Futures Terminology
Refers to the unit for calculating a futures contract.
For buyers, an option represents a right, not an obligation. To acquire this right, they must pay a fee. Conversely, sellers provide the right and bear the obligation of fulfillment, so they charge a premium. This premium is the value of the option, also known as the "Premium." The premium price fluctuates in line with market demand, depending on what buyers are willing to pay and sellers are willing to accept. When both parties reach a mutually acceptable price, the transaction is completed, and the price is set accordingly.
A security deposit required from participants in the futures market to reduce the risk of default. Early agricultural forward contracts presented two risks: price risk and default risk. Even when price movements were favorable, the other party might be unwilling or unable to fulfill the contract due to excessive losses. To avoid default risk in futures trading, both buyers and sellers must deposit an amount specified by the exchange as a guarantee. Additionally, daily mark-to-market settlements are conducted, and if losses exceed a certain threshold, additional margin deposits are required. Participants who cannot bear the risk will be forced to close their positions to prevent failure in fulfilling the contract. This collateral-like amount is known as the margin.
The margin required to be deposited in the account for each new contract. The initial margin ensures that participants have enough funds to cover potential price fluctuations on the first day of trading. Subsequently, any changes are handled through the maintenance margin system. Theoretically, the initial margin is calculated based on historical data within a defined confidence interval (e.g., 99%) to cover the maximum potential price movement. The initial margin must be adjusted with changes in contract value to adequately cover the potential risks of the contract.
Usually 75% of the initial margin, and when the margin balance falls below this threshold, participants must deposit additional funds. To prevent excessive losses that may affect contract fulfillment, when a participant's margin balance reaches only 75% of the initial margin, they must restore it to the initial margin level to demonstrate the ability to manage price fluctuations. Otherwise, they must exit the market. This is similar to margin calls in stock credit trading, except it has stricter conditions. Participants must restore funds within 24 hours or be forced to close out, unlike stock credit trading, which provides a three-day grace period. This margin call system effectively establishes a stop-loss point; when trading losses occur, the margin call serves as a prompt to exit rather than replenish the margin.
The clearing house calculates daily profits and losses based on the settlement price. Profits are credited, and losses are deducted immediately. The margin system alone does not eliminate default risk. Daily mark-to-market calculations ensure that the financial standing of each participant is continuously verified against potential price movements. After the daily close, the exchange selects a price (usually the closing price) as the basis for the day’s profit or loss calculation. Losses are deducted from the margin account, and gains are credited. If losses exceed a certain threshold (falling below the maintenance margin level), additional funds must be deposited on the same day, or the participant will be forced to close their position.
Holding a contract in the opposite direction to the original position to balance the initial position, removing exposure to price fluctuations. Unlike spot trading, holding a futures contract does not entail ownership of an asset that can be sold. In the futures market, going long on a futures contract without holding the physical asset means that to exit the position, the participant must open an opposite (short) position to clear the contract. This concept is similar to intraday margin trading, where holding a leveraged position requires offsetting the position to settle. This action of offsetting with an opposite contract is called "offsetting."
The number of contracts in the market affected by price movements. Unlike the stock market, which has supply limitations, the futures market can continuously create new positions, resulting in a concept known as open interest. Once a contract is held, daily mark-to-market calculations are made to determine profits or losses. If the contract has not been offset, it is considered part of the open interest, exposed to daily mark-to-market calculations and price risk. Open interest represents potential buying (selling) power in the market. During a bull market, both price increases and rising open interest indicate optimism among investors. When nearing a market peak, if open interest declines, it may suggest investor retreat, which is a warning sign.
The process of fulfilling contractual obligations for payment and goods upon contract expiration. Originally, futures contracts aimed to manage price risk, making physical goods necessary for hedgers. Upon contract expiration, buyers and sellers fulfill their obligations according to contract specifications. For convenience, some products are cash-settled rather than physically delivered. For example, Light Crude Oil (CL) is physically delivered, while Mini Crude Oil (QM) and Brent Crude Oil (B) are cash-settled, as are most financial futures.
