Opportuity AND Risk A Educatioal Guide to Tradig Futures ad Optios o Futures
Natioal Futures Associatio is a cogressioally authorized self-regulatory orgaizatio of the Uited States futures idustry. Its missio is to provide iovative regulatory programs ad services that protect ivestors ad esure market itegrity. NFA has prepared this book as part of its cotiuig public educatio efforts to provide iformatio to potetial ivestors. The booklet provides a ecessary overview of the opportuities ad risks i tradig futures ad optios o futures by presetig importat iformatio that ivestors eed to kow before they ivest. Opportuity AND Risk PUBLISHER Natioal Futures Associatio 300 South Riverside Plaza, Suite 1800 Chicago, IL 60606 800-621-3570 www.fa.futures.org DESIGN Lez Desig Chicago, Illiois www.lezdesig.com ILLUSTRATION Philip Nicholso Varberg, Swede www.illustratios.se A Educatioal Guide to Tradig Futures ad Optios o Futures 2006 Natioal Futures Associatio All Rights Reserved. No part of this book may be reproduced, stored, or trasmitted by ay meas, icludig electroic, mechaical, photocopyig, recordig, or otherwise, without writte permissio from Natioal Futures Associatio. The publicatio is desiged to provide accurate ad authoritative iformatio i regard to the subject matter covered. While great care was take i the preparatio of this book, Natioal Futures Associatio disclaims ay legal resposibility for ay errors or omissios ad disclaims ay liability for losses or damages icurred through the use of the iformatio i the book. If legal advice, fiacial advice, or other expert assistace is required, the services of a competet professioal perso should be sought.
Opportuity AND Risk Itroductio............................................... 6 How the Markets are Regulated............................ 10 Coductig Busiess with a Registered Firm.................. 12 Itroductio to Futures Tradig............................ 14 Futures Cotracts........................................ 14 How Prices are Quoted.................................... 16 The Market Participats................................... 17 Hedgers............................................ 17 Speculators......................................... 19 The Process of Price Discovery.............................. 20 Miimum Price Chages.............................. 21 Daily Price Limits.................................... 21 Positio Limits...................................... 22 Daily Close............................................. 23 The Arithmetic of Futures Tradig.......................... 24 Leverage........................................... 24 Margis............................................ 27 Basic Tradig Strategies................................... 30 Buyig (Goig Log) to Profit from a Expected Price Icrease.... 30 Sellig (Goig Short) to Profit from a Expected Price Decrease.... 32 Spreads............................................ 34 Stop Orders......................................... 36 How to Participate i Futures Tradig...................... 38 Trade Your Ow Accout..................................40 Have Someoe Maage Your Accout........................42 Use a Commodity Tradig Advisor..........................44 Participate i a Commodity Pool...........................46 Establishig a Accout...................................50 Itroductio to Optios o Futures.........................52 The Arithmetic of Optio Premiums.........................54 Itrisic Value......................................54 Time Value.........................................55 Uderstadig Optios Trasactio Fees.....................56 Leverage...........................................58 Calculatig the Break-Eve Price.......................58 Factors Affectig the Choice of a Optio................62 After You Buy a Optio..................................64 Offset the Optio....................................64 Cotiue to Hold the Optio...........................66 Exercise the Optio..................................66 Who Writes Optios ad Why...............................68 If a Dispute Should Arise...................................72 Glossary of Terms.........................................75 Additioal Resources......................................93 4 5
Itroductio Itroductio mortgage bakers bod dealers For early a cetury ad a half, futures markets have fulfilled a importat ecoomic fuctio: providig a efficiet ad effective mechaism for the maagemet of price risks. Begiig with agricultural futures cotracts traded o the Chicago Board of Trade i 1865, the U.S. futures markets ow list a everexpadig umber of istrumets, icludig metals, eergy, fiacial istrumets, foreig currecies, stock idexes, predictio markets ad evet futures. Additioally, the idustry itroduced tradig i optios o futures cotracts i 1982. 6 Just as the types of istrumets traded o futures exchages have evolved, so has the method of tradig those istrumets. Util the 1990s, futures tradig was coducted primarily o the floor of the exchages.traders crowded ito tradig pits or rigs, shoutig ad sigalig bids ad offers to each other. This type of tradig, kow as ope-outcry, resulted i competitive, orgaized price discovery. I the 1990s, exchages itroduced electroic tradig o certai cotracts durig offexchage hours. Sice the, electroic tradig has expaded to iclude side-by-side ope outcry ad electroic tradig, as well as cotracts that are exclusively traded electroically. Futures tradig has truly become a 24 hours a day, seve days a week fiacial marketplace. Participats i today s futures markets iclude mortgage bakers as well as farmers, bod dealers ledig istitutios as well as grai merchats, ledig istitutios ad idividual speculators. By buyig or sellig futures cotracts cotracts that establish a price level ow for items to be delivered later idividuals ad busiesses seek to achieve what amouts to isurace agaist adverse price chages.this is called hedgig. Other futures market participats are speculative ivestors who accept the price risks that idividual ivestors grai merchats farmers Who Trades? hedgers seek to avoid. Most speculators have o itetio of makig or takig delivery of the commodity. They seek istead to profit from a chage i the price. That is, they buy whe they aticipate risig prices ad sell whe they aticipate decliig prices. The iteractio of hedgers ad speculators helps to provide active, liquid ad competitive markets. 7
Itroductio Speculative participatio i futures tradig has become icreasigly widespread with the availability of alterative methods of participatio. Whereas may futures traders cotiue to prefer to make their ow tradig decisios such as what to buy ad sell ad whe to buy ad sell others choose to utilize the services of a professioal tradig advisor, or to avoid day-to-day tradig resposibilities by establishig a fully maaged tradig accout or participatig i a commodity pool which is similar i cocept to a mutual fud. For those idividuals who fully uderstad ad ca afford the risks which are ivolved, the allocatio of some portio of their capital to futures tradig ca provide a meas of achievig greater diversificatio ad a potetially higher overall rate of retur o their ivestmets. There are also a umber of ways i which futures ca be used i combiatio with stocks, bods ad other ivestmets. Speculatio i futures cotracts, however, is clearly ot appropriate for everyoe. Just as it is possible to realize substatial profits i a short period of time, it is also possible to icur substatial losses i a short period of time. The possibility of large profits or losses i relatio to the iitial commitmet of capital stems pricipally from the fact that futures tradig is a highly leveraged form of speculatio. Oly a relatively small amout of moey is required to cotrol assets havig a much greater value.as we will discuss ad illustrate, the leverage of futures tradig ca work for you whe prices move i the directio you aticipate or agaist you whe prices move i the opposite directio. The pages which follow are iteded to help provide you with the kids of iformatio you should obtai ad the questios you should seek aswers to before makig ay decisio to trade futures ad/or optios o futures. Topics covered iclude: The regulatory structure of the futures idustry How to coduct a backgroud check of a futures firm How futures cotracts are traded The costs of tradig How gais ad losses are realized How optios o futures are traded How to resolve futures-related disputes We have also icluded a Glossary at the back of this Guide for easy referece.i fact, we suggest that you become familiar with some of the terms icluded i the Glossary before cotiuig. It is ot the purpose of this Guide to suggest that you should or should ot participate i futures ad/or optios o futures tradig.that is a decisio you should make oly after cosultatio with your broker or fiacial advisor ad i light of your ow fiacial situatio ad objectives. Fially, this Guide focuses primarily o exchage-traded futures ad optios o futures cotracts. For iformatio regardig off-exchage foreig currecy (forex) futures ad optios, cosult the NFA brochure Tradig i the Off- Exchage Foreig Currecy Market: What Ivestors Need to Kow. The brochure is available free of charge o NFA s Web site (www.fa.futures.org). 8 9
How the Markets are Regulated How the Markets are Regulated NFA CFTC Exchages The U.S. futures idustry has experieced uprecedeted growth i tradig volume over the past several years, reflectig the high level of trust ad cofidece that customers have i the marketplace. This cofidece is due i part to a strog, effective regulatory structure that safeguards market itegrity ad protects ivestors. This regulatory structure has three mai compoets. The Commodity Futures Tradig Commissio (CFTC). I 1974 Cogress established the CFTC, a federal regulatory agecy with jurisdictio over futures tradig. The eforcemet powers of the CFTC are similar to those of other major federal regulatory agecies, icludig the power to seek crimial prosecutio by the Departmet of Justice where circumstaces warrat such actio. Natioal Futures Associatio (NFA). The same legislatio authorized the creatio of registered futures associatios, givig the futures idustry the opportuity to create a atiowide self-regulatory orgaizatio. NFA is the idustrywide, self-regulatory orgaizatio for the U.S. futures idustry. NFA s missio is to develop rules, programs ad services that safeguard market itegrity, protect ivestors ad help its Members meet their regulatory resposibilities. Firms ad idividuals that violate NFA rules of professioal ethics ad coduct or The CFTC provides govermet oversight for the etire futures idustry. All U.S. futures Exchages operate as self-regulatory orgaizatios, goverig their floor brokers, traders ad member firms. Ad NFA regulates every firm or idividual who coducts futures tradig busiess with public customers. that fail to comply with fiacial ad record-keepig requiremets ca, if circumstaces warrat, be permaetly barred from egagig i ay futures-related busiess with the public. Regulatory Relatioships U.S. futures exchages ad clearig orgaizatios. Futures Commissio Merchats (FCMs) which are members of a exchage are subject to ot oly CFTC ad NFA regulatio but also to regulatio by the exchages ad clearig orgaizatios of which they are members. Exchage ad clearig corporatio staffs are resposible, subject to CFTC oversight, for moitorig the busiess coduct ad fiacial resposibility of their member firms. Violatios of exchage rules ca result i substatial fies, suspesio or revocatio of tradig privileges, ad loss of exchage or clearig corporatio membership. Although the various regulatory orgaizatios i the futures idustry have their ow specific areas of authority, together they form a regulatory partership that oversees all idustry participats. 10 11
How the Markets are Regulated Coductig Busiess with a Registered Firm Membership i NFA is madatory, assurig that everyoe coductig busiess with the public o the U.S. futures exchages more tha 4,000 firms ad 55,000 associates must adhere to the same high stadards of professioal coduct. You ca quickly verify whether a particular firm or perso is curretly registered with the CFTC ad is a NFA Member through NFA s Backgroud Affiliatio Status Iformatio Ceter (BASIC), foud o NFA s Web site (www.fa.futures.org). 12 BASIC cotais curret ad historical registratio iformatio cocerig all curret ad former CFTC registrats, icludig ame, busiess address ad registratio history i the futures idustry. BASIC also cotais iformatio cocerig discipliary actios take by NFA, the CFTC ad all the U.S. futures exchages. If you are researchig a firm, you should also coduct a backgroud check of all the idividuals listed as pricipals of the firm, as well as the firm s salespeople. A BASIC backgroud check will tell everythig you eed to kow about the status of your fiacial firm or advisor (www.fa.futures.org). Sometimes the firm will have o discipliary history, but oe or more of the pricipals or salespeople may have bee disciplied while workig at other firms. I additio, BASIC gives you details cocerig NFA arbitratio matters ivolvig disputes betwee ivestors ad NFA Members if the case wet to hearig ad a award was issued after Jauary 1, 1990. You will also fid summary data cocerig the umber of cases filed by ivestors agaist registered firms ad idividuals with the CFTC reparatios program. 13
