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INTRODUCTION
This manual is intended to prepare you to pass the NASD Series 3 exam, which will allow you to be registered as an Associated Person AP, or Registered Commodity Representative, RCR, with any firm dealing in the trade of Futures and/or options on Futures contracts.
If you choose to memorize questions and answers prior to taking the exam, it will most probably result in failure.
It is important that certain concepts be learned, and applied in each exercise.
You must therefore decide to put forth 4 and ½ hours per day, with an honest effort, if you are to successfully pass your exam.
My goal is that you learn this material. I will teach you a few “tricks”, for easy interpretation of the problems.
Remember – This is an exam, not the real world. So, the information you are about to receive can be very deceiving. A question will appear with extra data to get you confused. The exam is extremely difficult! It will test how well you have prepared yourself for the task.
If you have investment experience, and begin to doubt the information presented in this manual, do not take it for granted. You need to know that many concepts differ between commodity trading and stock trading, including the commodity options.
You will be successful on your first exam attempt if you follow the LIGHTS FOR PASSING, which I will present to you as we move along.
At first, I am covering the MATH of the matter.
Then, we will add some theoretical relevancies to help you understand which LIGHT apply to each MATH problem. Finally, we will cover everything else.
I will be communicating with you during the entire process.
Let’s move on the next page to situate ourselves with the INDEX.
PS -
When finishing read – click one of the ads on the side for me to make some money.
Quando terminar de ler, clique na propaganda – assim ganho din din
INDEX
CHAPTER 1
1- Speculating FUTURES
1.1- Markets knowledge Applied – Long and Short, cash and cash forward contracts.
1.2 - Speculation Problems. How to solve them?
1.3 - Speculating with Financial Contracts
1.4 - Contract Pricing
1.5 - Speculating FUTURES with Margin - Problems
CHAPTER 2
2- Hedging FUTURES –
2.1 – Basic Hedging problems and how to approach
2.2 - Basis calculation Problems
2.3 - Hedging commodity futures – Chapter 4
2.4 - Hedging Financial and Monetary Futures – Chapter 5
Hedging Financial Contracts FUTURES – Problems
CHAPTER 3
Interest Rate FUTURES – Problems
Stock Index FUTURES – Problems
Foreign Currency FUTURES – Problems
CHAPTER 3
Options ON FUTURES – Problems
CHAPTER 4
Technical and Fundamental Analysis
CHAPTER 5
An overview of everything we learned so far!
CHAPTER 6
Everything else
CHAPTER 1
SPECULATION ON FUTURES –
1.1 Markets Knowledge Applied
Speculators try to forecast price changes and take positions based on their forecast. They are people like you and me, who can make money if they forecast correctly the direction of the price of any commodity, or lose money when they are wrong. Their role is to add liquidity, and not to forecast prices.
Speculators have no interest in owning the physical commodity, so they offset their futures position before delivery.
Speculators increase liquidity in the futures market. Liquidity here is money, which enable the market to operate more efficiently.
The more speculators, the more liquidity we see in the market, therefore Market Liquidity is found by increasing the number of traders.
Increasing trading volume allows large trades to be executed without dramatically affecting prices. When I say large trades, I mean large orders.
If we have only few speculators, and a large trade is executed, it can change the price of the commodity faster than when we have more speculators. For every contract traded by hedgers (Participants that usually take or make delivery of a commodity), there may be 30 or more contracts traded by speculators. Increasing trading volume allows large trades to be executed without dramatically affecting prices. When I say large trades, I mean large orders.
A Thin Market is usually more risky, for it is illiquid. Not much money changing hands. It is thin because it doesn’t have enough participants. So prices can be volatile. It can go up or down inconsistently. So, the greater the volatility in the market, the greater the markets risk.
Now, if we have a market with many participants, we have a market with increased liquidity, and it improves market efficiency.
This being said, I prefer cover speculation problems by giving you better information about futures contracts and how they work.
Basic Market Information –
I want to start with the CASH markets. There are two types of them. The first is the market we are familiar with. For instance when you purchase gold in a local store, the dealer will look at the current “going” price for gold, then add his “mark-up” to arrive to a retail CASH or spot price, which you must pay. A farmer would sell his product and receive the “going” or “cash” price, is another example.
