Series 3 - Some tips - By Milton Laene Araujo
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.
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. (((time to leave a comment to the author. )))
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 price per metric ton
$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 = .6530 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 ____
Continuation....
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.
If you like it, leave a comment -
Milton Laene Araujo
January 2011
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