Itroductio to Futures Tradig Itroductio to Futures Tradig Futures Cotracts A futures cotract is a legally bidig agreemet to buy or sell a commodity or fiacial istrumet at a later date. Futures cotracts are stadardized accordig to the quality, quatity ad delivery time ad locatio for each commodity. The oly variable is price. There are two types of futures cotracts, those that provide for physical delivery of a particular commodity or item ad those which call for a cash settlemet. The moth durig which delivery or settlemet is to occur is specified. For example,a July futures cotract is oe providig for delivery or settlemet i July. It should be oted that eve i the case of delivery-type futures cotracts very few actually result i delivery. Not may speculators have the desire to take or make delivery of 5,000 bushels of wheat or 112,000 pouds of sugar. Rather, the vast majority of speculators i futures markets choose to realize their gais or losses by buyig or sellig offsettig futures cotracts prior to the delivery date. Sellig a cotract that was previously purchased liquidates a futures positio i exactly the same way, for example, that sellig 100 shares of IBM stock liquidates a earlier purchase of 100 shares of IBM stock. Similarly, a futures cotract that was iitially sold ca be liquidated by a offsettig purchase. I either case, the resultig gai or loss is the differece betwee the buyig price ad the sellig price less trasactio costs (commissios ad fees). Sice delivery o futures cotracts is the exceptio rather tha the rule, why do most cotracts eve have a delivery provisio? There are two reasos. Oe is that it offers buyers ad sellers the opportuity to take or make delivery of the physical commodity if they so choose. More importatly, however, the fact that buyers ad sellers ca take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the cotract expires i.e., that futures ad cash prices will evetually coverge. It is covergece that makes hedgig a effective way to obtai protectio agaist a adverse price movemet i the cash market. Cash settlemet futures cotracts are precisely that, cotracts which are settled i cash rather tha by delivery at the time the cotract expires. Stock idex futures cotracts, for example, are settled i cash o the basis of the idex umber used for the fial settlemet. There is o provisio for delivery of the shares of stock that make up the various idexes. That would be impractical. With a cash settlemet cotract, covergece is automatic. Futures prices are established through competitive biddig ad are immediately ad cotiuously relayed aroud the world by wire ad satellite. A farmer i Nebraska, a merchat i Amsterdam, a importer i Tokyo ad a speculator i Ohio have simultaeous access to the latest market-derived price quotatios. Ad, should they choose, they ca establish a price level for future delivery or for speculative purposes simply by havig their broker buy or sell the appropriate cotracts. 14 15
Itroductio to Futures Tradig 16 FUTURES Future AGRICULTURAL Cor Soybeas Soybea Meal Soybea Oil Wheat Witer Wheat Oats Rough Rice Moetary uits per Exchage quatity CBT CBT CBT CBT CBT KC CBT CBT / bushel / bushel $ / to / lb / bushel / bushel / bushel $ / CWT Lifetime High Low Date Ope High Low Settle Chage 302 ¾ 736 227.00 26.57 418 ¼ 474 ½ 270 ½ 9.210 217 ¼ 485 158.70 19.61 268 ¾ 342 133 ¼ 6.900 Jul 06 Jul 06 Jul 06 Jul 06 Jul 06 Jul 06 Jul 06 Jul 06 238 ¼ 606 180.00 25.10 384 ¾ 468 ½ 189 8.460 243 612 181.50 25.35 389 ½ 472 ½ 190 ¼ 8.560 238 ¼ 604 ¾ 178.20 25.01 383 ½ 465 187 ½ 8.450 How Prices are Quoted Futures prices are usually quoted the same way prices are quoted i the uderlyig cash market. That is, i dollars, cets, ad sometimes fractios of a cet, per bushel, poud or ouce; also i dollars, cets ad icremets of a cet for foreig 240 606 178.80 25.28 384 ½ 465 ¼ 189 8.545 + 2 + 1 ½ --.70 +.20 -- ¼ -- 2 ¾ -- ¼ +.085 Ope Iterest 576,182 225,894 93,312 162,452 240,326 83,750 8,505 5,695 Crude Oil $80 I ewspaper fiacial sectios currecies; ad i poits ad percetages of a poit for fiacial istrumets. Cash settled idex cotract prices are quoted i terms of a idex umber, usually stated to two decimal poits. Be certai you uderstad the price quotatio system for the particular futures cotract you are cosiderig. O fiacial services websites SOYBEANS Delayed Futures -09:20 - Moday, 8 May ( Go to Daily ) ( Profile ) (Click o Cotract for Chart) Cotract Last Chage Ope High Low Prev. Stl. Time May 06 (SK06) 594-4 +3-6 597-0 601-4 593-0 590-6 05/05/06 Jul 06 (SN06) 606-4 +2-6 609-4 614-4 605-0 603-6 05/05/06 Aug 06 (SQ06) 612-0 +3-0 615-0 619-0 611-0 609-0 05/05/06 Sep 06 (SU06) 615-4 +2-2 620-0 622-0 614-0 613-2 05/05/06 Nov 06 (SX06) 625-2 +3-0 627-4 631-0 623-4 622-2 05/05/06 Ja 07 (SF07) 632-2 +3-0 636-0 636-0 632-0 629-2 05/05/06 Mar 07 (SH07) 639-0 +4-0 641-0 644-0 636-0 635-0 05/05/06 May 07 (SK07) 640-0 +3-0 641-0 643-0 638-0 637-0 05/05/06 Jul 07 (SN07) 643-0 +3-0 645-0 647-0 643-0 640-0 05/05/06 70 60 50 The Market Participats Should you at some time decide to trade i futures cotracts, either for speculatio or i coectio with a risk maagemet strategy, your orders to buy or sell will be commuicated from the brokerage office you use to the appropriate tradig pit or electroic tradig platform for executio.if you are a buyer, your order will seek a seller at the lowest available price. If you are a seller, your order will seek a buyer at the highest available price. Market fluctuatio is a process of fidig fair prices for both buyers ad sellers. I either case, the perso who takes the opposite side of your trade may be or may represet someoe who is a commercial hedger or perhaps someoe who is a public speculator. Or, quite possibly, the other party may be a idepedet trader. I becomig acquaited with futures markets, you should have at least a geeral uderstadig of who these various market participats are, what they are doig ad why. Hedgers The details of hedgig ca be somewhat complex but the priciple is simple. Hedgers are idividuals ad firms that make purchases ad sales i the futures market for the purpose of establishig a kow price level weeks or moths i advace for somethig they later ited to buy or sell i the cash market (such as at a grai 17
Itroductio to Futures Tradig elevator or i the bod market). I this way they attempt to protect themselves agaist the risk of a ufavorable price chage i the iterim. Cosider this example: A jewelry maufacturer will eed to buy additioal gold from his supplier i six moths. Betwee ow ad the, however, he fears the price of gold may icrease. That could be a problem because he has already published his catalog for the year ahead. To lock i the price level at which gold is presetly beig quoted for delivery i six moths, he buys a futures cotract at a price of $550 a ouce. If, six moths later, the cash market price of gold has rise, he will have to pay his supplier that icreased amout to acquire gold. However, the extra cost may be offset by a correspodig profit whe the futures cotract bought at $550 is sold for $570. I effect, the hedge provided isurace agaist a icrease i the price of gold. It locked i a et cost, regardless of what happeed to the cash market price of gold. Had the price of gold declied istead of rise, he would have icurred a loss o his futures positio, but this would have bee offset by the lower cost of acquirig gold i the cash market. The umber ad variety of hedgig possibilities are practically limitless. A cattle feeder ca hedge agaist a declie i livestock prices ad a meat packer or supermarket chai ca hedge agaist a icrease i livestock prices. Borrowers ca hedge agaist higher iterest rates, ad leders agaist lower iterest rates.i additio, ivestors ca hedge agaist a declie i stock prices. Whatever the hedgig strategy, the commo deomiator is that hedgers willigly give up the opportuity to beefit from favorable price chages i order to achieve protectio agaist ufavorable price chages. Speculators Were you to speculate i futures cotracts, the perso takig the opposite side of your trade o ay give occasio could be a hedger or it might well be a speculator someoe whose opiio about the probable directio of prices may differ from your ow. The arithmetic of speculatio i futures cotracts icludig the opportuities it offers ad the risks it ivolves will be discussed i detail later o. For ow, just kow that speculators are idividuals ad firms who seek to profit from aticipated icreases or decreases i futures prices. I so doig, they help provide the risk capital eeded to facilitate hedgig. Someoe who expects a futures price to icrease would purchase futures cotracts i the hope of later beig able to sell them at a higher price. This is kow as goig log. Coversely, someoe who expects a futures price to declie would sell futures cotracts i the hope of later beig able to buy back idetical ad offsettig cotracts at a lower price. The practice of sellig futures cotracts i aticipatio of lower prices is kow as goig short. Oe of the uique features of futures tradig is that oe ca iitiate a trasactio with a sale as well as with a purchase. 18 19
Itroductio to Futures Tradig Futures prices icrease ad decrease largely because of the myriad factors that ifluece buyers ad sellers judgmets about what a particular product will be worth at a give time i the future (aywhere from less tha a moth to more tha two years). Reasos for BUYING futures cotracts Reasos for SELLING futures cotracts HEDGERS To lock i a price To lock i a price ad thereby ad thereby obtai protectio obtai protectio agaist risig agaist decliig cash prices cash prices SPECULATORS To profit from To profit from risig futures prices decliig future prices The Process of Price Discovery As ew supply ad demad developmets occur ad as ew ad more curret iformatio becomes available, these judgmets are reassessed, ad the price of a particular futures cotract may be bid upward or dowward. The process of reassessmet (price discovery) is cotiuous. Thus, i Jauary, the price of a July futures cotract would reflect the cosesus of buyers ad sellers opiios at that time as to what the value of a commodity or item will be whe the cotract expires i July. O ay give day,with the arrival of ew or more accurate iformatio, the price of the July futures cotract might icrease or decrease i respose to chagig expectatios. As the term idicates, futures markets discover or reflect cash market prices. They do ot set them. Competitive price discovery is a major ecoomic fuctio ad, ideed, a major ecoomic beefit of futures tradig. I summary, futures prices are a ever chagig barometer of supply ad demad ad, i a dyamic market, the oly certaity is that prices will chage. Miimum Price Chages Exchages establish the miimum amout that the price ca fluctuate upward or dowward. This is kow as the tick. For example, each tick for grai is.0025 per bushel. O a 5,000 bushel futures cotract, that s $12.50. O a gold futures cotract, the tick is 10 per ouce, so oe tick o a 100 ouce cotract is $10. You ll wat to familiarize yourself with the miimum price fluctuatio the tick size for whatever futures cotracts you pla to trade. You ll also eed to kow how a price chage of ay give amout will affect the value of the cotract. Daily Price Limits Exchages establish daily price limits for tradig i some futures cotracts. The limits are stated i terms of the previous day s closig price plus ad mius so may cets or dollars per tradig uit. Oce a futures price has icreased by its daily limit, there ca be o tradig at ay higher price util the ext tradig sessio. Coversely, oce a futures price has declied by its daily limit, there ca be o tradig at ay lower price util the ext sessio. Thus, if the daily limit for a particular grai is curretly 10 a bushel ad the previous day s settlemet was $3.00, there caot be tradig durig the curret day at ay price below 2.90 or above 3.10. The price is allowed to icrease or decrease by the limit amout each day. 20 21
Itroductio to Futures Tradig For some cotracts, daily price limits are elimiated durig the moth i which the cotract expires.because prices ca become particularly volatile durig the expiratio moth (also called the delivery or spot moth), persos lackig experiece i futures tradig may wish to liquidate their positios prior to that time. At the very least, they should trade cautiously ad with a uderstadig of the risks which may be ivolved. Daily price limits set by the exchages are subject to chage. They ca, for example, be icreased or decreased o successive days. Because of daily price limits, there may be occasios whe it is ot possible to liquidate a existig futures positio at will. I this evet, possible alterative strategies should be discussed with a broker. Positio Limits Although the average trader is ulikely to ever approach them, exchages ad the CFTC establish limits o the maximum speculative positio that ay oe perso ca have at oe time i ay oe futures cotract.the purpose is to prevet oe buyer or seller from beig able to exert udue ifluece o the price i either the establishmet or liquidatio of positios. Positio limits are stated i umber of cotracts or total uits of the commodity. The easiest way to obtai the types of iformatio just discussed is to ask your broker or other advisor to provide you with a copy of the cotract specificatios for the specific futures cotracts you are thikig about tradig. You ca also obtai the iformatio from the exchage where the cotract is traded. Daily Close At the ed of a day s tradig, the exchage s clearig orgaizatio matches each clearig firm s purchases made that day with correspodig sales ad tallies each clearig firm s gais or losses based o that sessio s price chages a massive udertakig cosiderig that several millio futures cotracts are bought ad sold o a average day. Each firm, i tur, calculates the gais ad losses for each of its customers havig futures cotracts. Gais ad losses o futures cotracts are ot oly calculated o a daily basis, they are credited ad deducted by the clearig firm o a daily basis. For example, if a speculator were to have a $300 profit as a result of the day s price chages, that amout would be immediately credited to his brokerage accout ad, uless required for other purposes, could be withdraw. O the other had, if the day s price chages had resulted i a $300 loss, his accout would be immediately debited for that amout. The process just described is kow as a daily cash settlemet ad is a importat feature of futures tradig. As will be see whe we discuss margi requiremets (see page 27), it is also the reaso a customer who icurs a loss o a futures positio may be called o to deposit additioal fuds to his accout. 22 23
