Definition of 'Underlying Asset'

Definition: An underlying asset is the security on which a derivative contract is based upon. The price of
the derivative may be directly correlated (e.g. call option) or inversely correlated (e.g. put option), to the
price of the underlying asset. An underlying asset can be a stock, commodity, index, currency or even
another derivative (E.g. volatility index, VIX) product. Some exotic derivatives, like weather derivatives,
may
even
have
a
non-financial
entity
as
their
underlying
asset.
Description: Most of the times the underlying asset trades in a spot market (especially when the
underlying is a financial asset), where there needs to be a full upfront payment to acquire the asset (or
within a period of 1-2 days). Derivatives based on such assets usually do not require a 100 per cent
upfront payment to take exposure to them, thereby incorporating an inherent element of leverage in
them. Most of the listed stocks that trade on the stock exchanges are underlying asset of the various
futures and options contracts based upon them. Consider a stock, say ITC, which trades on the Indian
stock exchanges. Now, the ITC stock is the underlying asset traded on NSE or BSE and some of the
derivatives
that
have
this
stock
as
underlying
are:
A.
a.

Futures
1-month

b.
c.

futures

contract

2-month
3-month

(Near

futures
futures

contract

month)
contract

(Far

month)

B.

Options

a.

1-month

Call

options

at

various

strike

prices

b.

2-month

Call

options

at

various

strike

prices

c.

3-month

Call

options

at

various

strike

prices

d.

1-month

Put

options

at

various

strike

prices

e.

2-month

Put

options

at

various

strike

prices

f. 3-month Put options at various strike prices

Definition of 'Volatility'
Definition: It is a rate at which the price of a security increases or decreases for a given set of returns.
Volatility is measured by calculating the standard deviation of the annualized returns over a given period
of time. It shows the range to which the price of a security may increase or decrease.
Description: Volatility measures the risk of a security. It is used in option pricing formula to gauge the
fluctuations in the returns of the underlying assets. Volatility indicates the pricing behavior of the
security and helps estimate the fluctuations that may happen in a short period of time.
If the prices of a security fluctuate rapidly in a short time span, it is termed to have high volatility. If the
prices of a security fluctuate slowly in a longer time span, it is termed to have low volatility.

Definition of 'Yield'
Definition: In financial terms, yield is used to describe a certain amount earned on a security, over a
particular period of time. It refers to the interest or dividend earned on debt or equity, respectively, and is
conventionally expressed annually as a percentage based on the current market value or face value of
the
security.
Description: Yield is a major decision-making tool used by both companies and investors. It is a financial

ratio that indicates how much a company pays in dividend/interest to investors, each year, relative to the
security price. Yield is a measure of cash flow that an investor is getting on the money invested in a
security.
Suppose, a person A invests Rs 100 per share in the securities of XYZ Ltd for an annual return of Rs 10,
and B, another person, invests Rs 200 in the securities of ABC Ltd and gets the same return as A, i.e. Rs
10. Here the yield of A and B is 10% & 5%. While both are earning the same amount, B is getting less
return
as
he/she
has
invested
a
higher
amount
than
A.
Similarly, gains on stock prices also accrue profits to investors. This is why stocks with less growth
potential are more likely to offer higher dividend yield to investors than stocks with high growth potential
and, therefore, there is a better chance of earning returns from price appreciation. Yield varies between
investment period and return period. For instance, if you buy a stock for Rs 50 and its current price and
annual dividend is Rs 53 and Rs 2, respectively, the 'cost yield' will be 4% (Rs 2/Rs 50) and the 'current
yield' will be 3.77% (Rs 2/Rs 53).