The second type of cash market is known as the “cash forward” or to “arrive” market.
A cash forward contract is negotiated between buyer and seller, one-on-one, for a specific product, at an agreed upon price, and for a future delivery.
The difference between Cash forward contracts and futures contracts is that the buyer and seller do not meet. Instead, the transaction takes place in a trading floor of the commodity exchange. There are over 87 commodities, and they are traded in different market exchanges. The commodities are traded in an auction market. The futures contracts are legally binding. The main advantage of futures contracts is that it allows speculators to participate, bringing therefore, liquidity. It is standardized, with a set quantity, quality etc. This ability to speculate and hedge in the futures contracts help to keep prices lower. The futures market provides price forwarding because its liquidity. We are talking about price forwarding here… do not get confused with cash forward mentioned before.
Imagine a farmer who has not yet harvested his crop, but has already negotiated with the buyer of the crop to deliver his crop in three months at a set price. This farmer has negotiated a “cash forward” contract in order to assume himself of a price. The cash forward contract brings stability in the cash market. This contract is illiquid, and referred to as not efficient.
Now that we know what is “cash market”, we can then move on to FUTURES MARKETS.
A futures contract is a promise to make delivery (if short) or take delivery (if long) of a set quantity of product, with a set quality, at a set price, in a set time period.
Long – One who buys or holds the contract.
Short – One who sells or issues the contract.
SHORT AND LONG A FUTURE CONTRACT
Let’s first examine the long position.
Long the market – The owner of the Futures contract holds the contract with a price tag that is written in his contract. When he purchases the contract he goes long the market. He is the new owner of the contract. He wishes the market price (the “going” price) of that commodity to move up, higher than the price written in his contract, so he can sell for the current market value, (CMV), and keep the profit.
Picture this scenery:
Today is September 1st, and you (as an speculator), have an opinion that the price of Crude oil is going to move higher before the month of November. You go long the contract. What actually happened?
LONG 1 NOV CRUDE OIL CONTRACT @ 73
You called to your AP and told him to buy a Nov crude oil contract. The AP phoned the order to the floor of the exchange (the pit). The floor broker filled the order and returned it to the AP for reporting back to you, the client. The futures contract has just been transferred to you. You entered an agreement and backed it with your good faith money and a promise to take delivery. You good faith money is called Initial Margin. It is returned to you after the contract is traded. It ranges around 5% of the full price of the contract.
You are making a promise to do something in the future. You are promising to take delivery of 1000 barrels of oil in November, and pay $73 per barrel or $73,000.
Now, assume that by September 25th the current price of the NOV CRUDE OIL CONTRACT price is at $81 per barrel. You believe this price is a high as it will go, and decide to SELL your contract. If you get $81 on the sale, you are now rid of your agreement with the following results.
Bought a CRUDE OIL contract for $73 per barrel
Sold a CRUDE OIL contract for $81
This is an $8 profit - A gross profit of $8 x 1000 (the size of the crude oil contract)
= $8,000.
You bought (went long) then sold (liquidated) the contract.
- Anytime you go long, you have to get out by going short. And vice-versa.
Now Let’s examine the Short Position:
Short the Markets
On March 5th you have a hint that the price of sugar has topped out and will probably go down in the coming months. You make your calls and now went short the future contract. You told your AP to sell 1 may contract at 17 cents per pound. (One contract has 112,000 pounds)
SHORT 1 MAY SUGAR@17 ----- sugar is traded in cents per pound
The initial margin money is still placed with the clearinghouse, and a new agreement you have entered into. In this case you promise to make delivery of 112 thousands pounds of sugar sometime in May and receive $17 cents /pound or $19,040 (.17X112000 = 19,040).
Now assume on the 29th of March the May price of Sugar moves to 14 cents. You decide to buy back a contract for the same quantity, and for the same month in the same clearinghouse, to offset your responsibility and take your profits.
As you see now that you went short, to offset your contract you must go long.
You profited 3 cents per pound.
