Table of Contents / Instruments & Market Mechanics

Instruments & Market Mechanics

2. Instruments & Market Mechanics

This document covers the various financial instruments available for trading and the specific mechanics governing each market type, including derivatives, leverage, and crypto-specific considerations.

2.1 Spot Markets

Definition

Spot markets (also called cash markets) are financial markets where financial instruments are traded for immediate delivery and settlement. The "spot price" represents the current market price at which an asset can be bought or sold for immediate exchange.

Core Principles

Immediate Settlement: Transactions settle within a short timeframe (T+0 to T+2 depending on asset class)
Physical or Book-Entry Delivery: Actual ownership transfer of the underlying asset
Price Transparency: Spot prices reflect current supply and demand equilibrium
No Expiration: Unlike derivatives, spot positions have no expiration date
Direct Ownership: Holder has full ownership rights including dividends, voting rights, etc.

Common Use Cases

Long-term investment and portfolio construction
Basis for derivatives pricing (spot-futures relationships)
Arbitrage between spot and derivative markets
Direct exposure to asset price movements
Dividend capture and income strategies

Examples

Equity Spot Market: - Purchase 100 shares of AAPL at $175.50 - Settlement: T+2 (trade date plus two business days) - Ownership: Full shareholder rights, dividends, voting

Forex Spot Market: - Buy EUR/USD at 1.0850 - Settlement: T+2 (standard for major pairs) - Delivery: Exchange of currency amounts

Cryptocurrency Spot Market: - Buy 1 BTC at $45,000 - Settlement: Near-instantaneous (blockchain confirmation) - Custody: Direct ownership, can withdraw to personal wallet

Commodity Spot Market: - Buy 100 oz gold at $1,950/oz - Settlement: Varies (T+2 or physical delivery arrangements) - Delivery: Can take physical delivery or hold in vault

Best Practices for Traders

Understand settlement cycles to manage cash flow and margin requirements
Factor in custody and storage costs for physical commodities
Be aware of corporate actions affecting equity positions
Use spot markets for long-term directional exposure
Monitor spot-futures basis for arbitrage opportunities
Consider total cost of ownership including financing costs

Mathematical Rules/Formulas

Spot Return:

Simple Return = (P_t - P_(t-1)) / P_(t-1)
Log Return = ln(P_t / P_(t-1))

Total Return (with dividends):

Total Return = (P_t - P_(t-1) + Dividends) / P_(t-1)

Cost of Carry Relationship:

Futures Price = Spot Price * e^((r - y) * T)

Where r = risk-free rate, y = yield/dividend rate, T = time to expiration.

2.2 Futures & Perpetual Swaps

Definition

Futures: Standardized contracts obligating the buyer to purchase, or the seller to sell, an asset at a predetermined price on a specified future date.
Perpetual Swaps: Derivative contracts similar to futures but with no expiration date, commonly used in cryptocurrency markets, with periodic funding rate payments to maintain price alignment with spot.

Core Principles

Leverage: Futures allow exposure to large notional values with smaller margin deposits
Mark-to-Market: Daily settlement of profits and losses
Standardization: Contract specifications (size, expiration, tick size) are standardized
Convergence: Futures prices converge to spot prices at expiration
Funding Rates (Perpetuals): Periodic payments between longs and shorts to anchor price to spot

Common Use Cases

Hedging existing spot positions against price risk
Speculating on price direction with leverage
Calendar spreads (trading the difference between expiration months)
Basis trading (spot-futures arbitrage)
Rolling exposure without physical delivery

Examples

Futures Contract: - Asset: E-mini S&P 500 (ES) - Contract Size: $50 x S&P 500 Index - Tick Size: 0.25 points ($12.50) - Expiration: Quarterly (March, June, September, December) - Settlement: Cash settled to index value

Contango vs. Backwardation: - Contango: Futures price > Spot price (normal for storable commodities) - Backwardation: Futures price < Spot price (indicates supply shortage or high convenience yield)