Definition of 'Standard Deviation'

Definition: Standard deviation is the measure of dispersion of a set of data from its mean. It measures the
absolute variability of a distribution; the higher the dispersion or variability, the greater is the standard
deviation and greater will be the magnitude of the deviation of the value from their mean.
Description: The concept of Standard Deviation was introduced by Karl Pearson in 1893. It is by far the
most important and widely used measure of dispersion. Its significance lies in the fact that it is free from
those defects which afflicted earlier methods and satisfies most of the properties of a good measure of
dispersion. Standard Deviation is also known as root-mean square deviation as it is the square root of
means
of
the
squared
deviations
from
the
arithmetic
mean.
In financial terms, standard deviation is used -to measure risks involved in an investment instrument.
Standard deviation provides investors a mathematical basis for decisions to be made regarding their
investment in financial market. Standard Deviation is a common term used in deals involving stocks,
mutual funds, ETFs and others. Standard Deviation is also known as volatility. It gives a sense of how
dispersed
the
data
in
a
sample
is
from
the
mean.
In case of individual observations, Standard Deviation can be computed in any of the two ways:
1.

Take

the

deviation

2.

Take

the

deviation

of
of

the
the

items
item

from
from

the
the

actual

mean

assumed

mean

In case of a discrete series, any of the following methods can be used to calculate Standard Deviation:
1.

Actual

2.

Assumed

mean
mean

method
method

3. Step deviation method

Definition of 'Alpha'
Definition: Alpha is an estimated numeric value of a stock's expected excess return that cannot be
attributed
to
the
market's
volatility, but
may be
due
to
some
other
security.
Description: In other words, it is the difference between the investment return and the bench mark return
(for e.g. NSE Nifty). It is one out of the five technical risk ratios which help the investor to determine the
risk
reward
portfolio
of
the
mutual
fund.
Statistically, an alpha is generated by regressing a stock's excess return on benchmark (for example NSE
Nifty) excess return. Alpha is an intercept. For example, if a stock has an alpha of 1.20, that means
analysts expect 20% increase in the stock's price, not being affected by market fluctuations.
Fundamental investors always want an alpha to be positive and beta to be zero.

Definition of 'Strike Price'

Definition: Strike price is the pre-determined price at which the buyer and seller of an option agree on a
contract or exercise a valid and unexpired option. While exercising a call option, the option holder buys
the asset from the seller, while in the case of a put option, the option holder sells the asset to the seller.
In case of both call and put options, the strike price remains the same through the life of the contract.
The difference between the strike price and the current market price (or the underlying price) is one of
the inputs that determine the price or premium, which, in turn, decides whether the option is in-themoney or out-of-the-money. Usually, in-the-money options are more expensive than out-of-the-money
options.
Description: Strike price is an important element to any option contract, as exercising of an option
contract takes place on the strike price, and not on the market price of the underlying.
The difference between the strike price and market price on exercising an option shows profit per share
for
the
option
holder.
1) In Call option, if the strike price is less than market price on the day of expiry, the 'call option buyer'
will
exercise
the
same
and
the
price
difference
will
be
his
profit
2) In Put option, if the strike price is more than the market price on the day of expiry, the 'put option
buyer'
will
exercise
the
same
and
the
price
difference
will
be
his
profit
3) If holder of an option does not exercise the option, he has to pay 'option premium' to the other party,
and
not
the
strike
price
(When a Call option is exercised, the buyer of the option buys the asset from the option seller. In case of
a Put option, the option buyer sells the asset to the seller of the Put option).
Example:
On National Stock Exchange (India), suppose Tata Consultancy Services (TCS) is trading at Rs 2,531.50
in the cash market. Now a trader wants to buy TCS shares at this price, as he is expecting the stock to
jump in the near future, but not very certain about it. To avoid risk, he trades in NSE derivatives market
and buys TCS Call option (November) expiry at strike price Rs 2,500 at a market premium of Rs 70.50. On
the day of expiry, TCS stock price jumps to Rs 2,600. Now when the trader exercises the option, as he will
get shares at less than market price. But if TCS stock had tumbled to Rs 2,480 in cash market on the day
of
expiry,
this
option
would
have
expired
out-of-the-money.
The strike price for an option remains the same through the entire life of the contract (till expiry date).
The difference between the strike price and the current market price of the underlying asset is one of the
inputs that determine the market price of the option or option premium in the derivatives market. This
difference decides the 'status' of an option, which is whether the option is 'in-the-money', 'at-the-money'
or 'out-of-the-money'. Usually 'in-the-money' options are more expensive to buy than out-of-the-money
options. So when a trader buys or sells options expiring in the same month, he should consider the
strike
price
and
the
market
price.
At any point of time, there can be multiple Call and Put options on the derivative exchanges and every
option will have a defined strike price with an expiry date. So strike price for any security can be
explained with 'option chain', which has all listed call and put options with strike prices on one particular
expiry
date.
See the example below, the Option chain of a stock on the derivative exchange with November expiry
when the market price of the securities is Rs 2,540. The rates highlighted in blue are in-the-money,
because
a)
b)

