CHAPTER 1-
FUTURES TRADING THEORY AND BASIC FUNCTIONS TERMINOGY
You will be tested with 125 questions on these 16 topics.
1- General Theory
2- Cash markets
3- Forwarding Pricing
4- Efficiency
5- Liquidity
6- General Contract Functions
7- Normal and Inverted Market
8- Hedging Theory
9- Short Hedge
10- Long Hedge
11- Speculation Theory
12- General Futures Terminology
13- Cash Transactions
14- Forward Contracts
15- Futures Transactions
16- Options Terminology
17- Discussion Hints.
Let’s now analyze each Topic and possible questions on each topic.
1- GENERAL THEORY
The futures Industry affects the lives of millions of people by touching the food we eat, the clothes we wear, and the material that give us shelter.
With the growth of our population and the need for more food, it was necessary to have more output of food, and it required machineries with the ability to produce more food. Transportation, agricultural storage and efficient distribution were required to keep up with the new productivity.
2- CASH MARKETS
There are two types of 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.
3- FORWARDING PRICING
A risk of price change exists unless goods are sold or consumed immediately. Futures Markets provide a means for determining prices in advance for period of a year or more. Prices are established by the interaction of supply and demand, more specifically, by the bids and offers of buyers and sellers. A farmer or a businessman can secure a price for his needed goods of marketable wares in advance of their availability in the cash markets. Forwarding pricing is also available in forwarding contracts were the terms are negotiated for future delivery. The act of knowing the price of goods in a future time is known as “price discovery”.
4- EFFICIENCY
A Large number of traders gather in the pits, allowing prices to be determined readily. The more people involved, the larger the number of contracts traded, increasing liquidity, and consequently efficiency of the market.
5- LIQUIDITY
This term refers to the ability to move quickly in or out of the market at or near the last purchase price, and it relates to the number of participants in the market. The more liquid the market, the faster and more easily trade can be executed at or near specific prices. Without futures market in which to trade, the prices of commodities would not be determined as efficient, and probably be higher. This efficiency also helps the cash markets because the cash markets can use the more efficient determined futures prices. Another feature of liquidity combined with efficiency is the easy access for anyone who needs to transfer risk, or is willing to accept the risk. There is a readily accessible meeting place in which to do so. For every buyer there is a seller, and vice-versa.
6- GENERAL CONTRACT FUNCTIONS
A future contract is legally enforceable agreement to make delivery or to take delivery of a specific quantity and grade of a particular commodity, or cash during a designated delivery period (the contract month).
It is not necessary to hold the contract until the delivery period. If so, it will be required to make or take delivery. At any time, before the last day of trading for the contract month a contract can be repurchased or resold. The action of repurchasing or reselling a trader’s initial position offsets his initial position and frees the trader from any further obligation under the contract. It is fair to say that nearly 97% of all futures positions are liquidated before it expires and there is not delivery. The ability to deliver helps maintain the economic relationship between cash and futures prices.
The central theme of commodity futures markets is standardization. Contracts are standardized with regard to commodity, quantity, quality (grade), and point of delivery.
People that take delivery or make delivery are called user or producers. We refer to them as hedgers. These people do not like to take the risk of a price fluctuation. They try to lock in a price today for a merchandized that will be delivered in the future. Those who bid on price fluctuation are called speculators. Speculators are willing to accept the risk.
Risk transfer is facilitated because each contract for a particular commodity in a particular delivery month is identical in all of its terms with every other contract for that commodity and that delivery month. These parameters are interchangeable – another name for it is: fungible.
7- NORMAL AND INVERTED MARKET
Cash prices and future prices tend to move in tandem. The deferred futures prices are usually higher than the near cash price for non-financial contracts.
Normal market is associated with holding the commodity until the contract goes into delivery. The costs to hold these commodities are called “carrying charges or cost to carry”.
NORMAL MARKET – When cash prices of commodities are lower than futures prices.
Another name for normal market is Premium Market. Futures have a premium above cash prices. Futures price is higher.
INVERTED MARKET – When cash prices of commodities are higher than futures prices.