Perpetual Swap Funding: - BTC-PERP trading at $45,100 (spot at $45,000) - Premium indicates more longs than shorts - Funding rate: +0.01% every 8 hours - Longs pay shorts to hold positions - Incentivizes arbitrage to close premium

Best Practices for Traders

Monitor margin requirements and maintain adequate buffer above maintenance margin
Understand roll costs when maintaining continuous exposure
Watch funding rates in perpetuals to avoid unexpected costs
Use contango/backwardation information for directional signals
Be aware of contract expiration dates and auto-liquidation rules
Calculate effective leverage including notional exposure

Mathematical Rules/Formulas

Futures Fair Value:

F = S * e^((r - y) * T)

Basis:

Basis = Futures Price - Spot Price
Basis (%) = (F - S) / S * 100%

Annualized Basis:

Annualized Basis = (F/S - 1) * (365 / Days to Expiry) * 100%

Perpetual Funding Rate:

Funding Payment = Position Value * Funding Rate

If funding rate is positive: longs pay shorts If funding rate is negative: shorts pay longs

Contract Value:

Notional Value = Contract Multiplier * Current Price * Number of Contracts

2.3 Options

Definition

Options are derivative contracts that give the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specified price (strike) before or on a specified date (expiration).

Core Principles

Asymmetric Payoff: Limited downside (premium paid) with unlimited upside potential for buyers
Time Decay (Theta): Option value erodes as expiration approaches
Implied Volatility: Market's expectation of future volatility embedded in option prices
Non-Linear Risk: Option Greeks describe sensitivity to various factors
Exercise Styles: American (any time), European (expiration only)

Common Use Cases

Hedging portfolio against downside risk (protective puts)
Generating income from existing positions (covered calls)
Speculating on direction with defined risk
Volatility trading (straddles, strangles)
Complex multi-leg strategies for specific market views

Examples

Call Option: - AAPL Call, Strike $180, Expiration 30 days - Premium: $3.50 - Breakeven: $183.50 ($180 + $3.50) - Max Loss: $3.50 (premium paid) - Max Gain: Unlimited (above breakeven)

Put Option: - SPY Put, Strike $440, Expiration 45 days - Premium: $5.00 - Breakeven: $435.00 ($440 - $5.00) - Max Loss: $5.00 (premium paid) - Max Gain: $435.00 (if underlying goes to zero)

Covered Call: - Own 100 shares AAPL at $175 - Sell 1 Call, Strike $185, Premium $2.50 - Outcome if price stays below $185: Keep shares + $250 premium - Outcome if price exceeds $185: Shares called away at $185, total gain $12.50/share

Best Practices for Traders

Never sell naked options without understanding unlimited loss potential
Monitor implied volatility relative to historical volatility
Understand all Greeks, especially for complex positions
Calculate max loss before entering any options trade
Be aware of dividend dates for early exercise risk on American options
Use options for defined-risk directional bets rather than naked futures/spot
Close or roll positions well before expiration to avoid gamma risk

Mathematical Rules/Formulas

Black-Scholes Call Price:

C = S * N(d1) - K * e^(-rT) * N(d2)

d1 = (ln(S/K) + (r + sigma^2/2) * T) / (sigma * sqrt(T))
d2 = d1 - sigma * sqrt(T)

Put-Call Parity:

C - P = S - K * e^(-rT)

The Greeks:

Delta = dV/dS (sensitivity to underlying price)
Gamma = d(Delta)/dS (rate of change of delta)
Theta = dV/dT (time decay per day)
Vega = dV/d(sigma) (sensitivity to volatility)
Rho = dV/dr (sensitivity to interest rates)

Intrinsic and Time Value:

Call Intrinsic = max(S - K, 0)
Put Intrinsic = max(K - S, 0)
Time Value = Option Price - Intrinsic Value

2.4 Margin, Leverage & Liquidation Engines

Definition

Margin: Collateral deposited to cover potential losses, expressed as initial margin (to open) and maintenance margin (to maintain positions)
Leverage: The ratio of position size to margin, amplifying both gains and losses
Liquidation Engine: Automated system that forcibly closes positions when margin falls below maintenance requirements

