Understanding Futures & Options (Commodities)

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Forward Contract:

Back 1

Is a contract between a buyer and seller in which the seller agrees to deliver a specific commodity to the buyer at some time in the future.

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The Chicago Board of Trade:

Back 2

82 merchants banded together in 1848 to create a centralized meeting place for buyers and sellers of commodities to meet and promote commerce.

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Futures Contract:

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A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument sometime in the future. Are standardized according to quality, quanitity and delivery time and location for each commodity. The only variable is price, which is discovered on the trading floor.

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Grades:

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Listed in the rules of the exchange that must be met when delivering against future contract. These are often accompanied by an exchange set schedule of discounts and premiums allowable for delivery of commodities of lesser or greater quality than the standard called by the contract rules.

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What do Speculators do?

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Buy or sell contracts that may have not otherwise been traded, making the market larger and more liquid to help minimize price fluctuations. Looking to make money and take other other's risks.

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Hedger:

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A person who wishes to manage price risk by transfering risk to someone else.

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Option Price =

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Premium

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Futures markets:

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Are first and foremost a risk transference vehicle.

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Option:

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The right to buy or sell a commodity at a predetermined price, anytime within a specified timeframe.

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Offset:

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taking a second futures or options position opposite to the initial position. Example: buying a second same futures contract on the same commodity with the same delivery date is sold or to * the sale of a futures contract, a second commidities contract on the same commodity with the same delivery month is purchased.

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Cash Market:

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Refers to physical commodities,which you can touch- be they corn, beef, bonds, or stock.

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Arbitrage:

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When you buy something in one market and sell it in another in order to profit by exploiting price differences.

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Long Position:

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Entails the purchase of futures contracts in anticipation of rising prices.

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Short Position:

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Entails the sale of futures contracts in anticipation of lower prices.

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Hedging:

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The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures markets. Use the market to protect their business from adverse price changes.

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Greater supply =

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Lower prices

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In all hedging transactions, the basic idea is to:

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establish, in advance, an acceptable price or rate of interest.

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Speculators

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Assume the risk that Hedgers try to avoid. Profit is their motivation. Make markets less volatile. To engage in the buying and/or selling of commodities with an element of risk on the chance of a profit.

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Call Option:

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Contains the right to buy the underlying futures contract.

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Put Option:

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Contains the right to sell the underlying futures contract.

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Clearinghouse:

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An agency or separate corporation of a futures exchange that is responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. Act as a third party to every futures transaction.

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Initial Margin Requirement:

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the amount of money a party must have on account with a clearing firm/broker at the time an order is placed.

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Maintenance Margin:

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A set minimum margin that a party to a futures contract must maintain in his or her margin account to hold a futures position.

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Is it possible to lose more than your initial account balance or margin deposit as a Speculator?

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YES!

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Floor:

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Minimum selling price, established by seller- protects against falling markets without giving up possible rising market profit

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Ceiling:

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Maximum buying price, established by buyer- protects buyer from price increases

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Buyers want:

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Lowest option price

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Sellers want:

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Highest option price

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Intrinsic Value:

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Current value of exercised option at a given strike price, to obtain, compare strike price and underlying futures price

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Option Premium=

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Intrinsic Value + Time Value

Front 31

Name some of the trading floors in the United States:

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Chicago Board of Trade, Chicago Merchantile Exchange, New York Merchantile Exchange, New York Board of Trade, Kansas City Board of Trade, Minneapolis Grain Exchange

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Open Outcry:

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Within the trading pit of an exchange, people vocalize offers to buy and sell; in theory, allowing every trader the same opportunity.

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Bid:

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The highest price the floor is quoting for the purchase of a commodity contract.

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Offer (also known as the "ask):

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The lowest price the floor is quoting for the sale of a commodity contract, also known as the "ask".

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Bid/ask spread:

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The difference between the bid and the offer. Also known as the "market".

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The 2 types of Floor Traders:

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Floor brokers and Locals

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Floor Brokers trade for:

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commission houses/brokers, commercial interests, financial institutions, portfolio managers, processors and exporters and the general speculating public.

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Locals trade for:

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their own accounts or the accounts of the firms they below to (private brokers). There are generally 3 types- day traders, position traders, and scalpers.

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Order:

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Also called a "ticket"

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The lifecycle of an order:

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Go from the client to the broker, from the broker to the exchange trading floor desk, from the desk to the trading pitt via a "runner, executed by a floor broker and sent back to the desk to be reported to the original broker who informs the clients- roughly taking 12 minutes.

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In-the-money Option:

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An option having intrinsic value. A call option is in-the-money if its strike price is below the current price of the underlying futures contract. A put option is "in-the-money" if it's strike position is above the current price of the underlying futures contract.

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Out-of-the-money Option:

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An option when NO intrinsic value, as in a call whose price is above the current futures price or a put whose strike price is below the current futures price.

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At-the-money Option:

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Buyer or seller is buying/selling equal to their initial strike price to the current market value.

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Time Value:

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The amount of money option buyers are willing to pay for an option in anticipation that, over time, a change in the underlying futures prices will cause the option to increase in value. Also referred to as the "extrinsic value". Part of the "option premium" equation.

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Strike Price:

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The price at which the futures contract underlying a call or put option can be purchased (if a call) or sold (if a put). Also referred to as the "exercise price".

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You are __-the-money in this situation:

Call Option:
strike price less than futures
Put Option:
strike price is greater than futures

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In-the-money

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You are __-the-money in this situation:

Call Option:
strike price greater than futures
Put Option:
strike price less than futures

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Out-of-the-money

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You are __-the-money in this situation:

Call Option:
strike price is = futures
Put Option:
strike price is = futures

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At-the-money

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The two Time Value factors are:

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1. Time until expiration
2. Futures price volatility

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The three ways to Exit an Option Position:

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1. Offset the position
2. Exercise the option
3. Let the option expire

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Hedging can be seen in our everyday lives. Give some examples:

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1. Homeowners insurance
2. Repair warranties
3. College savings plans
4. Retirement plans

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What do Hedgers have?