Another name for inverted market is Discount Market. Discount on futures prices from cash prices. Cash price is higher.
NORMAL MARKET BRINGS A DISCOUNT BASIS
INVERTED MARKET BRINGS A PREMIUM BASIS
Inverted Market is caused by tight supply, high demand or an expected surplus. These circumstances cause current price to be higher than deferred prices.
Usually, the cash and futures prices move in the same direction by approximately the same amounts, making possible to hedge a position in the cash market by taking an opposite position in the futures market.
8- HEDGING THEORY
Hedging is the transfer of risk from one party to another.
The hedger reduces his price risk and assumes basis risk.
Basis is less volatile than prices, therefore the hedgers effectively reduces his overall risks.
Basis is the difference between cash and futures prices. (CASH –FUTURES=BASIS)
A hedge position in futures may not give full protection against an adverse price movement because of changes in the basis.
9 - SHORT HEDGE
Selling short is the sale of a contract with the promise to deliver the commodity or repurchase the contract at a future time.
An individual who produces or someone with an inventory who has or will have the commodity for sale in the future enter into the market now, trying to transfer the risk of a price change by selling short that commodity now in the futures market, with today’s price. Once he entered into the market he has two positions: A long cash position (the commodity he is holding) and a short futures position.
A short hedger promise to deliver goods in the near future, therefore he either delivers goods, or buys back his contract. It is fair to say that a person who goes short the market wants the price to decline, after he had entered. He sold today something for a price, and in three months he has to buy it back to get out of his obligation, and keep his profit from the hedging.
Another name for short hedge is: Substitute sale:
10 – LONG HEDGE
Buying long is the purchase of a futures contract with the promise to take delivery of the commodity or resell the contract at a future date.
An individual who processes goods that others produce, or an individual who uses it or a merchant who buys it to sale later for profit are example of long hedgers.
A person who goes long the market wants the price to go up.
Another name for long hedge is: Substitute purchase
When hedging we take two positions. We are either are long the futures or we are short the futures. These positions require that we do the opposite with the cash position. The base takes the same position as the cash position.
A long hedger is long the futures market, short the cash and short the basis.
11- SPECULATION THEORY
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.
Prices change for a reason, and knowledge of factors affecting the market enables speculators to forecast price movements. This knowledge is one factor separating speculators from gamblers.
12- GENERAL FUTURES TERMINOLOGY
Let’s compare: FUTURES CONTRACTS WITH:
13- CASH TRANSACTIONS: buyer and seller exchange goods for cash.
14- FORWARD CONTRACTS: is the same as cash forward sales or cash forward purchases. The execution will be carried sometime in the future. The terms are negotiated between buyer and seller. It is more difficult to do, for you need to know the seller. Hard to get out, for you need to find a buyer that you know. It can be done with a contract specifying grades etc.
15- FUTURES TRANSACTIONS: Is the terms of a futures contract and they are established by the exchange and are known to all. This facilitates trade because the exchange stands behind each contract. Because all contracts are fungible (identical), it is possible to offset (sell or buy back) a previously established position. To offset a long future contract, you sell the same contract. To offset a short future contract, you buy the same future contract
When futures prices call for execution, prices converge, meaning that the futures price will be equal to cash prices. It happens near expiration.
IN SUMMARY: Cash forward contracts and futures contracts differ in that:
A- Futures terms are standardized – Cash Forward terms are negotiated
B- Futures positions are easily offset – Cash Forward terms are decided before and may be impossible to cancel.
C- Futures are traded in exchanges and subject to Federal regulation – Forward Contracts are not
D- Open outcry or competitive bidding determines futures prices – Forward price are negotiated between a buyer and a seller.
16- OPTIONS TERMINOLOGY
Long a Call – The option purchaser has the right to buy the underlying futures contract at the same strike price as his call, within a certain period of time.
Long a Put – The option purchaser has the right to sell the underlying futures contract at the same strike price as his put, within a certain period of time
To better understand long and short calls and puts, let’s use some symbols to refer to them in relation to the markets.
A Long – -Takes an arrow up – We will say he wants the markets to go up.