Itroductio to Futures Tradig The Arithmetic of Futures Tradig Leverage To say that gais ad losses i futures tradig are the result of price chages is a accurate explaatio but by o meas a complete explaatio. Perhaps more so tha i ay other form of speculatio or ivestmet, gais ad losses i futures tradig are highly leveraged. A uderstadig of leverage ad of how it ca work to your advatage or disadvatage is crucial to a uderstadig of futures tradig. The leverage of futures tradig stems from the fact that oly a relatively small amout of moey (kow as iitial margi) is required to buy or sell a futures cotract. O a particular day, a margi deposit of oly $1,000 might eable you to buy or sell a futures cotract coverig $25,000 worth of soybeas. Or for $20,000, you might be able to purchase a futures cotract coverig commo stocks worth 24 Leverage ca work to realize swift profit Leverage ca as easily deliver great losses lev $200,000. The smaller the margi i relatio to the value of the futures cotract, the greater the leverage will be. If you speculate i futures cotracts ad the price moves i the directio you aticipated, high leverage ca produce large profits i relatio to your iitial margi. Coversely, if prices move i the opposite directio, high leverage ca produce large losses i relatio to your iitial margi. Leverage is a two-edged sword. Jue S&P 500 E-mii stock idex 1,420 1,400 1,380 % +2% -2% erage Each tick is a $50 gai For example, assume that i aticipatio of risig stock prices you buy oe Jue S&P 500 E-mii stock idex futures cotract at a time whe the Jue idex is tradig at 1400. Ad assume your iitial margi requiremet is $4,000. Sice the value of the futures cotract is 50 times the idex, each oe poit chage i the idex represets a $50 gai or loss. Each tick is a $50 loss $ $1,000 or 25% profit Iitial $4,000 Ivestmet -$1,000 or 25% loss Small movemets i the market ca create big chages i your accout. Thus, a icrease i the idex from 1400 to 1420 would produce a $1,000 profit (20 x $50) ad a decrease from 1400 to 1380 would be a $1,000 loss o your $4,000 margi deposit. That s a 25 percet gai or loss as the result of less tha a 2 percet chage i the stock idex. 25
Itroductio to Futures Tradig Said aother way, while buyig (or sellig) a futures cotract provides exactly the same dollars ad cets profit potetial as owig (or sellig short) the actual commodities or items covered by the cotract, low margi requiremets sharply icrease the percetage profit or loss potetial. Futures tradig, therefore, requires ot oly the ecessary fiacial resources but also the ecessary emotioal temperamet. For example, it ca be oe thig to have the value of your portfolio of commo stocks declie from $200,000 to $190,000 (a five percet loss) but quite aother, at least emotioally, to deposit $20,000 as margi ad ed up losig half of it as the result of oly a five percet declie. It is essetial for ayoe cosiderig tradig i futures cotracts whether it s sugar or stock idexes, pork bellies or petroleum to clearly uderstad the cocept of leverage as well as the amout of gai or loss that will result from ay give chage i the futures price of the particular futures cotract you would be tradig. If you caot afford the risk, or eve if you are ucomfortable with the risk, the oly soud advice is do t trade. Futures tradig is ot for everyoe. Margis As is apparet from the precedig discussio, the arithmetic of leverage is the arithmetic of margis. A uderstadig of margis ad of the several differet kids of margi is essetial to a uderstadig of futures tradig. If your previous ivestmet experiece has maily ivolved commo stocks, you kow that the term margi as used i coectio with securities has to do with the cash dow paymet ad moey borrowed from a broker to purchase stocks. But used i coectio with futures tradig, margi has a altogether differet meaig ad serves a altogether differet purpose. Rather tha providig a dow paymet, the margi required to buy or sell a futures cotract is solely a deposit of good faith moey that ca be draw o by your brokerage firm to cover losses that you may icur i the course of futures tradig. It is much like moey held i a escrow accout. Miimum margi requiremets for a particular futures cotract at a particular time are set by the exchage o which the cotract is traded. They are typically about five percet of the curret value of the futures cotract. Exchages cotiuously moitor market coditios ad risks ad, as ecessary, raise or reduce their margi requiremets. Idividual brokerage firms may require higher margi amouts from their customers tha the exchage-set miimums. There are two margi-related terms you should kow: iitial margi ad maiteace margi. Iitial margi (sometimes called origial margi) is the sum of moey that the customer must deposit with the brokerage firm for each futures cotract to be bought or sold. O ay day that profits accrue o your ope positios, the profits will be added to 26 27
Itroductio to Futures Tradig Iitial Margi Needed $2,000 Maiteace Margi Requiremet $1,500 Margi Call $600 If Your Accout Drops to $1,400 margi the balace i your margi accout. O ay day losses accrue, the losses will be deducted from the balace i your margi accout. If ad whe the fuds remaiig available i your margi accout are reduced by losses to below a certai level kow as the maiteace margi require- Assume, for example, that the iitial margi eeded to buy or sell a particular futures cotract is $2,000 ad that the maiteace margi requiremet is $1,500. Should losses o ope positios reduce the fuds remaiig i your tradig accout to $1,400 (a amout less tha the maiteace requiremet), you will receive a margi call for the $600 eeded to restore your accout to $2,000. met your broker will require that you deposit additioal fuds to brig the accout back to the level of the iitial margi. You may also be asked for additioal margi if the exchage or your brokerage firm raises its margi requiremets. Requests for additioal margi are kow as margi calls. Before tradig i futures cotracts, be sure you uderstad the brokerage firm s Margi Agreemet ad kow how ad whe the firm expects margi calls to be met. Some firms may require oly that you mail a persoal check. Others may isist you wire trasfer fuds from your bak or provide same-day or ext-day delivery of a certified or cashier s check. If margi calls are ot met i the prescribed time ad form, the firm ca protect itself by liquidatig your ope positios at the available market price (possibly resultig i a loss for which you would be liable). 28 29
Itroductio to Futures Tradig Basic Tradig Strategies Eve if you should decide to participate i futures tradig i a way that does t ivolve havig to make day-to-day tradig decisios (such as a maaged accout or commodity pool), it is oetheless useful to uderstad the dollars ad cets of how futures tradig gais ad losses are realized. If you ited to trade your ow accout, such a uderstadig is essetial. Dozes of differet strategies ad variatios of strategies are employed by futures traders i pursuit of speculative profits. Here is a brief descriptio ad illustratio of several basic strategies. 30 Buyig (Goig Log) to Profit from a Expected Price Icrease Someoe expectig the price of a particular commodity or item to icrease over a give period of time ca seek to profit by buyig futures cotracts. If correct i forecastig the directio ad timig of the price chage, the futures cotract ca later be sold for the higher price, thereby yieldig a profit.* If the price declies rather tha icreases, the trade will result i a loss. Because of leverage, the gai or loss may be greater tha the iitial margi deposit. For example, assume it s ow Jauary, the July soybea futures cotract is presetly quoted at $6.00 a bushel, ad over the comig moths you expect the price to icrease. You decide to deposit the required iitial margi of $1,000 ad buy oe July soybea futures cotract. Further assume that by April the July soybea futures price has rise to $6.40, ad you decide to take your profit by sellig. Sice each cotract is for 5,000 bushels, your 40-cet a bushel profit would be 5,000 bushels x 40 or $2,000 less trasactio costs. Price Per Value of 5,000 Bushel Bushel Cotract Jauary Buy 1 July soybea $6.00 $30,000 futures cotract April Sell 1 July soybea $6.40 $32,000 futures cotract GAIN $.40 $ 2,000 *For simplicity, examples do ot take ito accout commissios ad other trasactio costs. These costs are importat, however, ad you should be sure you fully uderstad them. 31
Itroductio to Futures Tradig 32 Price Per Value of 5,000 Bushel Bushel Cotract Jauary Buy 1 July soybea $6.00 $30,000 futures cotract April Sell 1 July soybea $5.60 $28,000 futures cotract Suppose, however, that rather tha risig to $6.40, the July soybea futures price had declied to $5.60 ad that, i order to avoid the possibility of further loss, you elect to sell the cotract at that price. O 5,000 bushels your 40-cet a bushel loss would thus come to $2,000 plus trasactio costs. Note that the loss i this example exceeded your $1,000 iitial deposit. Your broker would the call upo you, as eeded, for additioal fuds to cover the loss. Had you ot offset the positio ad the soybea cotract was ope i your accout, your broker would ask you to deposit more margi fuds ito your accout to LOSS $.40 $ 2,000 cover the projected losses marked to the settlemet price. Sellig (Goig Short) to Profit from a Expected Price Decrease The oly way goig short to profit from a expected price decrease differs from goig log to profit from a expected price icrease is the sequece of the trades. Istead of first buyig a futures cotract, you first sell a futures cotract. If, as expected, the price declies, a profit ca be realized by later purchasig a offsettig futures cotract at the lower price. The gai per uit will be the amout by which the purchase price is below the earlier sellig price. For example, assume that i Jauary your research or other available iformatio idicates a probable decrease i cattle prices over the ext several moths. I the hope of profitig, you deposit a iitial margi of $700 ad sell oe April live cattle futures cotract at a price of, say, 85 a poud. Each cotract is for 40,000 pouds, meaig each 1 a poud chage i price will icrease or decrease the value of the futures cotract by $400. If, by March, the price has declied to 80 a poud, a offsettig futures cotract ca be purchased at 5 a poud below the origial sellig price. O the 40,000 poud cotract, that s a gai of 5 x 40,000 lbs. or $2,000 less trasactio costs. Price Per Value of 40,000 Poud Poud Cotract Jauary Sell 1 April live cattle 85 $34,000 futures cotract March Buy 1 April live cattle 80 $32,000 futures cotract GAIN 5 $ 2,000 33
Itroductio to Futures Tradig 34 Price Per Value of 40,000 Poud Poud Cotract Jauary Sell 1 April live cattle 85 $34,000 futures cotract March Buy 1 April live cattle 90 $36,000 futures cotract Assume you were wrog. Istead of decreasig, the April live cattle futures price icreases to 90 a poud by the time i March whe you evetually liquidate your short futures positio through a offsettig purchase. The outcome would be as show above. I this example, the loss of 5 a poud o the future trasactio resulted i a total loss of the $2,000 plus trasactio costs. LOSS 5 $ 2,000 Spreads While most speculative futures trasactios ivolve a simple purchase of futures cotracts to profit from a expected price icrease or a equally simple sale to profit from a expected price decrease umerous other possible strategies exist. Spreads are oe example. A spread, at least i its simplest form, ivolves buyig oe futures cotract ad sellig aother futures cotract. The purpose is to profit from a expected chage i the relatioship betwee the purchase price of oe ad the sellig price of the other. As a illustratio, assume it s ow November, that the March CBOT mii Wheat futures price is presetly $3.50 a bushel ad the May CBOT mii Wheat futures price is presetly $3.55 a bushel, a differece of 5. Your aalysis of market coditios idicates that, over the ext few moths, the price differece betwee the two cotracts will wide to become greater tha 5. To profit if you are right, you could sell the March futures cotract (the lower priced cotract) ad buy the May futures cotract (the higher priced cotract). Assume time ad evets prove you right ad that, by February, the March futures price has rise to $3.60 ad May futures price is $3.75, a differece of 15. By liquidatig both cotracts at this time, you ca realize a et gai of 10 a bushel. Sice each cotract is 1,000 bushels, the total gai is $100. Spread November Sell March Buy March Mii Wheat Mii Wheat @ 3.50 bu. @ 3.55 bu. 5 February Buy March Sell March Mii Wheat Mii Wheat @ 3.60 bu. @ 3.75 bu. 15 $.10 LOSS $.20 GAIN Net gai = 10 per bushel Gai o 1,000 bushel cotract = $100 35