Core Principles

Leverage Amplification: Leverage multiplies returns in both directions
Margin Call: Warning when equity approaches maintenance margin
Forced Liquidation: Automatic position closure to prevent negative equity
Cross vs. Isolated Margin: Cross uses entire account balance; isolated limits risk per position
Insurance Funds: Exchange reserves to cover liquidation shortfalls in volatile markets

Common Use Cases

Increasing capital efficiency for qualified strategies
Hedging with reduced capital requirements
Short selling (borrowing assets)
Futures and derivatives trading
Crypto perpetual swap trading

Examples

Leverage Calculation: - Account Balance: $10,000 - Position Size: $50,000 - Leverage: 5x ($50,000 / $10,000)

Margin Requirements: - Initial Margin: 20% ($10,000 for $50,000 position) - Maintenance Margin: 10% ($5,000) - Liquidation Trigger: When equity falls below $5,000

Liquidation Scenario: - Position: 5x Long BTC at $50,000 (1 BTC exposure, $10,000 margin) - Liquidation Price: ~$40,000 (20% drop = 100% of margin) - Calculation: Entry - (Margin / Position Size) = $50,000 - $10,000 = $40,000

Cross vs. Isolated Margin: - Cross Margin: All account funds available for all positions - Isolated Margin: Only allocated margin used for specific position - Trade-off: Cross provides more buffer but exposes entire account to any position's loss

Best Practices for Traders

Never use maximum available leverage
Calculate liquidation price before entering any leveraged position
Maintain margin buffer significantly above maintenance requirements
Use isolated margin for high-risk trades to limit account exposure
Set stop-losses well above liquidation price
Understand the exchange's liquidation mechanism (gradual vs. full)
Monitor funding rates and margin requirements during volatility spikes
Account for spread widening during volatile periods when calculating liquidation risk

Mathematical Rules/Formulas

Leverage Ratio:

Leverage = Position Size / Margin
Effective Leverage = Notional Exposure / Account Equity

Long Position Liquidation Price:

Liquidation Price = Entry Price * (1 - Initial Margin % + Maintenance Margin %)

Short Position Liquidation Price:

Liquidation Price = Entry Price * (1 + Initial Margin % - Maintenance Margin %)

Margin Ratio:

Margin Ratio = Maintenance Margin Required / Account Equity

Liquidation occurs when Margin Ratio >= 100%

Return Amplification:

Leveraged Return = Leverage * Underlying Return
5x leverage, 2% move = 10% return (or loss)

2.5 Crypto-Specific Mechanics

Definition

Crypto-specific mechanics encompass the unique trading infrastructure, settlement systems, and market structures particular to cryptocurrency and digital asset markets, including decentralized exchanges, automated market makers, and blockchain-based settlement.

Core Principles

24/7 Markets: No close, continuous trading globally
Self-Custody: Users can hold assets directly without intermediaries
On-Chain vs. Off-Chain: Settlement can occur on blockchain or within exchange databases
Decentralization Spectrum: From fully decentralized (DEX) to centralized (CEX)
Network Fees: Blockchain transactions incur gas/network fees
Finality: Settlement finality depends on blockchain confirmation times

Common Use Cases

Trading on centralized exchanges (CEX) for liquidity and speed
Decentralized exchange (DEX) trading for self-custody and permissionless access
Yield farming and liquidity provision on AMMs
Cross-chain arbitrage
On-chain derivatives trading

Examples

Centralized Exchange (CEX): - Examples: Binance, Coinbase, Kraken - Order book model, high liquidity - Custody held by exchange - KYC required, faster execution - Counterparty risk to exchange

Decentralized Exchange (DEX): - Examples: Uniswap, SushiSwap, dYdX - Self-custody throughout trading - Permissionless, no KYC - Higher fees (gas), potential MEV exposure - Liquidity from liquidity pools

Automated Market Maker (AMM): - Bonding curve pricing (x * y = k constant product) - No order book, trades against liquidity pool - Price impact proportional to trade size - Liquidity providers earn fees but face impermanent loss - Examples: Uniswap V2/V3, Curve, Balancer