in
in

case
case

of

Call
of

option,
Put

option,

Strike

Price

Strike

<
Price

Market
>

Price
Market

and
Price

Derivatives exchange offer a range of strike prices for a security, which depends on market price and
volatility expected in that security in the future, based on its past and current performance. This range
percentage is different for all different underlying. So while picking strike price, consider the implied
volatility and market price of that underlying.

Definitio
n of 'Stop Loss'
Definition: Stop-loss can be defined as an advance order to sell an asset when it reaches a particular
price point. It is used to limit loss or gain in a trade. The concept can be used for short-term as well as
long-term trading. This is an automatic order that an investor places with the broker/agent by paying a
certain amount of brokerage. Stop-loss is also known as 'stop order' or 'stop-market order'. By placing a
stop-loss order, the investor instructs the broker/agent to sell a security when it reaches a pre-set price
limit.
Description: In case of a stop-loss order, the trading company or broker looks at the trading discipline to
help the investor cut losses by the current market bid price (i.e. the highest price for the stock at any
point of time at which the investor wants to place a bid), and vice-versa, while selling a stock.
For example, if investor ABC wants to place a bid for shares of XYZ company at a certain price point,
he/she would instruct his/her brokerage to set the limit against the stock purchase. When the stock
reaches the set bid price, an order will be executed automatically to purchase the same.
If you already own the shares of company X and want to sell them, you would ask your broker to sell
them when the price reaches at certain high or low. Accordingly, an automatic order will get triggered
once
the
price
range
matches
the
set
limits.
A stop-loss order is basically a tool used for short-term investment planning. It is used when the investor

doesn't want the pressure of monitoring a security on a day-to-day basis. The trade gets triggered
automatically and the limits are decided in advance. This can be very helpful for small investors.

Definition of 'Stocks'
Definition: A stock is a general term used to describe the ownership certificates of any company. A share,
on the other hand, refers to the stock certificate of a particular company. Holding a particular company's
share
makes
you
a
shareholder.
Description: Stocks are of two typescommon and preferred. The difference is while the holder of the
former has voting rights that can be exercised in corporate decisions, the later doesn't. However,
preferred shareholders are legally entitled to receive a certain level of dividend payments before any
dividends
can
be
issued
to
other
shareholders.
There is also something called 'convertible preferred stock'. This is basically a preferred stock with an
option of converting into a fixed number of common shares, usually any time after a predetermined date.

Definition of 'Stock Split'

Definition: When a company declares a stock split, the number of shares of that company increases, but
the market cap remains the same. Existing shares split, but the underlying value remains the same. As
the
number
of
shares
increases,
price
per
share
goes
down.
Description: Stock split is done to infuse liquidity and to make shares affordable for various investors
who could not buy the shares of that company before due to high prices.
People often confuse bonus shares with stock split. Distribution of bonus shares only changes its issued
share capital whereas stock split splits the company's authorized share capital.