others automatically. This order can be used to take advantage of volatility within a market or to stop an existing position.
OTC trade – An Over the Counter trade is not executed through an exchange, however as a bilateral agreement between two counterparties. This brings the advantage of flexibility over executing orders on the market, as contractual terms can be negotiated.
Option – Options are a type of derivative, and therefore are also specifically linked to an underlying asset. However, the Buyer of an option has the choice of whether or not to receive futures relating to an asset at a predetermined price, volume and expiry date in the future.
Put Option – A contract giving the right, but not the obligation, to SELL a specific amount of an underlying contract (e.g No. 11 Futures) at a specific price (strike price) at a specific time (Option expiration date).
Short – This refers to a position that makes a profit if the asset’s market price falls in price. An example of this is selling an asset that you do not own, with the requirement to buy it back at a subsequent point in time. Often referred to as ‘going short’ or ‘taking a short position’.
Spot Price – The price quoted on the exchange for the earliest possible delivery.
Strike Price – The agreed price for an underlying asset, this then forms the basis of an options contract.
Stop Loss Order – A limit order which triggers at a predetermined price. This can be useful for closing out a position in a volatile market when the market suddenly trades against you. Typically a stop loss order will be part of an OCO order.
Trailing stop – A type of stop loss that automatically follows positive movements in the market for the asset you are trading. The level that the order will `stop` at constantly revises, taking into account the movement in the market. As an example the trailing stop can be set at $5/MT lower than the high of the day, if the market is pushing new daily highs.
Value at Risk (VAR) – Risk measures and quantifies the level of financial risk within a firm or investment portfolio over a specific time frame. It is most commonly used by investment and commercial banks to determine the extent and occurrence ratio of potential losses in their international portfolios.
Vanilla derivatives – These are relatively simple and common derivatives contracts. A straight forward futures contract would be considered a vanilla derivative, compared to an accumulator which is a complex derivative formed of multiple instruments.
White Premium – This is a term you will hear a lot in the sugar industry. It means the difference in price between the raw sugar and white sugar futures markets in Dollars per metric tonne. A higher white premium gives an opportunity to buy raw sugar, refine it, and sell the refined sugar at a profit.
For more information about how we use derivatives trading you can read a blog about it here. We hope that this series has cast some light on the often mysterious world of trading. We will continue to share insights into our trading services and current market.
Author: Carys Wright