What Does Hedging Mean? Hedging means taking a position designed to reduce the effect of an adverse move in an existing exposure. The goal is not necessarily to make money on the derivative itself. A successful hedge may lose money when the underlying exposure gains value, because the combined position is what matters. Derivatives are particularly useful because they can [...]
What Is a Swap? A swap is a derivative agreement in which two parties exchange sets of cash flows according to predefined rules. Swaps are commonly traded over the counter and can be customized by notional amount, maturity, payment frequency and reference rate. The notional principal is often used only to calculate payments and may not itself be exchanged, depending [...]
Why Combine Options? Combining calls and puts allows investors to reshape risk rather than simply take a bullish or bearish position. Multi-leg strategies can cap losses, cap gains, target volatility, reduce premium cost or protect an existing portfolio. The trade-off is that changing one part of the payoff normally changes another. Bull Call Spread A bull call spread is a [...]
Why the Greeks Matter Option prices respond to several market variables at the same time. The Greeks summarize first- and second-order sensitivities and allow traders and risk managers to understand how an option portfolio may react when the underlying price, volatility, time or interest rates change. Delta Delta measures how much the value of an option is expected to change [...]
What Determines an Option Premium? An option premium reflects the economic value of the rights embedded in the contract. Its price is influenced by the underlying price, strike price, time to expiration, expected volatility, interest rates and expected cash flows such as dividends. Intrinsic Value Intrinsic value represents the value an option would have if it were exercised immediately. In [...]
Payoff and Profit Are Not the Same Option payoff describes the value generated by exercise at expiration. Profit adjusts that payoff for the premium paid or received. Ignoring the premium can therefore produce a misleading picture of the economics of an option trade. Long Call A long call gives the holder the right, but not the obligation, to buy the [...]
What Is an Option? An option is a derivative contract that gives its buyer a right, but not an obligation, to transact in an underlying asset under specified terms. The option seller, or writer, receives a premium and takes on the corresponding obligation if the buyer exercises the option. This asymmetry is what distinguishes options from forwards and futures. A [...]
What Is a Futures Contract? A futures contract is a standardized agreement to buy or sell an underlying asset at a future date. Unlike most forwards, futures trade on organized exchanges and are typically cleared through a central clearinghouse. Contract size, expiry months, settlement procedures and other terms are standardized. Futures exist on equity indices, government bonds, interest rates, currencies, [...]
What Is a Forward Contract? A forward contract is a bilateral agreement to buy or sell an underlying asset at a specified future date for a price agreed today. The party agreeing to buy is long the forward; the party agreeing to sell is short. Most forwards are negotiated over the counter, which means their notional amount, maturity and settlement [...]
What Is a Derivative? A derivative is a financial contract whose value depends on an underlying asset, rate, index or other reference variable. The underlying can be an equity, bond, currency, commodity, interest rate, market index or even a credit event. Unlike buying an asset outright, a derivative defines cash flows that depend on what happens to that reference variable [...]