Cash settlement calculates gains or losses based on the difference between the futures price and the final settlement price, serving as an effective hedge while avoiding the complexity of physical delivery. Hedgers often close their positions before expiration to achieve cost adjustments.
When investors engage in futures trading, they must pay close attention to the specific requirements set by each futures brokerage firm.
Domestic futures firms may not accept physical delivery for foreign futures contracts, and traders are expected to close their positions within the timeframe specified by the brokerage. If a position is not closed in time, the brokerage firm has the right to offset the expiring position. For cash-settled products, cash settlement is conducted according to exchange rules after the market closes on the last trading day.
For details on expiration and delivery methods, traders should refer to announcements on each exchange’s website.
The difference between the futures price and the spot price. Under normal circumstances, the futures price reflects holding costs and should therefore exceed the spot price, resulting in a positive basis (futures price minus spot price). However, the basis reflects not only holding costs but also market expectations for the future. Institutional investors frequently use futures to supplement their spot market activities, causing the basis to fluctuate. As the market heats up, a negative basis often widens with increased trading volume and open interest. Conversely, as a trend reaches its peak, the basis narrows, serving as a valuable indicator for observing market trends.
A trading strategy that involves buying one contract while selling another to profit from the price difference. Arbitrage takes advantage of price inefficiencies between corresponding products with a certain price relationship. Arbitrage traders aim to simultaneously execute buy-low and sell-high trades without concern for the overall market trend, as losses in one position are offset by gains in the other.
The use of futures contracts in the same or equivalent products to neutralize price volatility for holders or demanders in the spot market.
An order to buy or sell at the current market price, taking priority in the order of execution. Unlike Taiwan’s stock market, which only allows limit orders, futures trading includes both market and limit orders. Market orders are executed at the best available price in the market and are ideal for fast-moving trends. However, if the market direction is unclear, limit orders are preferable to avoid unexpected execution prices.
An order that only executes at a specified or better price. For example, if a buy limit order is set at 8000 points, the trade could be executed at 7995, 7998, or 8000 points but never higher. Limit orders provide price control and are preferable during consolidations. However, in highly liquid markets with strong trends, market orders are better for timely execution.
An order that becomes a market or limit order once the specified price is reached. A stop order, commonly known as a stop-loss order, is a crucial futures trading strategy that helps manage both losses and gains.
An order that becomes a market order when the market price reaches the specified price level. Known as a "watch order," it helps traders with entry and exit points. For example, if an investor believes Taiwan futures will encounter resistance near 10,000 points, they can place a buy MIT order below 10,000 points. When the index reaches this price, the position will automatically be exited at a profit. Similarly, short traders can use MIT orders near 10,000 points to enter the market. This order type is particularly useful when one has a clear view of market support or resistance points. (Not currently available in Taiwan futures market.)
An order that remains active until canceled. In the stock market, if an order is not executed by the close of trading, it becomes void and needs to be placed again the next day. In contrast, a GTC order in the futures market stays active until a specific date. For instance, if we believe the index will dip to 8000 points soon, we can place a GTC order at that level, securing a potentially better price. This order type is ideal when one expects a specific price level to appear soon, sparing the need for constant monitoring. (Not currently available in Taiwan futures market.)
An order placed before the market opens, which is executed at market price during the opening session (specific to each exchange and product). Traders anticipating significant market moves or who want to act quickly after important events may use this type of order to secure an early position.
An order placed before the market close, executed at market price during the closing session. It is useful for traders who wish to exit a position due to anticipated market changes or in light of upcoming events after the market closes.
When the market reaches a designated price, this order becomes a limit order, which may not always execute. A stop limit buy must be above the current market price, and a stop limit sell below it. (Not currently available in Taiwan futures market.)
A standard order that is only valid until the close of trading on the day it’s placed. If it is not executed by then, it expires automatically.
A spread trade involving the same product across different exchanges within the same trading session. For example, Nikkei 225 index futures are traded in Chicago, Singapore, and Osaka, with minor differences in specifications. Any price discrepancy between exchanges creates arbitrage opportunities. (Note: Trading hours vary across exchanges.)