Concentrated Liquidity (CLMM): - Liquidity providers set price ranges - More capital efficient than constant product AMMs - Higher yields but requires active management - Example: Uniswap V3

Best Practices for Traders

Use hardware wallets for significant holdings
Compare CEX and DEX execution for best prices
Account for gas fees in trade profitability calculations
Be aware of MEV (Maximal Extractable Value) risks on DEX
Monitor blockchain congestion before executing time-sensitive trades
Use reputable bridges for cross-chain operations
Verify smart contract addresses before interacting
Understand impermanent loss before providing liquidity

Mathematical Rules/Formulas

Constant Product AMM (Uniswap V2):

x * y = k

Output Amount = (y * Input Amount) / (x + Input Amount)

Price Impact (AMM):

Price Impact = Trade Size / (Pool Reserve + Trade Size)

Impermanent Loss:

IL = 2 * sqrt(price_ratio) / (1 + price_ratio) - 1

Where price_ratio = new_price / original_price

Concentrated Liquidity (V3):

Real Reserves = Virtual Reserves * (sqrt(P_upper) - sqrt(P_lower)) / sqrt(P_current)

2.6 FX Basics

Definition

The foreign exchange (FX or forex) market is the global marketplace for trading currencies. It is the largest and most liquid financial market, with daily turnover exceeding $7 trillion, operating 24 hours from Sydney open to New York close.

Core Principles

Currency Pairs: Currencies traded in pairs (EUR/USD, USD/JPY), first is base, second is quote
Pips: Smallest price movement, typically 0.0001 for most pairs (0.01 for JPY pairs)
Lot Sizes: Standard (100,000 units), Mini (10,000), Micro (1,000)
Interest Rate Differentials: Carry trade opportunities from rate differences
Interbank Market: Primary market among major banks, others access via brokers

Common Use Cases

Hedging foreign currency exposure for businesses
Carry trades exploiting interest rate differentials
Speculating on macroeconomic trends and central bank policy
Portfolio diversification across currencies
Arbitrage across currency crosses

Examples

Quote Convention: - EUR/USD = 1.0850 - Interpretation: 1 Euro costs 1.0850 US Dollars - Base currency: EUR - Quote currency: USD

Pip Value Calculation: - EUR/USD position: 100,000 units (1 standard lot) - Pip = 0.0001 - Pip Value = 100,000 * 0.0001 = $10 per pip

Carry Trade: - Borrow JPY at 0.1% interest - Invest in AUD at 4.0% interest - Carry = 3.9% annually - Risk: Currency movement can exceed carry return

Cross Rates: - EUR/USD = 1.0850 - USD/JPY = 150.00 - EUR/JPY = 1.0850 * 150.00 = 162.75

Best Practices for Traders

Understand the economic calendars driving FX moves
Monitor central bank communications and interest rate expectations
Be aware of market sessions and liquidity variations
Use appropriate position sizing given FX leverage availability
Consider correlation between currency pairs in portfolio construction
Account for swap rates (rollover) for positions held overnight
Watch for intervention risk in certain currency pairs

Mathematical Rules/Formulas

Pip Value:

Pip Value = (Pip Size / Exchange Rate) * Lot Size

Position Profit/Loss:

P/L = (Exit Price - Entry Price) * Lot Size * Pip Value

Swap/Rollover Calculation:

Swap = Position Size * (Base Currency Rate - Quote Currency Rate) / 365

Cross Rate:

If EUR/USD = a and USD/JPY = b
Then EUR/JPY = a * b

Forward Rate (Interest Rate Parity):

F = S * ((1 + r_quote) / (1 + r_base))^T

2.7 Settlement & Clearing

Definition

Settlement: The process of transferring ownership of securities and funds between parties to complete a trade
Clearing: The process of validating, matching, and preparing trades for settlement, including netting of obligations
Central Counterparty (CCP): Entity that interposes itself between buyers and sellers to guarantee trade completion