A Call – - Takes an arrow up – We will say he wants the markets to go up.
When we have arrows in the same direction going up for an option, we will say that it is bullish, and the client upon exercise of his option will obtain a Long futures position.
A Short – -Takes an arrow down – We will say he profits if markets go down.
A Put - -Takes an arrow down – We will say he profits if markets go down.
When we have arrows in the same direction, even going down, we will say that it is bullish, and the client upon being exercised by the long will obtain a Long futures position.
Long a call – - Bullish – Have the choice of exercising – receiving a Long Futures Position.
Long a put - - Bearish – Have a choice of exercising – receiving a Short Futures Position
Short a call - - Bearish – If exercised upon – Receives a Short Futures Position
Short a put - - Bullish – If exercised upon – Receives a Long futures position
When dealing with options being exercised is important to remember these arrows to find out whether it is bullish or bearish. Bullish takes a long futures Position while Bearish takes a short futures position.
A client, who purchases an option contract, pays for the premium
A client, who sells an option contract, receives the premium from the buyer.
By receiving the premium, a seller (short) is obligated to purchase a future contract.
In other words, the seller is taking the premium home. His only choice here is to buy back an exact option contract like his, to offset his position. This will happen faster if prices go down. If so, he will get the same contract cheaper and keep the profit.
Now, if markets go up, the Long will exercise his right of exchanging his contract for a futures contract, putting the seller into a harder situation and unlimited risk.
By paying the premium, a buyer has 3 choices. Let his contract expire, sell his contract to offset his position or exercise his right of exchanging his contract to a futures contract. Once he exercises, the seller is obligated to take the opposite position in the futures, which will bring more profit to the buyer than to the seller. Long only exercise if the market go on their direction.
When comparing Options and Futures is important to know:
- Standardization is a benefit for both futures and options on futures.
- Margin must be deposited for futures – When dealing with options, margin is required only when an option is sold. Short a call requires margin. Margin is required for the writer because he may be exercised by the longer and may have to deliver the underlying futures position.
- Margin is not required to buy an option
- The option is purchased for a premium
- The premium of an option is the value in which the option will be sold, and it fluctuates as supply and demand interacts.
- The risk involved when buying an option is the premium paid.
When you buy an option, your risk is only the premium paid. Even when you buy a put, which will give you a short future position if you exercise, we know that you would only exercise if you were deep in the money.
As an example: If you go long a put. Although, in futures we learned that if we go long we want the market to go up, it doesn’t apply in options alone. In options when we go long it just mean that we purchased the contract and that we have the right to exercise it because we paid the premium. The “call or put” is what decides how we like the market to behave.
Put me DOWN – Puts wants the market to go down. Be it long or short
Call me UP – Calls want the market to go up. Be it long or short.
This theory is to be used during the duration of an option contract. If the position was liquidated, we then calculate profit or loss.
The buyer of a put has the right to sell his contract at a specific price within a certain period of time. He will sell if prices go on his direction. If not, he lets it expire and loses only his premium.
Buyer of a put – Maximum he can lose is the premium, for he decides whether to let expire or to sell. If prices go down, he will be deep in the money, and he will exercise it, obtaining then a short future position, which will allow him to make more money in the futures. If he sold it, he will cease his obligation without receiving a futures position. This is one of the rights of a buyer of an option. He can sell it, let it expire or exercise.
Lets analyze each one with a simple example:
Long a Put – wanting prices to go down
A costumer buying 800 June COMEX gold futures put. We rewrite this way:
Long 1 800 June COMEX Gold put @ 50.00
Long – He is the buyer, therefore he has the right to sell it, let it expire or to exercise.
1 – Number of contracts – Gold contract size is 100 oz.
800 – The same as $800, which is the strike price of the option.
Gold –The commodity of the underlying future contract of this option.
Put – The right to sell it – Wants price to go down PUT ME DOWN
$50.00 – The premium paid to the seller.
Now, let see with a current market value of gold today:
CMV = $730 per oz.