Itroductio to Futures Tradig Had the spread (the price differece) arrowed by 10 a bushel rather tha wideed by 10 a bushel, the trasactios just illustrated would have resulted i a loss of $100. Because of the potetial of oe leg of the spread to hedge agaist price loss i the other leg ad because gais ad losses occur oly as the result of a chage i the price differece rather tha as a result of a chage i the overall level of futures prices spreads are ofte cosidered more coservative ad less risky tha havig a outright log or short futures positio. I geeral, this may be the case. It should be recogized, though, that the loss from a spread ca be as great as or eve greater tha that which might be icurred i havig a outright futures positio. A adverse wideig or arrowig of the spread durig a particular time period may exceed the chage i the overall level of futures prices, ad it is possible to experiece losses o both of the futures cotracts ivolved (that is, o both legs of the spread). Virtually ulimited umbers ad types of spread possibilities exist, as do may other, eve more complex futures tradig strategies. These, however, are beyod the scope of a itroductory booklet ad should be cosidered oly by someoe who fully uderstads the risk/reward arithmetic ivolved. Stop Orders A stop order is a order placed with your broker to buy or sell a particular futures cotract if ad whe the price reaches a specified level. Stop orders are ofte used by futures traders i a effort to limit the amout they might lose if the futures price moves agaist their positio. For example, were you to purchase a crude oil futures cotract at $61 a barrel ad wished to limit your loss to $1 a barrel, you might place a stop order to sell a offsettig cotract if the price should fall to $60 a barrel. If ad whe the market reaches whatever price you specify, a stop order becomes a order to execute the desired trade. There ca be o guaratee, however, that it will be possible uder all market coditios to execute the order at the price specified. I a active, volatile market, the market price may be decliig (or risig) so rapidly that there is o opportuity to liquidate your positio at the stop price you have desigated. It is importat to uderstad each exchage s rules ad regulatios as to the type of orders permitted ad the uaces of each. I the evet that prices have rise or falle i a market that utilizes a maximum daily limit, ad there is presetly o tradig i the cotract (kow as a lock limit market), it may ot be possible to execute your order at ay price. I additio, although it happes ifrequetly, it is possible that markets may be lock limit for more tha oe day, resultig i substatial losses to futures traders who may fid it impossible to liquidate losig futures positios. Subject to the kids of limitatios just discussed, stop orders ca oetheless provide a useful tool for the futures trader who seeks to limit his losses. I additio to providig a way to limit losses, stop orders ca also be employed to protect profits. For istace, if you have bought crude oil futures at $61 a barrel ad the price is ow at $64 a barrel, you might wish to place a stop order to sell if ad whe the price declies to $63. This (agai subject to the described limitatios of stop orders) could protect $2 of your existig $3 profit while still allowig your positio to beefit from ay cotiued icrease i price. 36 37
How to Participate i Futures Tradig How to Participate i Futures Tradig Now that you have a overview of what futures markets are, why they exist ad how they work, the ext step is to cosider various ways i which you may be able to participate i futures tradig. There are a umber of alteratives ad the oly best alterative if you decide to participate at all is whichever oe is best for you. I additio to describig several possibilities, the pages that follow suggest questios you should ask ad iformatio you should obtai before makig a decisio. 38 Choosig a method of participatig i the futures markets is largely a matter of decidig how directly ad extesively you, persoally, wat to be ivolved i makig tradig decisios ad maagig your accout. May futures traders prefer to do their ow research ad aalysis ad make their ow decisios about what ad whe to buy ad sell. That is, they maage their ow futures trades i much the same way they would maage their ow stock portfolios. Others choose to rely o or at least cosider the recommedatios of a brokerage firm or accout executive. Some purchase idepedet tradig advice. Others would rather have someoe else be resposible for tradig their accout ad therefore give tradig authority to their broker or a tradig advisor. Still others purchase a iterest i a commodity tradig pool. Futures Commissio Merchats (FCMs) are brokerage firms doig busiess with the public. Commodity Pool Operators (CPOs) maage combied fuds, much like a mutual fud. Itroducig Brokers (IBs) act as sales firms, solicitig customer accouts which are traded through FCMs. Commodity Tradig Advisors (CTAs) offer tradig advice to idividuals, orgaizatios ad commodity pools. Categories of NFA Members There s o formula for decidig. Your decisio should, however, take ito accout such thigs as your kowledge of ad ay previous experiece i futures tradig, how much time ad attetio you are able to devote to tradig, the amout of capital you ca afford to commit to futures, ad, perhaps most importatly, your idividual temperamet ad tolerace for risk. Some idividuals thrive o beig directly ivolved i the fast pace of futures tradig. Others are uable, reluctat, or lack the time to make the immediate decisios that are frequetly required. Some recogize ad accept the fact that futures tradig all but ievitably ivolves havig some losig trades. Others lack the ecessary dispositio or disciplie to ackowledge that they were wrog o this particular occasio ad liquidate the positio. May experieced traders suggest that, of all the thigs you eed to kow before tradig i futures cotracts, oe of the most importat is to kow yourself. This ca help you make the right decisio about whether to participate at all ad, if so, i what way. 39
How to Participate i Futures Tradig It bears repeatig, that you should ever participate i futures tradig uless the capital you would commit is risk capital. That is, capital you ca afford to lose. It should be capital over ad above that eeded for ecessities, emergecies, savigs ad achievig your log-term ivestmet objectives. You should also uderstad that, because of the leverage ivolved i futures, the profit ad loss fluctuatios may be wider tha i most types of ivestmet activity ad you may be required to cover deficiecies due to losses over ad above what you had expected to commit to futures. Trade Your Ow Accout This ivolves opeig your idividual tradig accout ad with or without the recommedatios of the brokerage firm makig your ow tradig decisios. You will also be resposible for assurig that adequate fuds are o deposit with the brokerage firm for margi purposes, or that such fuds are promptly provided as eeded. Practically all of the major brokerage firms you are familiar with, ad may you may ot be familiar with, have departmets or eve separate divisios to serve cliets who wat to allocate some portio of their ivestmet capital to futures tradig. All brokerage firms coductig futures busiess with the public must be registered with the CFTC as Futures Commissio Merchats (FCMs) or Itroducig Brokers (IBs) ad must be Members of NFA. Differet firms offer differet services. Some, for example, have extesive research departmets ad ca provide curret iformatio ad aalysis cocerig market developmets as well as specific tradig suggestios. Others tailor their services to cliets who prefer to make market judgmets ad arrive at tradig decisios o their ow. Still others offer various combiatios of these ad other services. A idividual tradig accout ca be opeed either directly with a FCM or through a IB. Whichever course you choose, the accout itself will be carried by a FCM, as will your moey. IBs do ot accept or hadle customer fuds but most offer a variety of tradig-related services. FCMs are required to maitai the fuds ad property of their customers i segregated accouts, separate from the firm s ow moey, if used for tradig futures or optios o futures o a exchage. I additio to the particular services a firm provides, you should also discuss the commissios ad tradig costs that will be ivolved. Ad, as metioed, clearly uderstad how the firm requires that ay margi calls be met. Remember, you should always coduct a backgroud check o the firm usig NFA s BASIC system o NFA s Web site (www.fa.futures.org) or cotact NFA s Iformatio Ceter toll-free at 800-621-3570. 40 41
How to Participate i Futures Tradig Have Someoe Maage Your Accout A maaged accout is also your idividual accout. The major differece is that you give someoe else a accout maager writte power of attorey to make ad execute decisios about what ad whe to trade. He or she will have discretioary authority to buy or sell for your accout or will cotact you for approval to make trades he or she suggests.you, of course, remai fully resposible for ay losses which may be icurred ad, as ecessary, for meetig margi calls, icludig makig up ay deficiecies that exceed your margi deposits. Although a accout maager is likely to be maagig the accouts of other persos at the same time,there is o sharig of gais or losses of other customers. Tradig gais or losses i your accout will result solely from trades which were made for your accout. May FCMs ad IBs accept maaged accouts. I most istaces, the amout of moey eeded to ope a maaged accout is larger tha the amout required to establish a accout you ited to trade yourself. Differet firms ad accout maagers, however, have differet requiremets ad the rage ca be quite wide. Be certai to read ad uderstad all of the literature ad agreemets you receive from the broker. Some accout maagers have their ow tradig approaches ad accept oly cliets to whom that approach is acceptable. Others tailor their tradig to a cliet s objectives. I either case, obtai eough iformatio ad ask eough questios to assure yourself that your moey will be maaged i a way that s cosistet with your goals. Discuss fees. I additio to commissios o trades made for your accout, it is ot ucommo for accout maagers to charge a maagemet fee, ad/or there may be some arragemet for the maager to participate i the et profits that his maagemet produces. These charges are required to be fully disclosed i advace. Make sure you kow about every charge to be made to your accout ad what each charge is for. Fially,take ote of whether the accout maagemet agreemet icludes a provisio to automatically liquidate positios ad close out the accout if ad whe losses exceed a certai amout.ad, of course, you should kow ad agree o what will be doe with profits, ad what, if ay, restrictios apply to withdrawals from the accout. 42 43
How to Participate i Futures Tradig Use a Commodity Tradig Advisor As the term implies, a Commodity Tradig Advisor (CTA) is a idividual (or firm) that, for a fee, provides advice o commodity tradig, icludig specific tradig recommedatios such as whe to establish a particular log or short positio ad whe to liquidate that positio. Geerally, to help you choose tradig strategies that match your tradig objectives, advisors offer aalysis ad judgmets as to the prospective rewards ad risks of the trades they suggest. Tradig recommedatios may be commuicated by phoe, electroically via the Iteret or through the mail. Some provide a frequetly updated hot-lie or Web site you ca access for curret iformatio ad tradig advice. Eve though you may trade o the basis of a advisor s recommedatios, you will eed to ope your ow accout with, ad sed your margi paymets directly to,a FCM.CTAs caot accept or hadle their customers fuds uless they are also registered as FCMs. Some CTAs offer maaged accouts, with the advisor desigated i writig to make ad execute tradig decisios o a discretioary basis.the accout itself, however, must still be with a FCM ad i your ame. CFTC Regulatios require that CTAs provide their customers, i advace, with what is called a Disclosure Documet. Read it carefully ad ask the CTA to explai ay poits you do t uderstad. If your moey is importat to you, so is the iformatio cotaied i the Disclosure Documet! The prospectus-like documet cotais iformatio about the advisor, his experiece ad his curret (ad ay previous) performace records. If you use a advisor to maage your accout, he must first obtai a siged ackowledgmet from you that you have received ad uderstood the Disclosure Documet. As i ay method of participatig i futures tradig, discuss ad uderstad the advisor s fee arragemets. Ad if he will be maagig your accout, ask the same questios you would ask of ay accout maager you are cosiderig. Most CTAs must be registered as such with the CFTC, ad registered CTAs that accept authority to maage customer accouts must also be Members of NFA. You ca verify whether a advisor is registered ad a NFA Member by coductig a backgroud check usig NFA s BASIC system o NFA s Web site (www.fa.futures.org) or by callig NFA toll-free at 800-621-3570. 44 45