Core Principles

Counterparty Risk Mitigation: CCPs reduce bilateral counterparty exposure
Netting: Reducing gross obligations to net amounts for efficiency
Delivery vs. Payment (DvP): Simultaneous exchange of securities and cash
Settlement Cycles: T+0 (same day) to T+2 (trade date plus two days)
Margin Requirements: Collateral held by CCPs to cover potential losses

Common Use Cases

Understanding when funds and securities become available
Managing cash flow around settlement dates
Assessing counterparty risk in OTC markets
Calculating margin requirements for cleared derivatives
Corporate action processing

Examples

Equity Settlement (T+2): - Trade executed Monday - Settlement Wednesday - Cash debited/credited and shares transferred

Futures Settlement (Daily): - Daily mark-to-market - Variation margin exchanged each day - Final settlement at expiration

Crypto Settlement: - CEX: Internal ledger, instant - DEX: On-chain, block confirmation time (seconds to minutes) - Withdrawal: Network confirmation required

Best Practices for Traders

Ensure sufficient funds available on settlement date
Understand settlement conventions for each asset class
Monitor CCP margin requirements for cleared positions
Be aware of settlement failures and their implications
Account for settlement timing in cash management
Understand the difference between trade date and settlement date accounting

Mathematical Rules/Formulas

Netting Benefit:

Gross Obligations = Sum of all trade values
Net Obligation = |Total Buys - Total Sells|
Netting Efficiency = (Gross - Net) / Gross * 100%

Exposure at Default:

EAD = Replacement Cost + Potential Future Exposure

2.8 Contract Specifications

Definition

Contract specifications define the standardized terms and conditions of derivative contracts, including size, tick increments, expiration rules, and settlement methods. Understanding specifications is essential for proper position sizing, risk calculation, and P&L computation.

Core Principles

Standardization: Exchange-traded derivatives have fixed specifications
Multiplier/Contract Size: Defines notional value per contract
Tick Size: Minimum price increment
Expiration Rules: When and how contracts expire and settle
Trading Hours: Session times and any restrictions

Common Use Cases

Calculating position size and notional exposure
Determining margin requirements
Understanding roll procedures
Comparing similar contracts across exchanges
Backtesting with accurate contract specifications

Examples

E-mini S&P 500 (ES): - Exchange: CME - Multiplier: $50 - Tick Size: 0.25 points ($12.50) - Settlement: Cash settled to S&P 500 index - Expiration: Third Friday of contract month

Bitcoin Futures (BTC): - Exchange: CME - Multiplier: 5 BTC per contract - Tick Size: $5 ($25 per tick) - Settlement: Cash settled to CME CF Bitcoin Reference Rate

Crude Oil (CL): - Exchange: NYMEX - Multiplier: 1,000 barrels - Tick Size: $0.01 ($10 per tick) - Settlement: Physical delivery (most traders roll before expiration)

Best Practices for Traders

Always verify contract specifications before trading new instruments
Calculate notional exposure and tick value before entering positions
Understand settlement procedures (cash vs. physical)
Be aware of contract roll dates and procedures
Monitor for specification changes announced by exchanges
Use correct specifications in backtesting and risk systems

Mathematical Rules/Formulas

Notional Value:

Notional = Price * Multiplier * Number of Contracts

Tick Value:

Tick Value = Tick Size * Multiplier

P&L Calculation:

P/L = (Exit Price - Entry Price) / Tick Size * Tick Value * Contracts

Margin Requirement (Initial):

Initial Margin = Notional Value * Initial Margin Percentage

Summary

Understanding instruments and market mechanics is fundamental to successful trading. Each instrument type has unique characteristics affecting:

Capital Efficiency: Leverage availability varies dramatically across instruments
Risk Profile: Options offer defined risk; futures have unlimited downside
Settlement: Timing and method of settlement impacts cash management
Costs: Transaction costs, funding rates, and carry vary by instrument
Liquidity: Market depth and trading hours affect execution quality

Traders should match instrument selection to their strategy requirements, risk tolerance, and operational capabilities. Master the mechanics before deploying capital.