.03 X 112000 = profiting $ 3360 per contract Gross.
************
When you go short, you promise to deliver something that you do not have, and before expiration you need to buy the same commodity, hoping that the price went bellow your selling contract. Because you went short, now need to buy, or go long to offset your position. Speculators who go short the market are forecasting that the prices of the commodity will decrease.
A hedger, as mentioned before, is a person who is involved in large purchases or sells because he either produces or uses the commodity. He is an active participant of the markets and therefore is said to be less risky.
A Hedger pays less for his initial margin than a speculator. They offer less risk, for they can back up with a merchandize, while a speculator will have to come up with cash to settle his contract. Only 3% of all contracts traded are delivered. The rest is all speculation, or participants trying to forecast what price will go up in the near future, or in the distant future. It is necessary to have the real commodity to be able to create a contract.
1.2 SPECULATION PROBLEMS – How to solve them
Solving problems concerning speculation will involve a basic knowledge of everything we are going to study. Speculation is the calculation of gain or loss of the futures half of a hedge problem. Profits accrue for a long when prices rise, and for a short when price decline. The following LIGHTS will be applied in different type problems.
LIGHT 1- SPECULATION
Always work ONE contract through first, THEN multiply the answer times the number of contract.
In other words, find the profit or loss net and later multiply by the number of contracts.
Example 1:
1- your client is long 2 cocoa contracts, which he purchased for $1,150 per metric ton. Later, the client sells the contract for $1,247 per ton. With Commissions of $65 per round turn (per contract – including buying and selling the contract), and a contract size of 10 metric tons, what is the result of the trade?
SOLUTION:
2 10 metric tons $ 65
___________ ________________ _____________
# Contracts Contract size Commission
$1,247 Sale
$1,150 Purchase price per metric ton
$ 97.00 Per ton Gain (gross)
X 10 Contract size = 10 metric tons
$ 970.00 Profit per contract GROSS
- 65.00 Commission
$ 905.00 Profit per contract NET
X 2 Number of contracts
$1,810.00 Net profit on the trade
LIGHT 2 – SPECULATION
Work every speculation problem as above. Follow the organization pattern presented to you. Write down each step as above, and do not calculate total commissions to subtract. And remember, if you have a profit you must subtract commission. If you have a loss, you must add commission.
Your mistakes in calculating will appear when you use short cuts. We have many things to cover, and it is necessary that you follow this pattern. If you skip this pattern, things will get more complicated later. Remember that when you do speculative problems, you are going to do it with commodities quoted in cents, and financial instruments that use points. It is a lot to remember! Therefore, follow my instructions.
LIGHT 3 – SPECULATION
ANY and ALL commodities quoted in “cents” per unit, (cents per pound, per ounce, per gallon, etc.) MUST be converted to “dollars” per unit, by moving the decimal two places to the left BEFORE working the problem.
Example 2:
2- a client buys 4 live cattle contracts when the price is at 81.525 cents per pound and later liquidates when the price is at $83.275 cwt. With a commission of $70 per contract, and a contract size of 50,000 lbs, what is the result of the transaction?
A problem such as this will be in your test. It starts stating cents and then, it gives the other price in cwt. You see a dollar sign in one part and are let to decide the other part.
HINT: 81.525 cents per lb = .81525 per pound
$83.275 cwt (cwt means per hundred pounds). = .83275 per pound
SOLUTION: Result of transaction?
4 50,000 lbs $70
# Of Contracts Contract size Commission
Sell .83275
Buys .81525
.0175 PROFIT OF per pound
X 50,000 per contract size
$ 875 PROFIT per contract gross
- $ 70 Commission per contract
$ 805 PROFIT net per contract
X 4 Number of contracts
$ 3,220 Net profit on a trade = result of the transaction
1.3 LIGHTS FOR SPECULATING IN FINACIAL CONTRACTS
As you have seen so far, speculating is the act of purchasing and selling a contract, or vice-versa. You know what to do when you see a commodity price quoted in cents. (See LIGHT3)
Financial contracts are those contracts we purchase from financial institutions. There are two types of Financial Contracts: Short term and long term. We work them differently.