How to Participate i Futures Tradig Participate i a Commodity Pool Aother alterative method of participatig i futures tradig is through a commodity pool, which is similar i cocept to a commo stock mutual fud. It is the oly method of participatio i which you will ot have your ow idividual tradig accout. Istead, your moey will be combied with that of other pool participats ad, i effect, traded as a sigle accout.you share i the profits or losses of the pool i proportio to your ivestmet i the pool. Oe potetial advatage is greater diversificatio of risks tha you might obtai if you were to establish your ow tradig accout. Aother is that your risk of loss is geerally limited to your ivestmet i the pool, because most pools are formed as limited parterships.ad you wo t be subject to margi calls. Bear i mid, however, that the risks which a pool icurs i ay give futures trasactio are o differet tha the risks risks icurred by a idividual trader. The pool still trades i futures cotracts which are highly leveraged ad i markets which ca be highly volatile. Ad like a idividual trader, the pool ca suffer substatial losses.a major cosideratio, therefore, is who will be maagig the pool i terms of directig its tradig. While a pool must execute all of its trades through a brokerage firm which is registered with the CFTC as a FCM,it may or may ot have ay other affiliatio with the brokerage firm. Some brokerage firms, to serve those customers who prefer to participate i commodity tradig through a pool, either operate or have a relatioship with oe or more commodity tradig pools. Other pools operate idepedetly. I most istaces, a Commodity Pool Operator (CPO) caot accept your moey util it has provided you with a Disclosure Documet that cotais iformatio about the pool operator, the pool s pricipals ad ay outside persos who will be providig tradig advice or makig tradig decisios. It must also disclose the previous performace records, if ay, of all persos who will be operatig or advisig the pool (or, if oe, a statemet to that effect). Disclosure Documets cotai importat iformatio ad should be carefully read before you ivest your moey. Aother requiremet is that the Disclosure Documet advise you of the risks ivolved. I the case of a ew pool, there is frequetly a provisio that the pool will ot begi tradig util (ad uless) a certai amout of moey is raised. Normally, a time deadlie is set ad the CPO is required to state i the Disclosure Documet what that deadlie is (or,if there is oe, that the time period for raisig fuds is idefiite). Be sure you uderstad the terms, icludig how your moey will 46 47
How to Participate i Futures Tradig be ivested i the meatime, what iterest you will ear (if ay), ad how ad whe your ivestmet will be retured i the evet the pool does ot commece tradig. Determie whether you will be resposible for ay losses i excess of your ivestmet i the pool. If so, this must be idicated promietly at the begiig of the pool s Disclosure Documet. fees costs restrictios Ask about fees ad other costs, icludig what, if ay, iitial charges will be made agaist your ivestmet for orgaizatioal or admiistrative expeses. Such iformatio should be oted i the Disclosure Documet. You should also determie from the Disclosure Documet how the pool s operator ad advisor are compesated. Uderstad, too, the procedure for redeemig your shares i the pool, ay restrictios that may exist, ad provisios for liquidatig ad dissolvig the pool if more tha a certai percetage of the capital were to be lost. Ask about the pool operator s geeral tradig philosophy, what types of cotracts will be traded, whether they will be day-traded, etc. disclosures With a few exceptios, CPOs must be registered with the CFTC ad be Members of NFA. You ca verify that these requiremets have bee met by coductig a backgroud search o NFA s BASIC system at NFA s Web site (www.fa.futures.org) or by cotactig NFA toll-free at 800-621-3570. 48 49
How to Participate i Futures Tradig Establishig a Accout At the time you apply to establish a futures tradig accout, you ca expect to be asked for certai iformatio beyod simply your ame, address ad phoe umber. The requested iformatio will geerally iclude (but ot ecessarily be limited to) your icome, et worth, what previous ivestmet or futures tradig experiece you have had, ad ay other iformatio eeded i order to advise you of the risks ivolved i tradig futures cotracts. You will also be required to provide proof of idetity to comply with federal law. At a miimum, the perso or firm who will hadle your accout is required to provide you with risk disclosure documets or statemets specified by the CFTC ad obtai writte ackowledgmet that you have received ad uderstood them. Opeig a futures accout is a serious decisio ad should obviously be approached as such. Just as you would t cosider buyig a car or a house without carefully readig ad uderstadig the terms of the cotract, either should you establish a tradig accout without first readig ad uderstadig the Accout Agreemet ad all other documets supplied by your broker. It is i your iterest ad the firm s iterest that you clearly kow your rights ad obligatios as well as the rights ad obligatios of the firm with which you are dealig before you eter ito ay futures trasactio. If you have questios about exactly what ay provisios of the Agreemet mea, do t hesitate to ask. A good ad cotiuig relatioship ca exist oly if both parties have, from the outset, a clear uderstadig of the relatioship. Nor should you be hesitat to ask, i advace, what services you will be gettig for the tradig commissios the firm charges. As idicated earlier, ot all firms offer idetical services, ad ot all cliets have idetical eeds. If it is importat to you, for example, you might iquire about the firm s research capability ad whatever reports it makes available to cliets. Other subjects of iquiry could be how trasactio ad statemet iformatio will be provided, ad how your orders will be hadled ad executed. 50 51
Itroductio to Optios o Futures Itroductio to Optios o Futures Although futures cotracts have bee traded o U.S. exchages sice 1865, optios o futures cotracts were ot itroduced util 1982. There are two styles of optios America ad Europea. For the purposes of this discussio, we will focus o America-style optios. A optio o a futures cotract gives the optio buyer the right but ot the obligatio to buy or sell a particular futures cotract at a stated price at ay time prior to a specified date. There are two types of optios: calls ad puts. chase a particular futures cotract at a stated price at ay time durig the life of the optio. A put optio coveys to the optio buyer the right to sell a particular futures cotract at a stated time value put itrisic value price at ay time durig the life of the optio. Optios o futures cotracts ca offer a wide rage of ivestmet opportuities. call However, optios tradig is a speculative ivestmet ad should be treated as such. Eve though the purchase of optios o futures cotracts limits your potetial losses to the amout of the ivestmet,it is oetheless possible to lose your etire ivestmet i a short period of time. Ad for ivestors who sell rather tha buy optios, there may be o limit at all to the size of potetial losses. A call optio coveys to the optio buyer the right to pur- premium 52 53
Itroductio to Optios o Futures The Arithmetic of Optio Premiums A optio premium is the price paid by the buyer of the optio ad received by the seller of the optio. At the time you purchase a particular optio, its premium cost may be $1,000. A moth or so later, the same optio may be worth oly $800 or $700 or $600. Or it could be worth $1,200 or $1,300 or $1,400. Sice a optio is somethig that most people buy with the itetio of evetually liquidatig (hopefully at a higher price), it s importat to have at least a basic uderstadig of the compoets which make up the premium. There are two, kow as itrisic value ad time value.the premium is the sum of these. Itrisic Premium = + Value Itrisic Value Time Value Itrisic value is the amout of moey that could curretly be realized by exercisig the optio at its strike price ad liquidatig the acquired futures positio at the preset price of the futures cotract For example, at a time whe a U.S. Treasury bod futures cotract is tradig at a price of 120-00, a call optio coveyig the right to purchase the futures cotract at a below-the-market strike price of 115-00 would have a itrisic value of $5,000. A optio that curretly has itrisic value is said to be ithe-moey (by the amout of its itrisic value). A optio that does ot curretly have itrisic value is said to be either at-the-moey or out-ofthe-moey. For example, at a time whe a U.S. Treasury bod futures cotract is tradig at 120-00, a call optio with a strike price of 123-00 would be out-of-the-moey by $3,000. Time Value Optios also have time value. I fact, if a give optio has o itrisic value curretly outof-the-moey its premium will cosist etirely of time value. Time value is the amout optio buyers are presetly willig to pay (ad optio sellers are willig to accept) over ad above ay itrisic value the optio may have for the specific rights that a give optio coveys. It reflects, i effect, a cosesus opiio as to the likelihood of the optio s icreasig i value prior to its expiratio. The three pricipal factors that affect a optio s time value are: Time Value 1 Time remaiig util expiratio. Time value declies as the optio approaches expiratio. At expiratio, it will o loger have ay time value. (This is why a optio is said to be a wastig asset.) 2 Time to Expiratio Relatioship betwee the optio strike price ad the curret price of the uderlyig futures cotract. The further a optio is removed from beig worthwhile to exercise the further out-of-the-moey it is the less time value it is likely to have. 54 55
Itroductio to Optios o Futures 3 Uderstadig Optios Trasactio Fees Volatility. The more volatile a market is, the more likely it is that a price chage may evetually make the optio worthwhile to exercise. Thus, the optio s time value ad premium are geerally higher i volatile markets. 56 + = Before you decide to buy ad/or sell (write) optios, you should uderstad the other costs ivolved i the trasactio commissios ad fees. Commissio is the amout of moey, per optio purchased or sold, that is paid to the brokerage firm for its services, icludig the executio of the order o the tradig floor of the exchage. The commissio charge icreases the cost of purchasig a optio ad reduces the sum of moey received from sellig a optio. I both cases, the premium ad the commissio should be stated separately. Each firm is free to set its ow commissio charges, but the charges must be fully disclosed i a maer that is ot misleadig. I cosiderig a optio ivestmet, you should be aware that: Commissio ca be charged o a per-trade or a roud-tur basis, coverig both the purchase ad sale. Commissio charges ca differ sigificatly from oe brokerage firm to aother. Some firms charge commissios per optio trasactio ad others charge a percetage of the optio premium, usually subject to a certai miimum charge. Commissio charges based o a percetage of the premium ca be substatial, particularly if the optio is oe that has a high premium. Commissio charges ca have a major impact o your chaces of makig a profit.a high commissio charge reduces your potetial profit ad icreases your potetial loss. You should fully uderstad what a firm s commissio charges will be ad how they re calculated. If the charges seem high either o a dollar basis or as a percetage of the optio premium you might wat to seek compariso quotes from oe or two other firms. If a firm seeks to justify a uusually high commissio charge o the basis of its services or performace record, you might wat to ask for a detailed explaatio or documetatio i writig. I additio to commissios, some firms will iclude a separate charge for exchage ad NFA fees. 57
Itroductio to Optios o Futures Leverage Just as i futures tradig, leverage plays a importat role i tradig optios o futures. The premium paid for a optio is oly a small percetage of the value of the assets covered by the uderlyig futures cotract. Therefore, eve a small chage i the futures cotract price ca result i a much larger percetage profit or a much large percetage loss i relatio to the premium. Cosider the followig example: A ivestor pays $200 for a 100-ouce gold call optio with a strike price of $500 a ouce at a time whe the gold futures price is $500 a ouce. If, at expiratio, the futures price has rise to $503 (a icrease of less tha oe percet), the optio value will icrease by $300 (a gai of 150 percet o your origial ivestmet of $200). But always remember that leverage is a two-edged sword. I the above example, uless the futures price at expiratio had bee above the optio s $500 strike price, the optio would have expired worthless, ad the ivestor would have lost 100 percet of his ivestmet plus ay commissios ad fees. Calculatig the Break-Eve Price Before purchasig ay optio, it s essetial to determie precisely what the uderlyig futures price must be i order for the optio to be profitable at expiratio.the break-eve poit may vary if you choose to offset the optio prior to expiratio, because it may have time value. The calculatio is t difficult. All you eed to kow to figure a give optio s break-eve price is the followig: The optio s strike price; The premium cost; ad Commissio ad other trasactio costs. Use the followig formula to determie the break-eve price for a call optio if you are the purchaser: Optio Strike Price Commissio & + Optio + Trasactio = Premium Costs Break Eve Price Example: It s Jauary ad the 1,000 barrel April crude oil futures cotract is curretly tradig at aroud $62.50 a barrel. Expectig a potetially sigificat icrease i the futures price over the ext several moths, you decide to buy a April crude oil call optio with a strike price of $63. Assume the premium for the optio is 95 a barrel ad that the commissio ad other trasactio costs are $50, which amouts to 5 a barrel. Before ivestig, you eed to kow how much the April crude oil futures price must icrease by expiratio i order for the optio to break eve or yield a et profit after expeses. The aswer is that the futures price must icrease to $64.00 for you to break eve ad to above $64.00 for you to realize ay profit. Optio Strike Price $63.00 Premium +.95 Commissio & Trasactio +.05 Costs Break-Eve $64.00 Price 58 59