Client long call exercised: He received a Short Futures contract – Now he exchange his option contract for a similar Futures Contract that will read:
Short 1 COMEX June Gold @ 800
Now that he is short the futures – He wants price to go down, and the price is exactly 730.00. Now he became a seller of a futures contract, and he thinks that this profit is good enough, and decides to off set his short position by purchasing the same contract with the strike price of 800, when the market price is 730.
He then went Long 1 COMEX June Gold @ 730 offsetting his position and making the profit of $70.00 per oz. gross.
In dollars it would be $7,000.
If while being short, he still thinks that the gold would go down even further, he could continue with his contract open and receiving $100 dollars for each time the gold would go down one dollar per oz. When to get out of the market is the job of the AP who will be watching the futures market behavior to get out on the right time.
Long a Call wants price to go up
Long 1 800 June COMEX Gold call @ 20.00
Long – He is the buyer, therefore he has the right to sell it, let it expire or to exercise.
1 – Number of contracts – Gold contract size is 100 oz.
800 – The same as $800, which is the strike price of the option.
Gold –The commodity of the underlying future contract of this option.
Call – The right to buy the futures contract – Wants price to go up – CALL ME UP
$50.00 – The premium paid to the seller.
Current Market Value = $730.00
When he purchased he thought the market had found a bottom, and was going up more than 900 for him to sell it. However, the market went against him. Because he purchased it and paid the premium he has 3 choices. The first is to let it expire and lose only the premium, regardless of the market movement. The second it to sell his option for a lesser price, for the premium for an option so out of the money is lower than what he paid. That is not necessary. The other is to exercise, but he doesn’t want to get a Long futures position and be losing much more money than the premium. So he will let it expire and lose his premium of $50.00 per oz.
100 oz X $20 = $2,000
We go long a call when we think the market value of the underlying futures contract is going to increase. If we are wrong our loss is limited to the premium paid.
If they increase, we can exercise and get into futures without paying any margin. Once in futures, chances are the writer will offset and cut his losses.
Short a Put = wanting futures prices to go up
We refer to futures prices – the price of the underlying commodity when the contract was exercised. If it was exercised. As far as the option, the put wants the price to go down to get out by buying the same contract strike price for the current market value.
A costumer selling a 800 June COMEX gold futures put. We rewrite this way:
Short 1 800 June COMEX Gold put @ 50.00
Short – He is the seller, therefore he has the obligation to deliver if exercised upon.
1 – Number of contracts – Gold contract size is 100 oz.
800 – The same as $800, which is the strike price of the option.
Gold –The commodity of the underlying future contract of this option.
Put – The right to sell it – Wants price to go down – PUT ME DOWN
$50.00 – The premium received from the buyer.
Now, let see with a current market value of gold today:
CMV = $730 per oz. – The short can buy it back and keep the premium and eliminate the contract.
Long client will let the option expire. He loses the premium
If prices had increased, instead of gone down, then the buyer of a put would exercise and the short put had to get out immediately.
We go short a put when we think the market will go down. Although we make money immediately if the option value decreases, Ultimately, if we are exercised upon we want the market to go up.
The goal of a short put is to see the price stay the same forever or going up.
Going short a put – Maximum gain = Premium
Risk – Unlimited
Short a Call – call wanting futures prices to go down = opposite arrows
A costumer selling a 800 June COMEX gold futures call. We rewrite this way:
Short 1 800 June COMEX Gold call @ 50.00
Short – He is the seller, therefore he has the obligation to deliver if exercised upon.
1 – Number of contracts – Gold contract size is 100 oz.
800 – The same as $800, which is the strike price of the option.
Gold –The commodity of the underlying future contract of this option.
Call – The right to buy it – Wants price to go up or stay flat. CALL ME UP
$50.00 – The premium received from the buyer.
Now, let see with a current market value of gold today:
CMV = $830 per oz.
In this case the long will let it expire and lose his premium only.
The short call gets his maximum profit – the premium already received.
If prices had increased, instead of gone down, the long would have exercised.
The seller of a call, when exercised by the long, will deliver a Long Futures to the call holder at the strike price (price written in the option contract, and not the current market value), thereby establishing a short futures position in his own account.