Short-term financials considered 90 days:
Treasure Bills (T-Bills)
Eurodollars
Certificate of deposit (CDs)
Commercial paper (CP)
LIGHT 4 –SPECULATION – Short Terms
ANY Financial Futures with a decimal in the quote is short term, drop the decimal, and each point is equal to $25,00
LIGHT 5 – SPECULATION – short-term Contract sizes
With short term we do not use the contract size to figure the profit or loss on the trade. As soon as you determine it to be a short term financial, follow LIGHT 4.
Example 3:
3- a speculator goes long 6 Treasure bill futures for 91.75 and later offsets the trade when futures are at 92.78. With a contract size of $1,000,000 and commissions of $75 a round turn, what is the result?
SOLUTION - What is the result?
Note that it is a short-term contract!
6 1 Million $75
# Of Contracts Contract size Commission
Sell 9278 - Note that the decimal vanished and we have points
Buys 9175
103 Point gain
X $25 per point value <Instead of contract size>
$ 2575 PROFIT per contract gross
- $ 75 Commission per contract
$ 2500 PROFIT net per contract
X 6 Number of contracts
$ 15,000 Net profit on a trade = result of the transaction
LIGHT 5 – How to find
Long Term Financials considered years:
Treasure Notes (5 and 10 years)
Treasure Bonds (20 years)
Corporate Bonds (20 years)
Municipal Bonds (20 years – Munies)
GNMA (30 years)
LIGHT 6 – SPECULATION Long Term financials
ALL Long Term financials futures have a “hyphen” or “dash” in the quote. All financial Futures with a dash in the quote are in 32nds, and 1/32 = $31.25
Example: 96-14 = 96 thousand dollars plus 14/32 or (14x $31.25) = $437.50 for a total of = 96,437.50
Example 4: – Long Term
Mario sells 3 contracts of September T bonds when the prices was 98-14, and latter off set his position by going long the contracts at 96-18. With Commissions of $60 per contract, and a contract size of $100,000 what is the result of the trade?
SOLUTION – What is the result of the trade?
Note that it is a long term contract!
3 100 Thousand $60
# of Contracts Contract size Commission
Sell 98-14/32 - Note that we have a dash
Buys 96-18/32
Here we have a situation where we cannot subtract 18 from 14. In this case 14 needs to borrow one point from the 98. This way, 98 become 97- (14 receives 32 points becoming 46) – So, it was 98-14 and it became 97-46 (same value).
Therefore:
98-14 = 97-46
- 96-18
1-28 Gross per contract
1-28 = One thousand (plus 28/32 = 28X 31.25 = 875.00) = $1,875
$1875 PROFIT per contract gross
- $ 60 Commission per contract
$1815 PROFIT net per contract
X 3 Number of contracts
$5,445 Net profit on a trade = result of the transaction
It is really important that you learn and follow the above LIGHTS. If not, you will have a difficult time working with the financial problems on the series 3 exam.
1.4 CONTRACT PRICING
It is necessary to observe which form the price was given to you. It can be given in various forms. Although, we only covered a few ways, most mistakes occur when we oversee pricing.
It is not necessary to memorize contract sizes. All the questions of the exam will give you the contract size, even when it is not necessary to know it in order to calculate profit or loss, as in case with the financial contracts. It is however, necessary that you know how to work with the information you are given.
The main difficulty most people encounter is trying to deal with the price quote of a commodity if it is quoted in less than a penny.
$ 2.10 = 2 dollars and 10 cents
$ .10 = 10 cents
$ .1000 = 10 cents (the number of zeros after the decimal point change nothing)
$ .01 = 1 cent
$ .0100 = 1 cent
$ .0150 = 1.5 cents (1 and 5 tenths of a cent) or 1½ cent.
$ .0125 = 1 ¼ cent (1 and 25 hundredths)
$ .0050 = ½ cent (5 tenths or 50 hundredths)
$ .0001 = 1/100th of a cent
Sugar, for example, is quoted in cents. If the price of Sugar today is 7.25 cents per pound = .0725 dollars per pound. We need to convert into dollars.