Itroductio to Optios o Futures The optio will exactly break eve if the April crude oil futures price at expiratio is $64.00 a barrel. For each $1 a barrel the price is above $64.00, the optio will yield a profit of $1,000. If the futures price at expiratio is $64.00 or less, there will be a loss. But i o evet ca the loss exceed the $1,000 total of the premium, commissio ad trasactio costs. The arithmetic for determiig the break-eve price for purchasig a put optio is the same as for a call optio except that istead of addig the premium, commissio ad trasactio costs to the strike price, you subtract them. Optio Strike Price Commissio Optio & Trasactio = Premium Costs Break Eve Price Example: The price of gold is curretly about $500 a ouce, but durig the ext few moths you thik there may be a sharp declie. To profit from the price decrease if you are right, you cosider buyig a put optio with a strike price of $495 a ouce. The optio would give you the right to sell a specific gold futures cotract at $495 a ouce at ay time prior to the expiratio of the optio. Assume the premium for the put optio is $3.70 a ouce ($370 i total) ad the commissio ad trasactio costs are $50 (equal to 50 a ouce). For the optio to break eve at expiratio, the futures price must declie to $490.80 a ouce or lower. Optio Strike Price $495.00 Premium 3.70 Commissio & Trasactio Costs.50 Break-Eve $490.80 Price The optio will exactly break eve at expiratio if the futures price is $490.80 a ouce. For each $1 a ouce the futures price is below $490.80 it will yield a profit of $100. If the futures price at expiratio is above $490.80, there will be a loss. But i o case ca the loss exceed $420 the sum of the premium ($370) plus commissio ad other trasactio costs ($50). 60 61
Itroductio to Optios o Futures Factors Affectig the Choice of a Optio If you expect a price icrease, you ll wat to cosider the purchase of a call optio. If you expect a price declie, you ll wat to cosider the purchase of a put optio. However, i additio to price expectatios, there are two other factors that affect the choice of optio: 62 The amout of time util the expiratio of the optio (time value); ad The optio strike price (itrisic value). The legth of a optio Oe of the attractive features of optios is that they allow time for your price expectatios to be realized. The more time you allow, the greater likelihood the optio could evetually become profitable. This could ifluece your decisio about whether to buy, for example, a optio o a March futures cotract or a optio o a Jue futures cotract. Bear i mid that the legth of a optio (such as whether it has three moths to expiratio or six moths) is a importat variable affectig the cost of the optio. A optio with more time commads a higher premium. The optio strike price The relatioship betwee the strike price of a optio ad the curret price of the uderlyig futures cotract is, alog with the legth of the optio, a major factor affectig the optio premium.at ay give time there may be tradig i optios with a half doze or more strike prices some of them below the curret price of the uderlyig futures cotract ad some of them above. A call optio with a lower strike price will have a higher premium cost tha a call optio with a higher strike price because the lower strike price will more likely ad more quickly become worthwhile to exercise. For example, the right to buy a crude oil futures cotract at $61 a barrel is more valuable tha the right to buy a crude oil futures cotract at $62 a barrel. strike price legthgeerally speakig,premiums Coversely, a put optio with a higher exercise price will have a higher premium cost tha a put optio with a lower exercise price. For example, the right to sell a crude oil futures cotract at $62 a barrel is more valuable tha the right to sell a crude oil futures cotract at $61 a barrel. While the choice of a call optio or put optio will be dictated by your price expectatios ad your choice of expiratio moth by whe you look for the expected price chage to occur, the choice of strike price is somewhat more complex. That s because the strike price will ifluece ot oly the optio s premium cost but also how the value of the optio, oce purchased, is likely to respod to subsequet chages i the uderlyig futures cotract price. Specifically, optios that are out-of-the-moey do ot ormally respod to chages i the uderlyig futures price the same as optios that are at-themoey or i-the-moey. for out-of-the-moey optios do ot reflect, o a dollar for dollar basis, chages i the uderlyig futures price. The chage i optio value is usually less. Ideed, a chage i the uderlyig futures price could have little effect, or eve o effect at all, o the value of the optio. This could be the case if, for istace, the optio remais deeply outof-the-moey after the price chage or if expiratio is ear. 63
Itroductio to Optios o Futures After You Buy a Optio At ay time prior to the expiratio of a optio, you ca: 64 Offset the optio; Cotiue to hold the optio; or Exercise the optio. Offset the Optio Liquidatig a optio i the same marketplace where it was bought is the most frequet method of realizig optio profits. Liquidatig a optio prior to its expiratio for whatever value it may still have is also a way to reduce your loss (by recoverig a portio of your ivestmet) i case the futures price has t performed as you expected it would, or if the price outlook has chaged. I active markets, there are usually other ivestors who are willig to pay for the rights your optio coveys. How much they are willig to pay (it may be more or less tha you paid) will deped o (1) the curret futures price i relatio to the optio s strike price, (2) the legth of time still remaiig util expiratio of the optio ad (3) market volatility. Net profit or loss, after allowace for commissio charges ad other trasactio costs, will be the differece betwee the premium you paid to buy the optio ad the premium you receive whe you liquidate the optio. Example: I aticipatio of risig sugar prices, you bought a call optio o a sugar futures cotract. The premium cost was $950 ad the commissio ad trasactio costs were $50. Sugar prices have subsequetly rise ad the optio ow commads a premium of $1,250. By liquidatig the optio at this price, your et gai is $250. That s the sellig price of $1,250 mius the $950 premium paid for the optio mius $50 i commissio ad trasactio costs. You should be aware, however, that there is o guaratee that there will actually be a active market for the optio at the time you decide you wat to liquidate. If a optio is too far removed from beig worthwhile to exercise or if there is too little time remaiig util expiratio, there may ot be a market for the optio at ay price. Premium paid for optio $ 950 Premium received whe optio is liquidated $ 1,250 Icrease i premium $ 300 Less trasactio costs $ 50 Net profit $ 250 Assumig, though, that there s still a active market, the price you get whe you liquidate will deped o the optio s premium at that time. Premiums are arrived at through ope competitio betwee buyers ad sellers accordig to the rules of a exchage. 65
Itroductio to Optios o Futures Cotiue to Hold the Optio The secod alterative you have after you buy a optio is to hold a optio right up to the fial date for exercisig or liquidatig it.this meas that eve if the price chage you ve aticipated does t occur as soo as you expected or eve if the price iitially moves i the opposite directio you ca cotiue to hold the optio if you still believe the market will prove you right. If you are wrog, you will have lost the opportuity to limit your losses through offset. O the other had, the most you ca lose by cotiuig to hold the optio is the sum of the premium ad trasactio costs. This is why it is sometimes said that optio buyers have the advatage of stayig power. You should be aware, however, that optios typically declie i value as they approach expiratio. (See Time Value o page 55). Exercise the Optio You ca also exercise the optio at ay time prior to the expiratio of the optio. It does ot have to be held util expiratio. It is essetial to uderstad, however, that exercisig a optio o a futures cotract meas that you will acquire either a log or short positio i the uderlyig futures cotract a log futures positio if you exercise a call ad a short futures positio if you exercise a put. Example: You ve bought a call optio with a strike price of 70 a poud o a 40,000 poud live cattle futures cotract. The futures price has rise to 75 a poud. Were you to exercise the optio, you would acquire a log cattle futures positio at 70 with a paper gai of 5 a poud ($2,000). Ad if the futures price were to cotiue to climb, so would your gai. But there are both costs ad sigificat risks ivolved i acquirig a positio i the futures market. For oe thig, the broker will require a margi deposit to provide protectio agaist possible fluctuatios i the futures price. Ad if the futures price moves adversely to your positio, you could be called upo perhaps eve withi hours to make additioal margi deposits. There is o upper limit to the extet of these margi calls. Secodly, ulike buyig a optio, which limits potetial losses, a futures positio has potetially ulimited risk. The further the futures price moves agaist your positio, the larger your loss. exercise hold offset Eve if you were to exercise a optio with the itetio of promptly liquidatig the futures positio acquired through exercise, there s the risk that the futures price which existed at the momet may o loger be available by the time you are able to liquidate the futures positio. Futures prices ca ad ofte do chage rapidly. For all these reasos, oly a small percetage of optio buyers elect to realize optio tradig profits by exercisig a optio. Most choose the alterative of havig the broker offset i.e., liquidate the optio at its curretly quoted premium value. 66 67
Itroductio to Optios o Futures Who Sells (Writes) Optios ad Why Up to ow, we have discussed oly the buyig of optios. But it stads to reaso that whe someoe buys a optio, someoe else sells it. I ay give trasactio, the seller may be someoe who previously bought a optio ad is ow liquidatig it. Or the seller may be a idividual who is participatig i the type of ivestmet activity kow as optios writig. The attractio of optio writig to some ivestors is the opportuity to receive the premium that the optio buyer pays. A optio buyer aticipates that a chage i the optio s uderlyig futures price at some poit i time prior to expiratio will make the optio worthwhile to exercise. A optio writer, o the other had, aticipates that such a price chage wo t occur i which evet the optio will expire worthless ad he will retai the etire amout of the optio premium that was received for writig the optio. Example: At a time whe the March U.S. Treasury Bod futures price is 125-00, a ivestor expectig stable or lower futures prices (meaig stable or higher iterest rates) ears a premium of $400 by writig a call optio with a strike price of 129. If the futures price at expiratio is below 129-00, the call will expire worthless ad the optio writer will retai the etire $400 premium. His profit will be that amout less the trasactio costs. While optio writig ca be a profitable activity, it is also a extremely high risk activity. I fact, a optio writer may have a ulimited risk. Except for the premium received for writig the optio, the writer of a optio stads to lose ay amout the optio is i-the-moey at the time of expiratio (uless he has liquidated his optio positio i the meatime by makig a offsettig purchase). 68 69
Itroductio to Optios o Futures I the previous example, a ivestor eared a premium of $400 by writig a U.S. Treasury Bod call optio with a strike price of 129. If, by expiratio, the futures price has climbed above the optio strike price by more tha the $400 premium received, the ivestor will icur a loss. For istace, if the futures price at expiratio has rise to 131-00, the loss will be $1,600. That s the $2,000 the optio is i-themoey less the $400 premium received for writig the optio (ot icludig trasactio costs). As you ca see from this example, optio writers as well as optio buyers eed to calculate a break-eve price. For the writer of a call, the break-eve price is the optio strike price plus the et premium received after trasactio costs. For the writer of a put, the break-eve price is the optio strike price mius the premium received after trasactio costs. A optio writer s potetial profit is limited to the amout of the premium less trasactio costs.the optio writer s potetial losses may be ulimited.ad a optio writer may eed to deposit fuds ecessary to cover losses as ofte as daily. Optio writig as a ivestmet is absolutely iappropriate for ayoe who does ot fully uderstad the ature ad the extet of the risks ivolved ad who caot afford the possibility of a potetially ulimited loss. It is also possible i a market where prices are chagig rapidly that a optio writer may have o ability to cotrol the extet of his losses. Optio writers should be sure to read ad thoroughly uderstad the Risk Disclosure Statemet that is provided to them. 70 71
If a Dispute Should Arise If a Dispute Should Arise All but a small percetage of trasactios ivolvig regulated futures ad optios o futures cotracts take place without problems or misuderstadigs. However, i ay busiess i which millios of cotracts are traded each day, occasioal disagreemets are ievitable. Obviously, the best way to resolve a disagreemet is through direct discussios by the parties ivolved. Failig this, however, participats i futures markets have several alteratives (uless some particular method has bee agreed to i advace). 72 I may circumstaces, it may be possible to seek resolutio through the exchage where the futures cotracts were traded or to file a claim for reparatios with the CFTC. Uless you have siged a predispute arbitratio agreemet, you ca also file a claim i court. However, most ivestors choose to resolve the disagreemet through the arbitratio program coducted by Natioal Futures Associatio. There are several advatages: It teds to be faster ad less expesive tha the other alteratives. You have a choice of selectig idustry or o-idustry related arbitrators. You do ot ecessarily have to kow what the law is to successfully prove your claim. I some cases, it may be possible to coduct arbitratio etirely through writte submissios. The best way to resolve a disagreemet is through direct discussios by the parties ivolved. If a hearig is required, it ca geerally be scheduled at a time ad place coveiet for both parties. Uless you wish to do so, you do ot have to employ a attorey. For a plai laguage explaatio of the arbitratio program ad how it works, write or phoe NFA for a copy of Arbitratio: A Way to Resolve Futures-Related Disputes. This free booklet is also available o NFA s Web site. 73