A spread trade within the same product and exchange but across different contract months. Price differences arise due to factors like seasonal patterns or varying volatility between near-term and far-term contracts, offering potential arbitrage opportunities. For example, corn futures often see lower prices in July compared to December due to harvest season.
An arbitrage strategy exploiting price differences between futures and spot markets. Ideally, the price difference (basis) should reflect holding costs; otherwise, arbitrage opportunities arise. For instance, buying a July futures contract and shorting key component stocks when a reverse basis occurs creates arbitrage profit.
The proportion of futures contracts needed to offset the price risk of a cash position. Hedge ratios can be calculated in various ways, based on minimum risk, risk-reward, or simple hedging. By considering risk tolerance and the correlation between futures and cash, one can effectively determine the appropriate hedge position.
A long hedge is a position taken by someone concerned about rising prices, while a short hedge addresses the risk of falling prices. A buyer of the cash commodity will take a long hedge to offset price increases, while a seller will short futures to mitigate the risk of price declines.
Hedging with futures contracts that are different from the cash commodity. For example, using index futures to hedge stock portfolios. Historical correlations between futures and cash assets are used to calculate the hedge ratio.
Rolling a futures position by simultaneously buying and selling to transition from a nearby to a more distant contract month.
The maximum number of contracts an investor may hold, as defined by the exchange. However, hedgers may be exempt from these limits with proper documentation.
A membership-based organization responsible for clearing trades, reducing credit risk, and ensuring the market's integrity by acting as a counterparty in cases of default. Clearing houses may be part of the exchange (like CME) or independent (like CBOT).
Financial futures include contracts on interest rates, exchange rates, and stock indices. Originating after the Bretton Woods agreement ended, financial futures address the need for hedging against exchange rate and interest rate volatility. Today, interest rate, exchange rate, and index futures are critical in financial markets, with some serving as leading indicators.
A document signed when opening a futures trading account to acknowledge the understanding of futures risks. It covers leverage, market risk, margin requirements, and potential adjustments in trading conditions, offering traders essential information to gauge their risk tolerance before trading.
If the balance in a margin account falls below the maintenance margin, the futures broker must issue a margin call notice to the client, who must then deposit enough margin to restore the account to the original margin level.
A futures broker that is not a clearing member consolidates clients' accounts (two or more) into one and then opens a trading account with a clearing member broker to handle transaction settlements.
Investment risk generally consists of systematic and unsystematic risks. Systematic risk is typically caused by broader political, economic, and social factors. It affects every company or stock in the market, so it cannot be eliminated through diversification.
Investment risk generally consists of systematic and unsystematic risks. Non-systematic risk refers to the risk inherent in a specific security or company, which fluctuates randomly, often due to factors like company management, financial health, or unforeseen events (such as fire, theft, etc.). Non-systematic risk can be reduced through portfolio diversification and is considered a diversifiable risk. Systematic risk, on the other hand, is caused by broader political, economic, and social conditions and affects all companies and stocks in the market, making it impossible to avoid through diversification.
The beta coefficient is a risk index used to measure the volatility of a single stock or mutual fund compared to the overall market. It indicates how the return of a security changes relative to a change in the return of a stock market index. A lower beta indicates lower risk for the security, while a higher beta indicates higher risk. If the beta of a fund exceeds 1, the fund's value fluctuates more than the market, making it more volatile and potentially offering higher returns. Conversely, a beta less than 1 indicates less volatility than the market. In general, the market’s beta is 1, and if a fund’s net asset value fluctuates more than the overall market, its beta will be greater than 1. If it fluctuates less, the beta will be less than 1.
A fast market occurs when sudden events cause a large number of buy or sell orders to be placed in a very short period of time, leading to a significant increase in trading volume. This can cause delays in reporting, difficulties in placing orders, and significant differences between the expected and actual transaction prices, or even lead to incorrect transactions. During a fast market, investors bear all the consequences, whether favorable or unfavorable, and clearing members or futures brokers are not liable for these situations.