Silver, for example, is quoted in cents. If the price of Silver is quoted at 975.5 cents per ounce = $9.755 per ounce or nine dollars seventy five cents and ½ cent.
1.5 SPECULATING FUTURES WITH MARGIN - PROBLEMS
INITIAL MARGIN – PERFOMANCE BOND - When dealing with Futures Contracts, the performance bond invested is called Initial Margin. It can be referred to as Original Margin. The Margin occurs at the end of each trading day whenever a new position is entered, long or short, during the trading session.
The exchange sets the Initial Margin.
It varies from Commodity to Commodity
It usually represents 5% of the total value of the Contract
The exchange may raise or lower margin requirements whenever the board of governors deems necessary.
It is retroactive – it goes to all open contracts and new contracts.
It is not a down payment. It is “good faith” money.
A call made to a client requesting Initial Margin money to be deposited to enter a new position, is called Margin Call.
Margin requirements is usually met by cash
When a client use a financial instrument, such as government securities or stock of the clearing corporation, he will pay the determined “hair cut” which is a percentage of 10 to 20 % of the value of his instrument. T-NOTES 80% of the value is released to the client; T-Bones 80% also, and stocks 75%.
When stocks are used for margin, it is called: Taking the Discount. It can only be used for Original or Initial Margin. Not for Maintenance margin, which can only be met in cash.
The individual firm may require more initial margin per contract than the exchange, but never less.
MAITENANCE MARGIN CALL –
If a client had gone “short” gold at a contract price of $850, and at the end of the day the contract was quoted at $860, the account would have an unrealized loss of $10/oz or $ 1000. Even though the client has not actually taken the loss yet, the account will still reflect decrease in equity.
Therefore, at the end of the day, all accounts are “marked-to-market”.
After the account is marked to the Market, each is reviewed for possible maintenance margin calls. If the equity in the account is lower than 75% of the required (original or Initial) margin, the client will be placed on a maintenance margin call.
Once the maintenance call is “triggered”, the client must restore the account to the full original margin.
No money can be taken when the account only has a balance between Maintenance Margin and Initial Margin.
Example:
LONG 1 NOV SILVER @ $7.50
The original Margin is $1,000. The maintenance margin is $750.00
If in the end of a trading day, your account goes to a balance lower than 750.00 a maintenance call will be originated. The silver contract size is 5000 ounces. If the price of silver closed at $7.40 per ounce, the margin call will be for $500. The client would have to send another $500 to bring the account to the original $1000.
The marked cannot take a client off a maintenance call.
If in the end of the day, the client had equity above his initial margin, it is called Excess Margin and the client can use this equity.
The AP, or whoever handles the account is responsible in making the call and collecting the margins.
The equity can also be used to acquire new positions.
If there is equity less than the maintenance level, the client must bring the account to the initial margin. If the equity is in between maintenance and initial, customer cannot take any money out.
LIGHT 7 - The Chicago Board of Trade members only meet the margin call on the NET positions. In other words, if the firm or IB has clients in 100 long gold contracts, and 103 short gold contracts, the firm will only meet margin call for 3 contracts.
LIGHT 8 – The New York Mercantile Exchange (NYMEX), and the Chicago Mercantile Exchange (CME), requires firms to meet margin calls on ALL positions without netting. The client must meet margin calls on ALL positions. There are no lower requirements for bona-fide spreads.
PROBLEMS – SPECULATING FUTURES AND MARGIN
1- Initial Margin on corn is 20 cents per bushel; a client deposits $5,000 in margin and takes a long position in the maximum number of contracts he can at 291 cents per bushel. Contract size is 5000 bushels. What percentage of the market value of the corn is the customer margin?
HINT:
Customer margin = 20 cents per bushel or $.020 per bushel
Market value of the corn = 291 cents = $2.91 per bushel. This problem is paid over maid.
2- Assume a 20c/bu. is the initial margin for soybean futures on the CBOT. Your client goes short 3 soybeans contracts at $9.80 and commissions are $50.00 per round turn. If she covers her position at $9.63, what percentage of profit (after commissions) did she earn on her initial margin deposit?