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Individuals or companies that own or are planning to own a cash commodity- corn, wheat, soybeans, cattle, U.S. Treasury Bonds, Stocks, Foreign Currencies, etc. who are concerned that the cost of the commodity may change before they either buy or sell it.

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Name some examples of Hedgers?

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Farmers, Grain elevators, merchandisers, producers, exporters, importers, bankers, bond dealers, brokerage houses, insurance companies, money managers, portfolio managers, airlines, transportation companies, governments, etc.

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What is the difference between the cash market and futures market?

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The cash market refers to physical commodities you can touch- be they corn, wheat, beef, bonds, etc. The futures market refers to the RIGHT or OBLIGATION to make or accept delivery of these physical commodities. A cash transaction is between individuals while a futures contract is between exchange clearing members.

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The basis equation is:

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Basis = Cash Price - Futures Price

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Basis:

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The difference between the current cash price and the futures cash price of the same commodity. Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate.

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Successful Hedgers need to:

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1. Understand their business's costs
2. How their local markets react to national markets
3. Willing to change their views- be flexible as conditions change.

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The futures markets are known as a zero sum game, meaning:

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For every winner, there is a loser.

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The Pit:

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Area of the trading floor where futures and options on future contracts are bought and sold. Usually raised octagonal platforms with steps descending on the inside that permit buyers and sellers to see each other.

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Liquidity:

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A characteristic of a security or commodity market with enough units outstanding to allow large transactions without a substantial change in price.

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Three types of Options:

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European Option: only excercised on expiration

American Option: may be exercised on any trading day on or before expiration.

Flex Option: CBOT Treasury allows choice of strike price, style and expiration month.

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Traders who are in anticipation of higher prices are said to be: Bullish or Bearish?

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Bullish

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Traders who are in anticipation of lower prices are said to be: Bullish or Bearish?

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Bearish

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The bull and bear expressions come from what story?

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In the bull and bear fights of the Romans, the bull would gore the bear by shifting his horns upward. The bear would attack by heaving his claws downward. Hence bulls become the symbol of upward movement and bears became the symbol of downward movement.

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When initiating a long position (buying) you hope for: higher or lower prices?

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Higher Prices: (Your profits are the difference between the purchase price and the sale price.

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When initiating a short position (selling) you hope for: higher or lower prices?

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Lower prices: profits are calculated by the sale price less the purchase price.

Front 67

Margin is not a down payment for a futures contract, but a _________ deposit to ensure contract performance.

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security

Front 68

Who are the regulators of the Futures industry?

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1. Commodity Futures Trading Commission (CFTC)
2. Existing Commodity Exchange Authority
3. Commodity Exchange Commission Personnel

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What does anticipatory hedging allow market users to do?

Back 69

Buy and sell futures contracts before they actually own the cash commodity.

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What does cross-hedging allow market users to do?

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Use a different but related commodity futures contract when there is no futures contract for the cash commodity being traded.

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Give an example of 2 commodities that could be used with cross-hedging?

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You could look at corn for milo, heating fuels for jet fuel, etc.

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The CFTC has the right to:

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1. Govern delivery points that underlie the futures contracts
2. Require an exchange to add or change delivery locations
3. Review exchange actions- denying membership, access privileges, or discipline membersl
4. Authorized to take emergency steps in the markets under certain conditions, such as actual or threatened market manipulation.

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What is a futures commission merchant? (FCM)

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A firm that transacts futures and options business on futures exchanges on behalf of financial and commercial institutions, as well as the general public.

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Who is the introducing broker (IB)?

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A person or firm that solicits or accepts orders to buy or sell futures contracts or commodity options, but does not accept money. Money can only be accepted by futures clearing merchants.

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Who/What are associated persons (AP)?

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Series three licensed employees of either Introducing Brokers or Futures Clearing Merchants who act as agents of a firm. Most commonly known as brokers or broker assistants.

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What is the general licensing test given to all associated persons to ensure their basic proficiency with the concepts of futures trading and hedging.

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Series three exam

*The exam is a 4 hour long exam testing market knowledge and rules and regulations. There is a 70 percent passing score on both portions.

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What is the name of the industry supported, industry-wide, self-regulatory organization for the futures industry.

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National Futures Association (NFA)

* The organizations's ethical standards prohibit fraud, manipulative and deceptive acts/practices, and unfair business dealings. Employees must follow procedures similar to the CFTC requirements.

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Futures Commission Merchants are comparable to:

Introducing Brokers are comparable to:

Associated Persons are:

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FCM: ADM Investor Services
IB: Water Street Solutions
AP: The Market Advisors at Water Street Solutions

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The Chicago Board of Trade and the Chicago Mercantile Exchange have merged to become:

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The CME Group

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To assign:

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is to make an option seller perform his obligation to assume a short futures position (as a seller of a call option) or a long futures position (as a seller of a put option).

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A bearish person is someone who believes:

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market prices will decline

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A brokerage fee is:

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A fee charged by a broker for executing a transaction.

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A brokerage house is:

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An individual or organization that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets from customers to support such orders.

*Also referred to as a commission house or wire house.

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A bullish person:

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Someone who thinks market prices will rise.

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A canceling order is:

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An order that deletes a customer's previous order.

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A carryover is:

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A commodity not consumed during the marketing year and remain in storage at the years end. They are then added to the stocks produced during the new crop year.

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Cash Commodity is:

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An actual physical commodity someone is buying or selling such as soybeans, corn, gold, silver, treasury bonds, etc.