Contango is the difference between the futures price and the spot price. If the futures price is higher than the spot price, it is considered contango. Generally, futures prices tend to lead the spot market. In a bullish market, futures prices rise ahead of the spot market, increasing the positive spread between futures and spot prices. In a bearish market, futures prices decrease ahead of the spot market, reducing or even reversing the positive spread, turning it into a backwardation.
Backwardation is the difference between the futures price and the spot price. If the futures price is lower than the spot price, it is considered backwardation. Generally, futures prices tend to lead the spot market. In a bullish market, futures prices rise ahead of the spot market, increasing the positive spread between futures and spot prices. In a bearish market, futures prices decrease ahead of the spot market, reducing or even reversing the positive spread, turning it into backwardation.
The first Taiwan stock index product, launched in 1998 on the Singapore International Financial Exchange. The MSCI Taiwan Index, used in the Taiwan stock index futures, includes about 77 constituent stocks. The contract specifications include four quarterly months plus the two nearest months. The value per point is 100 USD, meaning that if the index is at 400 points, the contract value would be 40,000 USD. The minimum price movement is 0.1 points, equivalent to 10 USD. The limit for price fluctuation is 7%, but after a 10-minute trading halt, the limit is relaxed to 10%, and if it hits the price limit again, the limit is relaxed to 15%. The main participants in MSCI Taiwan Index Futures are foreign investors and major local traders. Despite having fewer constituents, it provides a strong reference for pricing.
Options Terminology
The clearinghouse calculates profits and losses based on the settlement price for the day. Profit will be credited to the account immediately, while losses will be deducted from the account. Depositing margin funds does not entirely eliminate default risk. The profits and losses generated by price fluctuations must be reflected in each participant's position before the contract is fulfilled to ensure that participants have enough financial resources to handle price volatility and are not unable to meet obligations. Therefore, a daily settlement system is in place. After the market closes, a price (usually the closing price) is selected by the exchange as the basis for calculating the day's profits and losses. For those with losses, the amount will be deducted from their margin account and transferred to the account of the profit holder. If the losses exceed a certain threshold (below the maintenance margin), additional margin must be deposited to cover the loss on the same day; otherwise, forced liquidation will occur.
The buyer of a European option can only exercise the option on the expiration date.
The buyer of an American option can exercise the option on or before the expiration date.
The strike price is equal to the market price of the underlying asset.
The strike price is favorable compared to the market price of the underlying asset. For a call option, it means the strike price is lower than the current market price of the specific stock. For a put option, it means the strike price is higher than the current market price of the specific stock.
The strike price is unfavorable compared to the market price of the underlying asset. For a call option, it means the strike price is higher than the current market price of the specific stock. For a put option, it means the strike price is lower than the current market price of the specific stock.
For the buyer, an option is a right, not an obligation. To obtain this right, the buyer must pay a price. Conversely, the seller provides the right and bears the obligation to perform, so they receive a price in return. This price is called the premium. The premium price is determined by supply and demand in the market, based on what the buyer is willing to pay and what the seller is willing to accept. When the price reaches a level that both parties can accept, the transaction occurs, and the price is thus determined.
Factors influencing the option price include the underlying asset's market price, strike price, risk-free interest rate, option maturity, and volatility of the underlying asset. The value of an option can be divided into two components: intrinsic value and time value. Intrinsic value refers to the profit gained by exercising the option immediately, while time value represents the expected value that decreases over time.
Intrinsic value is the profit that can be obtained by immediately exercising an in-the-money option.
Time value is the amount the buyer is willing to pay for the possibility of the option becoming in-the-money, which decreases as time passes, eventually reaching zero on the expiration date.
The strike price is the price at which the underlying asset can be bought or sold when the option is exercised. Each option contract has a fixed strike price.
For example, if an investor buys a call option for TSMC stock expiring in March with a strike price of 55, the investor has the right to buy 1,000 shares of TSMC stock at 55 dollars on the third Wednesday of March. The investor may choose not to exercise the option and sell the call option before or on the expiration date.