HINT:
Calculate the gain per bushel using the speculation method. Remember to multiply the profit by the number of bushels in a contract
Remember to deduct commissions and after, that multiply by the number of contracts. Once the profit is calculated, divide by the margin paid in 3 contracts.
You can also do in only one contract – the ratio will be the same. This problem is made over paid.
3- A Client purchases soybean oil at $46.46/cwt. If the minimum margin is $1100 per contract, what percent of total contract value is required margin? (60,000 pounds/contract).
HINT:
Total contract value is the actual price times the contract size. This is the amount in risk. Remember to move the decimals before doing the calculation. Once found the Total contract value, we then take the margin and divide by the total contract value. Here is paid over maid.
4- September British Pounds are quoted at $1.8960 while the carrying charges to the next delivery month are 1.5 cents per month. If initial margin is $1000 and the September contracts declines to $1.8910, what is the percent of initial margin lost on a long position? There are 25,000 British Pounds per contract.
HINT:
We went long and the price declined. We have a loss.
The mention of carrying charges is smoke.
Calculate the loss and multiply by contract size. Find what the client lost, and then divide by the margin paid per contract. Here is made over paid.
5- If March Wheat contracts are sold short at 400 and repurchased at 415, with a round trip commission of $50.00 per contract, the net gain or loss on the transaction is: (5000 bushels)
HINT:
Wheat is sold in dollars. Move decimal that doesn’t appear two places to the left
6- If $3,500 is deposited and a $.20 per bushel margin is required for soybean contracts currently priced at 875, what is the percentage of required margin gained or lost if the price of soybean declines 3%? (5000 bushels)
HINT:
Wheat is sold in dollars. Move decimal that doesn’t appear two places to the left. We only need to calculate how much is 3% of the price and then multiply it by the contract size. Then divide it by the margin price per contract. It is made over paid.
7- A Trader is long one contract of Japanese Yen on the International Monetary Market of the Chicago Mercantile Exchange at .004267. The original margin is $2500 and the trader unwinds her position at .004415; with $60 per trade commission, what is the return on investment? 12,500,000 Yen per contract.
HINT:
Subtract yen values and calculate the profit. Multiply by contract size to get the profit, or your return. Subtract commission and Divide return by investment. Maid over paid
8- A Speculator deposits $2,500 of original margin and then buys one March Treasure Bill at 90.15, what is the ration of margin to total contract value? ($1,000,000)
HINT: 1,000,000 – 225,375 = 774,625
2500 / 774625 =
9- A trader foresees an opportunity in corn and buys a contract at $4.75 which requires a margin of $.30 per bushel; he deposits $3,500. If corn drops 3% in its value, what percent of his original margin is lost?
Hint: Do it like number 6.
10 COMEX Exchange margin is $2000 per contract for gold. The customer decides to sell one call with a strike price of $800 per ounce and the premium of $20 per ounce. The underlying price of the instrument is $790. The Margin requirement is? (Contract size 100 ounces).
HINT: The COMEX requires that the margin for option writing be the futures margin plus the premium received for the sale.
11 -A corn farmer realizes that his local basis is exceptionally strong, providing an excellent opportunity to liquidate his cash crop at a profit. The farmer believes that the price of corn will continue to rise, but that it is better for him to sell his crop and go long on the “board”; therefore he purchases a July corn contract at 341 ¾ c/bu (5000 bu per contract). His purchase required only 25% of his margin deposit of $5,000. Soon after, the corn prices rose to $425c/bu and he decided to liquidate his futures position. What was his profit? What was his return on required margin? If commissions charged were $50.00 per contract, what was his net return?
12- A livestock producer expects to produce 80,000 pounds of fat cattle. He decides to hedge, selling 6 June Live Cattle contracts on the CME (40000 lbs each contract). His Margin is $7,200 and his commission is $50 per contract round turn. If the price of cattle was $76.05 cwt when Joe sold his six contracts, what was his net speculative gain or loss if he liquidated at $71.10cwt?
13- Your client goes long 3 contracts of May Sugar, which was filled at 8.95c per pound. His position is liquidated at 8.60c per pound. What was the total value of one sugar contract when your client bought it? (World Sugar contracts are 112000 lbs.). What was the net gain or loss on the trade, if round turn commissions are $65.