Glossary I Closig This Guide eds where it bega, with the statemet that it is ot our itetio to suggest either that you should or should ot participate i futures markets. Low margis, high leverage, frequetly volatile prices, ad the cotiuig eeds of hedgers to maage the price ucertaities iheret i their busiess create opportuities to realize potetially substatial profits. But for each such opportuity, there is commesurate risk. Tradig futures ad optios o futures, as stated at the outset, is ot for everyoe. Hopefully, the precedig pages have helped to provide a better uderstadig of the opportuities ad the risks alike, as well as a uderstadig of what futures markets are, how they work, who uses them, alterative methods of participatio ad, by o meas least, the vital ecoomic fuctio which futures markets perform. I o way, it should be emphasized, should aythig discussed herei be cosidered tradig advice or recommedatios. That should be provided by your broker or advisor. Similarly, your broker or advisor as well as the exchages where futures cotracts are traded are your best sources for additioal,more detailed iformatio about futures tradig. Glossary of Terms Tradig Futures ad Optios o Futures 74 75
Glossary Actuals See Cash Commodity. Aggregatio The policy uder which all futures positios owed or cotrolled by oe trader or a group of traders are combied to determie reportable positios ad speculative limits. Arbitrage The simultaeous purchase ad sale of similar commodities i differet markets to take advatage of a price discrepacy. Arbitratio The process of resolvig disputes betwee parties by a perso or persos (arbitrators) chose or agreed to by them. NFA's arbitratio program provides a forum for resolvig futures-related disputes betwee NFA Members or betwee Members ad customers. Associated Perso (AP) A idividual who solicits orders, customers or customer fuds o behalf of a Futures Commissio Merchat, a Itroducig Broker, a Commodity Tradig Advisor or a Commodity Pool Operator ad who is registered with the Commodity Futures Tradig Commissio. At-the-Moey Optio A optio whose strike price is equal or approximately equal to the curret market price of the uderlyig futures cotract. Basis The differece betwee the curret cash price of a commodity ad the futures price of the same commodity. Bear Market (Bear/Bearish) A market i which prices are decliig. A market participat who believes prices will move lower is called a bear. A ews item is cosidered bearish if it is expected to result i lower prices. Bid A expressio of willigess to buy a commodity at a give price; the opposite of Offer. Board of Trade See Cotract Market. Broker A compay or idividual that executes futures ad optios orders o behalf of fiacial ad commercial istitutios ad/or the geeral public. Bull Market (Bull/Bullish) A market i which prices are risig. A market participat who believes prices will move higher is called a bull. A ews item is cosidered bullish if it is expected to result i higher prices. Call Optio (America Style) A optio which gives the buyer the right, but ot the obligatio, to purchase ( go log ) the uderlyig futures cotract at the strike price o or before the expiratio date. Carryig Broker A member of a futures exchage, usually a clearighouse member, through which aother firm, broker or customer chooses to clear all or some trades. Cash Commodity The actual physical commodity as distiguished from the futures cotract based o the physical commodity. Also referred to as Actuals. Cash Market A place where people buy ad sell the actual commodities (i.e., grai elevator, bak, etc.). See also Forward (Cash) Cotract ad Spot. Cash Settlemet A method of settlig certai futures or optios cotracts whereby the market participats settle i cash (paymet of moey rather tha delivery of the commodity). Chartig The use of graphs ad charts i the techical aalysis of futures markets to plot price movemets, volume, ope iterest or other statistical idicators of price movemet. See also Techical Aalysis. Churig Excessive tradig that results i the broker derivig a profit from commissios while disregardig the best iterests of the customers. 76 77
Glossary Circuit Breaker A system of tradig halts ad price limits o equities ad derivatives markets desiged to provide a coolig-off period durig large, itraday market declies or rises. Clear The process by which a clearighouse maitais records of all trades ad settles margi flow o a daily mark-to-market basis for its clearig members. Clearighouse A corporatio or separate divisio of a futures exchage that is resposible for settlig tradig accouts, collectig ad maitaiig margi moies, regulatig delivery ad reportig trade data. The clearighouse becomes the buyer to each seller (ad the seller to each buyer) ad assumes resposibility for protectig buyers ad sellers from fiacial loss by assurig performace o each cotract. Clearig Member A member of a exchage clearighouse resposible for the fiacial commitmets of its customers. All trades of a o-clearig member must be registered ad evetually settled through a clearig member. Closig Price See Settlemet Price. Closig Rage A rage of prices at which futures trasactios took place durig the close of the market. Commissio A fee charged by a broker to a customer for executig a trasactio. Commissio House See Futures Commissio Merchat. Commodity Exchage Act (CEA) The federal act that provides for federal regulatio of futures tradig. Commodity Futures Tradig Commissio (CFTC) The federal regulatory agecy established i 1974 that admiisters the Commodity Exchage Act.The CFTC moitors the futures ad optios o futures markets i the Uited States. Commodity Pool A eterprise i which fuds cotributed by a umber of persos are combied for the purpose of tradig futures or optios cotracts.the cocept is similar to a mutual fud i the securities idustry. Also referred to as a Pool. Commodity Pool Operator (CPO) A idividual or orgaizatio which operates or solicits fuds for a commodity pool.a CPO may be required to be registered with the CFTC. Commodity Tradig Advisor (CTA) A perso who, for compesatio or profit, directly or idirectly advises others as to the advisability of buyig or sellig futures or commodity optios. Providig advice icludes exercisig tradig authority over a customer s accout. A CTA may be required to be registered with the CFTC. Cofirmatio Statemet A statemet set by a Futures Commissio Merchat to a customer whe a futures or optios positio has bee iitiated.the statemet shows the price ad the umber of cotracts bought or sold. Sometimes combied with a Purchase ad Sale Statemet. Cotract Market A board of trade desigated by the CFTC to trade futures or optios cotracts o a particular commodity. Commoly used to mea ay exchage o which futures are traded.also referred to as a Exchage. Cotract Moth The moth i which delivery is to be made i accordace with the terms of the futures cotract.also referred to as Delivery Moth. Covergece The tedecy for prices of physical commodities ad futures to approach oe aother, usually durig the delivery moth. Covered Optio A short call or put optio positio which is covered by the sale or purchase of the uderlyig futures cotract or physical commodity. 78 79
Glossary Cross-Hedgig Hedgig a cash commodity usig a differet but related futures cotract whe there is o futures cotract for the cash commodity beig hedged ad the cash ad futures market follow similar price treds (e.g., usig soybea meal futures to hedge fish meal). Customer Segregated Fuds See Segregated Accout. Day Order A order that if ot executed expires automatically at the ed of the tradig sessio o the day it was etered. Day Trader A speculator who will ormally iitiate ad offset a positio withi a sigle tradig sessio. Default The failure to perform o a futures cotract as required by exchage rules, such as a failure to meet a margi call or to make or take delivery. Deferred Delivery Moth The distat delivery moths i which futures tradig is takig place, as distiguished from the earby futures delivery moth. Delivery The trasfer of the cash commodity from the seller of a futures cotract to the buyer of a futures cotract. Each futures exchage has specific procedures for delivery of a cash commodity. Some futures cotracts, such as stock idex cotracts, are cash settled. Delivery Moth See Cotract Moth. Derivative A fiacial istrumet, traded o or off a exchage, the price of which is directly depedet upo the value of oe or more uderlyig securities, equity idices, debt istrumets, commodities, other derivative istrumets, or ay agreed upo pricig idex or arragemet. Derivatives ivolve the tradig of rights or obligatios based o the uderlyig product but do ot directly trasfer that product.they are geerally used to hedge risk. Desigated Self-Regulatory Orgaizatio (DSRO) Whe a Futures Commissio Merchat (FCM) is a member of more tha oe Self-Regulatory Orgaizatio (SRO), the SROs may decide amog themselves which of them will be primarily resposible for eforcig miimum fiacial ad sales practice requiremets. The SRO will be appoited DSRO for that particular FCM. NFA is the DSRO for all o-exchage member FCMs. See also Self-Regulatory Orgaizatio. Disclosure Documet The statemet that some CPOs must provide to customers. It describes tradig strategy, fees, performace, etc. Discout (1) The amout a price would be reduced to purchase a commodity of lesser grade; (2) sometimes used to refer to the price differeces betwee futures of differet delivery moths, as i the phrase July is tradig at a discout to May, idicatig that the price of the July future is lower tha that of May; (3) applied to cash grai prices that are below the futures price. Discretioary Accout A arragemet by which the ower of the accout gives writte power of attorey to someoe else, usually the broker or a Commodity Tradig Advisor, to buy ad sell without prior approval of the accout ower. Also referred to as a Maaged Accout. Electroic Order A order placed electroically (without the use of a broker) either via the Iteret or a electroic tradig system. Electroic Tradig Systems Systems that allow participatig exchages to list their products for tradig electroically. These systems may replace, supplemet or ru alog side of the ope outcry tradig. Equity 1) The value of a futures tradig accout if all ope positios were offset at the curret market price; 2) a owership iterest i a compay, such as stock. 80 81
Glossary Exchage See Cotract Market. Exercise The actio take by the holder of a call optio if he wishes to purchase the uderlyig futures cotract or by the holder of a put optio if he wishes to sell the uderlyig futures cotract. Exercise Price See Strike Price. Expiratio Date Geerally the last date o which a optio may be exercised. It is ot ucommo for a optio to expire o a specified date durig the moth prior to the delivery moth for the uderlyig futures cotracts. Extrisic Value See Time Value. First Notice Day The first day o which otice of itet to deliver a commodity i fulfillmet of a expirig futures cotract ca be give to the clearighouse by a seller ad assiged by the clearighouse to a buyer.varies from cotract to cotract. 1) The value of a futures tradig accout if all ope positios were offset at the curret market price; 2) a owership iterest i a compay, such as stock. Floor Broker A idividual who executes orders o the tradig floor of a exchage for ay other perso. Floor Trader A idividual who is a member of a exchage ad trades for his ow accout o the floor of the exchage. Forward (Cash) Cotract A cotract which requires a seller to agree to deliver a specified cash commodity to a buyer sometime i the future, where the parties expect delivery to occur.all terms of the cotract may be customized, i cotrast to futures cotracts whose terms are stadardized. Fully Disclosed A accout carried by a Futures Commissio Merchat i the ame of a idividual customer; the opposite of a Omibus Accout. 82 Fudametal Aalysis A method of aticipatig future price movemet usig supply ad demad iformatio. Futures Commissio Merchat (FCM) A idividual or orgaizatio which solicits or accepts orders to buy or sell futures cotracts or commodity optios ad accepts moey or other assets from customers i coectio with such orders. A FCM must be registered with the CFTC. Futures Cotract A legally bidig agreemet to buy or sell a commodity or fiacial istrumet at a later date. Futures cotracts are ormally stadardized accordig to the quality, quatity, delivery time ad locatio for each commodity, with price as the oly variable. Grator See Writer. Guarateed Itroducig Broker A Guarateed Itroducig Broker is a IB that has a writte agreemet with a Futures Commissio Merchat that obligates the FCM to assume fiacial ad discipliary resposibility for the performace of the Guarateed Itroducig Broker i coectio with futures ad optios customers. A Guarateed Itroducig Broker is ot subject to miimum fiacial requiremets. Hedgig The practice of offsettig the price risk iheret i ay cash market positio by takig a opposite positio i the futures market. A log hedge ivolves buyig futures cotracts to protect agaist possible icreasig prices of commodities. A short hedge ivolves sellig futures cotracts to protect agaist possible decliig prices of commodities. High The highest price of the day for a particular futures or optios o futures cotract. Holder The opposite of a Grator. See also Optio Buyer. 83