The short call, which now has obtained a short futures position may lose all his money if prices keep going up. He sold a call
The call holder now is long futures or offsets an existing short.
SHORT A CALL - wants the price to stay flat or to go down. Although it is a call, the seller intentions is to keep the premium, and the only way for him to keep the premium is to see the market going down for the holder to let it expire. This is when in futures. If it is an option, call wants price up to get out of the obligation.
We go short a call when we forecast the market staying flat or going ultimately down.
Going short a call – Maximum gain = Premium
Risk – Unlimited
RISK - The unlimited risk with options exists when we short a call or short a put. So, selling an option without being covered with the futures can be extremely risky. This action of selling an option without any coverage is called naked option.
When you go long with options you risk only the premium.
Summary:
Long Options – The owner of an option has a long position. He paid money (the premium) for the right specified in the option contract. The CFTC requires options buyers to pay full premium when the option position initiated.
- The owner of a call has the right to buy the underlying futures contract at the specified strike price any time up to expiration date.
- The owner of a put has the right to sell the futures contract at the specified strike price until the expiration date.
Short Options
- The seller of an option has a short position. He receives money (premium) to take on the obligation specified in the option contract.
- The seller of a call is obligated to sell the underlying futures position contract at the specified strike price to the holder of the call if the option is exercised by its expiration date. For promising fulfillment under contract provisions, the writer receives the premium.
- The seller of a put is obligated to buy the futures contract at the strike price any time through the expiration date if the put owner exercised the option. For agreeing to the contract terms, the put writer receives the premium.
INFORMATION FOR THIS CHAPTER:
1- Futures Market provides forwarding pricing, attract speculators, Assemble, standardize, and grade commodities.
2- Hedgers primary motive is to cut costs.
3- Offsetting a futures contract doesn’t require deliver, in fact almost 97% of all contracts do not end with a deliver.
4- Only when delivery takes place that the title of a commodity is transferred.
5- Without futures markets prices would probably be higher.
6- Speculator is a person who subjects himself into price fluctuations by buying or selling economic goods.
7- To hedge against something, means to go with the flow. Hedge against rising price we go along with the profit that we get when prices rise. We go long futures.
8- Hedging is the act of selling futures against an insured crop.
9- A Long hedge does a substitute purchase while the short hedge does a substitute sale.
10- Another difference between cash and futures Markets lies on inspections procedures, commodity grade and ability to offset before delivery.
11- Speculators besides assuming the risk provided by the hedgers they provide liquidity.
12- There are two types of options contracts. Call Option and Put Option. A Call option gives the purchaser of that option the right to purchase the underlying futures contract that accompanies an option. A Put option gives the purchaser of that option the right to sell the underlying asset within a certain time period at a specified price.
13- Speculators besides liquidity offer volume to the market. More contracts being exchanged when they are involved. Without volume, a contract’s price will tend to display increased volatility.
14- Forward contracts are different from futures contract because forward contracts are non-standard, non-regulated and non-competitive.
15- We go short a futures contract when we think the price of that commodity is going to decline. Our protection against a price decline is to go along with the decline (flow), and profit from it. So, in a declining market one goes short.
16- Short hedgers plans on selling his product on a future date.
17- Short the basis means that we do not have the physical commodity, but will need to buy in the future.
18- A Long put option position has the right to sell the underlying asset at a specified price during a certain time period. A long put is the option purchaser, and if he exercises, he receives a short futures position at the strike price of the option, and not the current market value.
19- A speculator sells a call when he expects prices to decline, and if they do, he keeps the premium.
20- Option contract is a wasting asset because the premium deteriorates as times passes. Futures contracts’ margin deteriorates as well, if prices go against you. In a flat market a call seller will keep the premium he received from the call holder. Both futures and options have limited duration.
CALL PUT
Buy / Sell Buy / Sell
Buy a call: Think the market will go up
Sell a Call: Think the market will stay flat or go down
Buy a put: Think the market will go down
Sell a put: Think the market will stay flat or go up
21- A Long futures put position has the right, not the obligation to sell a futures contract.
End of this chapter.
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Milton Laene Araujo
January 2011
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