14- A crude Oil speculator is expecting a decline on the price of crude oil. He sells 3 contracts of March Crude at $96.00 /bbl. He then sells 5 additional contracts at $94.00/bbl. He decides after all to purchase 10 contracts at 94.75. He sells 2 contacts at $97.65/bbl (barrel) What is his profit or loss after commissions, if commissions are $60 per round turn? (contract size =1000 barrels or 42000 gallons).
CHAPTER 2
CHAPTER 2
2- Hedging FUTURES –
2.1 – Basic Hedging problems and how to approach
2.2 - Basis calculation Problems
2.3 - Hedging commodity futures – Chapter 4
2.4 - Hedging Financial and Monetary Futures – Chapter 5
Hedging is the purchase or sale of a futures contract in anticipation of a later purchase or sale of the cash commodity. It can also be said that a hedger, in order to avoid price risk, transfer that risk to the speculator.
It is against the regulations to speculate in a hedge account. Hedging reduces working capital requirements.
There are two types of hedgers. Long hedger and short hedger
A Hedger who grows, manufacturers, or has a product in inventory is sometimes referred to as a “producer”. This hedger has it; therefore he is a seller, or short hedger. As a seller of a commodity, he would like to see the price of the commodity increase in so that when the time comes to sell his product, he will sell it at a higher price. The risk is in the possibility that the price will drop. To protect himself against a loss in a down market, the hedger will short the futures by placing a selling hedge.
A Hedger who will need that commodity in the future is sometimes called a “user”. This hedger needs it; therefore he is a buyer, or long hedger. The hedger would like to see the cash price drop, so at the time of purchase, the cost will be less. His risk is the possibility of an increase in price, for it would cause the user to spend more money. To protect against a possibility of an increase in price, the user will buy the futures contract. He will place a long hedge.
Before hedging, both the producer and the user would be at price risk. Once hedged they are at basis risk,
The futures position is also called the hedge or the substitute.
BASIS – Defined as the price difference between the cash commodity and the price of the futures.
Cash – Futures = Basis
When determining the basis, ask yourself where is the cash price in relation to the futures price. Is it under or over and how much. The basis reflects whether the cash is over or under the futures price.
Trends of the basis are: Strengthening, weakening, widening or narrowing
Who usually hedges?
- Importer, exporter, manufacturers
- In currencies to pay out with low value …be paid with something of higher value.
- In Financials to match maturities by hedging long term instruments with short-term instruments and vice-versa.
- When you issue, it means that you are going to sell something and then you invest it means that you are going to buy something. Want the cash price to go down.
HOW TO APPROACH?
1- When doing hedge problems you need to determine your positions in the cash market, futures market, and basis. Place yourself in the trade and ask yourself if you have the product or if you need the product. If I have it I am short the futures. If I need it I am long the futures. The cash and basis are always the same, and they are the opposite of the futures. If you are short the futures, you are therefore long the cash and long the basis. If you are long the futures, you are therefore short the cash and short the basis.
2- The Futures means the Hedge means the Substitute.
3- Start asking yourself what would you do in the future? Buy or sale, and start from here. If you remember that a producer hedge has it, therefore he is Selling or short Hedge (short the futures). When you are selling the futures you are long the basis, and as the basis becomes more positive, more going up, or strengthening you make a profit. You are also long the cash.
When working Hedging problems, we will work with basis calculation, and it is imperative that we learn how to manipulate each problem.
3 100 Thousand $60
# of Contracts Contract size Commission
Cash Futures Basis
S L S
Place
Target or Cash Price - Futures Price = Calculate!
Near date
Lift
Actual Cash Price - Futures Price = Calculate!
Far date
CHANGE Calculate! Calculate! Calculate!
Things you need to know:
1- What is the position of the cash ___ Futures ___ Basis ___
2- What is the contract size __________
3- How many contract should be hedged ______
4- What are the commissions
5- What is the target (buy/sell) price_____ and futures price____
6- What is the actual (buy/sell) price_____ and futures price ____