Glossary I-the-Moey Optio A optio that has itrisic value.a call optio is i-the-moey if its strike price is below the curret price of the uderlyig futures cotract.a put optio is i-the-moey if its strike price is above the curret price of the uderlyig futures cotract. Idepedet Itroducig Broker A Idepedet Itroducig Broker is a IB subject to miimum capital requiremets. Iitial Margi The amout a futures market participat must deposit ito a margi accout at the time a order is placed to buy or sell a futures cotract. See also Margi. Itrisic Value The amout by which a optio is i-the-moey. Itroducig Broker (IB) A firm or idividual that solicits ad accepts commodity futures orders from customers but does ot accept moey, securities or property from the customer.all Itroducig Brokers must be registered with the CFTC. Last Tradig Day The last day o which tradig may occur i a give futures or optio. Leverage The ability to cotrol large dollar amouts of a commodity with a comparatively small amout of capital. Limit See Positio Limit, Price Limit, Variable Limit. Liquidate To sell a previously purchased futures or optios cotract or to buy back a previously sold futures or optios positio. Also referred to as Offset. Liquidity (Liquid Market) A characteristic of a security or commodity market with eough uits outstadig ad eough buyers ad sellers to allow large trasactios without a substatial chage i price. Local A member of a exchage who trades for his ow accout. 84 Log Oe who has bought futures cotracts or optios o futures cotracts or ows a cash commodity. Low The lowest price of the day for a particular futures or optios o futures cotract. Maiteace Margi A set miimum amout (per outstadig futures cotract) that a customer must maitai i his margi accout to retai the futures positio. See also Margi. Maaged Accout See Discretioary Accout. Margi A amout of moey deposited by both buyers ad sellers of futures cotracts ad by sellers of optios cotracts to esure performace of the terms of the cotract (the makig or takig delivery of the commodity or the cacellatio of the positio by a subsequet offsettig trade). Margi i commodities is ot a dow paymet, as i securities, but rather a performace bod. See also Iitial Margi, Maiteace Margi ad Variatio Margi. Margi Call A call from a clearighouse to a clearig member,or from a broker or firm to a customer, to brig margi deposits up to a required miimum level. Mark-to-Market To debit or credit o a daily basis a margi accout based o the close of that day s tradig sessio. I this way, buyers ad sellers are protected agaist the possibility of cotract default. Market Order A order to buy or sell a futures or optios cotract at whatever price is obtaiable whe the order reaches the tradig floor. Maximum Price Fluctuatio See Price Limit. 85
Glossary Miimum Price Fluctuatio See Tick. Naked Optio See Ucovered Optio. Natioal Futures Associatio (NFA) Authorized by Cogress i 1974 ad desigated by the CFTC i 1982 as a registered futures associatio, NFA is the idustrywide self-regulatory orgaizatio of the futures idustry. Nearby Delivery Moth The futures cotract moth closest to expiratio. Also referred to as the Spot Moth. Net Asset Value The value of each uit of participatio i a commodity pool. Basically a calculatio of assets mius liabilities plus or mius the value of ope positios whe marked to the market, divided by the total umber of outstadig uits. Net Performace A icrease or decrease i et asset value exclusive of additios, withdrawals ad redemptios. Offer A idicatio of willigess to sell a futures cotract at a give price; the opposite of Bid. Offset See Liquidate. Omibus Accout A accout carried by oe Futures Commissio Merchat (FCM) with aother FCM i which the trasactios of two or more persos are combied ad carried i the ame of the origiatig FCM rather tha of the idividual customers; the opposite of Fully Disclosed. Ope The period at the begiig of the tradig sessio officially desigated by the exchage durig which all trasactios are cosidered made at the ope. 86 Ope Iterest The total umber of futures or optios cotracts of a give commodity that have ot yet bee offset by a opposite futures or optio trasactio or fulfilled by delivery of the commodity or optio exercise. Each ope trasactio has a buyer ad a seller, but for calculatio of ope iterest, oly oe side of the cotract is couted. Ope Outcry A method of public auctio for makig bids ad offers i the tradig pits of futures exchages. Ope Trade Equity The urealized gai or loss o ope positios. Opeig Rage The rage of prices at which buy ad sell trasactios took place durig the opeig of the market. Optio Buyer The purchaser of either a call or put optio. Optio buyers receive the right, but ot the obligatio, to assume a futures positio.also referred to as a Holder. Optio Cotract A cotract which gives the buyer the right, but ot the obligatio, to buy or sell a specified quatity of a commodity or a futures cotract at a specific price withi a specified period of time. The seller of the optio has the obligatio to sell the commodity or futures cotract or to buy it from the optio buyer at the exercise price if the optio is exercised. See also Call Optio ad Put Optio. Optio Premium The price a buyer pays (ad a seller receives) for a optio. Premiums are arrived at through the market process. There are two compoets i determiig this price extrisic (or time) value ad itrisic value. Optio Seller See Writer. Out-of-the-Moey Optio A call optio with a strike price higher or a put optio with a strike price lower tha the curret market value of the uderlyig asset (i.e., a optio that does ot have ay itrisic value). 87
Glossary Over-the-Couter Market (OTC) A market where products such as stocks, foreig currecies ad other cash items are bought ad sold by telephoe, Iteret ad other electroic meas of commuicatio rather tha o a desigated futures exchage. Pit The area o the tradig floor where tradig i futures or optios cotracts is coducted by ope outcry.also referred to as a rig. Pool See Commodity Pool. Positio A commitmet, either log or short, i the market. Positio Limit The maximum umber of speculative futures cotracts oe ca hold as determied by the CFTC ad/or the exchage where the cotract is traded. See also Price Limit, Variatio Limit. Positio Trader A trader who either buys or sells cotracts ad holds them for a exteded period of time, as distiguished from a day trader. Premium Refers to (1) the price paid by the buyer of a optio; (2) the price received by the seller of a optio; (3) cash prices that are above the futures price; (4) the amout a price would be icreased to purchase a better quality commodity; or (5) a futures delivery moth sellig at a higher price tha aother. Price Discovery The determiatio of the price of a commodity by the market process. Price Limit The maximum advace or declie, from the previous day's settlemet price,permitted for a futures cotract i oe tradig sessio.also referred to as Maximum Price Fluctuatio. See also Positio Limit, Variatio Limit. Purchase ad Sale Statemet (P&S) A statemet set by a Futures Commissio Merchat to a customer whe a futures or optios positio has bee liquidated or offset.the statemet shows the umber of cotracts bought or sold, the prices at which the cotracts were bought or sold, the gross profit or loss, the commissio charges ad the et profit or loss o the trasactio. Sometimes combied with a Cofirmatio Statemet. Put Optio A optio which gives the buyer the right, but ot the obligatio, to sell the uderlyig futures cotract at a particular price (strike or exercise price) o or before a particular date. Quotatio The actual price or the bid or ask price of either cash commodities or futures or optios cotracts at a particular time. Rage The differece betwee the high ad low price of a commodity durig a give tradig sessio, week, moth, year, etc. Regulatios (CFTC) The regulatios adopted ad eforced by the CFTC i order to admiister the Commodity Exchage Act. Reparatios The term is used i cojuctio with the CFTC s customer claims procedure to recover civil damages. Reportable Positios The umber of ope cotracts specified by the CFTC whe a firm or idividual must begi reportig total positios by delivery moth to the authorized exchage ad/or the CFTC. Roud Tur A completed futures trasactio ivolvig both a purchase ad a liquidatig sale, or a sale followed by a coverig purchase. Rules (NFA) The stadards ad requiremets to which participats who are required to be Members of Natioal Futures Associatio must subscribe ad coform. 88 89
Glossary Scalper A trader who trades for small, short-term profits durig the course of a tradig sessio, rarely carryig a positio overight. Segregated Accout A special accout used to hold ad separate customers assets for tradig o futures exchages from those of the broker or firm.also referred to as Customer Segregated Fuds. Self-Regulatory Orgaizatio (SRO) Self-regulatory orgaizatios (i.e., the futures exchages ad Natioal Futures Associatio) eforce miimum fiacial ad sales practice requiremets for their members. See also Desigated Self-Regulatory Orgaizatio. Settlemet Price The last price paid for a futures cotract o ay tradig day. Settlemet prices are used to determie ope trade equity, margi calls ad ivoice prices for deliveries. Also referred to as Closig Price. Short Oe who has sold futures cotracts or plas to purchase a cash commodity. Speculator A market participat who tries to profit from buyig ad sellig futures ad optios cotracts by aticipatig future price movemets. Speculators assume market price risk ad add liquidity ad capital to the futures markets. Spot Usually refers to a cash market for a physical commodity where the parties geerally expect immediate delivery of the actual commodity. Spot Moth See Nearby Delivery Moth. Spreadig The buyig ad sellig of two differet delivery moths or related commodities i the expectatio that a profit will be made whe the positio is offset. Stop Order A order that becomes a market order whe the futures cotract reaches a particular price level. A sell stop is placed below the market, a buy stop is placed above the market. Strike Price The price at which the buyer of a call (put) optio may choose to exercise his right to purchase (sell) the uderlyig futures cotract. Also called Exercise Price. Techical Aalysis A approach to aalysis of futures markets which examies patters of price chage, rates of chage, ad chages i volume of tradig, ope iterest ad other statistical idicators. See also Chartig. Tick The smallest icremet of price movemet for a futures cotract. Also referred to as Miimum Price Fluctuatio. Time Value The amout of moey optios buyers are willig to pay for a optio i aticipatio that over time a chage i the uderlyig futures price will cause the optio to icrease i value.i geeral,a optio premium is the sum of time value ad itrisic value.ay amout by which a optio premium exceeds the optio's itrisic value ca be cosidered time value.also referred to as Extrisic Value. Ucovered Optio A short call or put optio positio which is ot covered by the purchase or sale of the uderlyig futures cotract or physical commodity. Also referred to as a Naked Optio. Uderlyig Futures Cotract The specific futures cotract that the optio coveys the right to buy (i case of a call) or sell (i the case of a put). Variable Limit A price system that allows for larger tha ormal allowable price movemets uder certai coditios. I periods of extreme volatility, some exchages permit tradig at price levels that exceed regular daily price limits. See also Positio Limit, Price Limit. 90 91
Glossary Variatio Margi Additioal margi required to be deposited by a clearig member firm to the clearighouse durig periods of great market volatility or i the case of high-risk accouts. Volatility A measuremet of the chage i price over a give time period. Volume The umber of purchases ad sales of futures cotracts made durig a specified period of time, ofte the total trasactios for oe tradig day. Writer A perso who sells a optio ad assumes the potetial obligatio to sell (i the case of a call) or buy (i the case of a put) the uderlyig futures cotract at the exercise price.also referred to as a Optio Grator. Yield A measure of the aual retur o a ivestmet. Additioal Resources Commodity Futures Tradig Commissio (CFTC) Three Lafayette Cetre 1155 21st Street, NW Washigto, DC 20581 (202) 418-5800 www.cftc.gov CBOE Futures Exchage (CFE) 400 S. LaSalle St. Chicago, IL 60605 (312) 786-5600 www.cfe.cboe.com Chicago Board of Trade (CBOT) 141 W. Jackso Blvd. Chicago, IL 60604 (312) 435-3500 www.cbot.com Chicago Climate Futures Exchage (CCFE) 400 S. LaSalle St. Chicago, IL 60605 (312) 554-3350 www.chicagoclimatex.com Chicago Mercatile Exchage (CME) 30 S. Wacker Dr. Chicago, IL 60606 (312) 930-1000 www.cme.com HedgeStreet 1825 S. Grat St., Suite 500 Sa Mateo, Ca 94402 www.hedgestreet.com Mieapolis Grai Exchage (MGE) 400 S. Fourth St. Mieapolis, MN 55415 (612) 321-7101 www.mgex.com New York Board of Trade (NYBOT) 174 Hudso St. New York, NY 10013 (718) 391-7000 www.ybot.com New York Mercatile Exchage (NYMEX) Oe North Ed Aveue World Fiacial Ceter New York, NY 10282-1101 (212) 299-2000 www.ymex.com OeChicago 141 W. Jackso Blvd., Suite 2240 Chicago, IL 60604 (312) 424-8500 www.oechicago.com Philadelphia Board of Trade (PBOT) 1900 Market St. Philadelphia, PA 19103 (215) 496-5000 www.phlx.com/pbot U.S. Futures Exchage (Eurex US) 233 S. Wacker Dr., Suite 2450 Chicago, IL 60606 (312) 544-1100 www.eurexus.com 92 Kasas City Board of Trade (KCBT) 4800 Mai St., Suite 303 Kasas City, MO 64112 (816) 753-7500 www.kcbt.com 93