Intro to Futures & Options
- What are Futures and Options?
- Terms to Know
- Is Futures trading for you?
What are Futures & Options
A futures contract is an obligation to buy or sell a specific quantity and quality of a commodity at a certain price on a specified future date. A futures contract month, also called the “delivery month,” identifies the month and year in which the futures contract ceases to exist and when the contract's obligation must be fulfilled. If the contract is not offset (sold if one has bought; bought if one has sold) prior to the delivery date, it is settled either by the exchange of the physical commodity, or in cash.
Options on Futures contracts
Options on futures were introduced in the 1980's. An option on a futures contract conveys the right, not the obligation, to assume a position in the underlying futures market at a specific price any time before the option expires. A call option is the right to buy a commodity futures contract. A put option is the right to sell a commodity futures contract.
The Futures Contract - What's already determined?
- The commodity
- The quantity of the commodity
- The quality of the commodity
- The delivery date for the commodity futures contract
- The delivery point or cash settlements
EX: Random Length Lumber
Take the Random Length Lumber futures contract, which trades at the Chicago Mercantile Exchange (CME) as an example. The contract quantity is already determined (110,000 board feet). The lumber quality is also determined (grade stamped Construction and Standard, Standard and Better, or #1 or #2 2x4's of random lengths from 8 feet to 20 feet).
The delivery date of the contract is already decided too. That's when the contract matures. There are six different Lumber futures contracts traded each year, each with a specified delivery date – February, March, May, July, September and November. So when you buy a March Lumber contract, you know the contract matures in March.
The delivery points for Random Length futures contracts are also known. That means if you make or take delivery of 1 Lumber contract (equivalent to 110,000 board feet of Lumber) when the delivery date arrives, you know exactly to which warehouses you can send your truck. (For many commodities, there's a cash settlement instead of delivery of the actual commodity.)
Here's an interesting point to remember. Most people who buy and sell Random Length Lumber futures don't deliver or pick up a load of lumber when the contract matures. They usually offset the trade and get out of the market before that point. They don't really want the Lumber. They've traded the futures contracts for other reasons such as protection against rising or falling lumber prices or simply to earn a profit on the trade.
The Futures exchange
Futures contracts are traded at a futures exchange and only at a futures exchange. There are several futures exchanges in the United States. They are:
- The Chicago Mercantile Exchange
- The Sugar, Coffee and Cocoa Exchange
- The New York Mercantile Exchange
- The Chicago Board of Trade
The Clearing Function
One of the most important functions of a futures exchange is to provide a clearing operation. This operation is called the Clearing House. The Clearing House is responsible for clearing trades and for the day-to-day settlement. What does that mean? The Clearing House records all the trades happening in the trading pits each day. At the end of the trading session, it matches or reconciles contracts bought and sold.
The Clearing House also settles the traders' accounts to the market each day. When you buy or sell a commodity futures contract, the exchange requires you to put up a performance bond. That's a cash deposit to cover any loss your investment may incur. Money is added to your performance bond balance if your position earned a profit that day. However, if your position lost money that day, money is subtracted from the balance. And you may get a margin call to put more money into the account. The Clearing House figures everything out for you.
Options on futures- What does an option on a futures contract specify?
- The commodity and the contract month of the commodity futures contract.
- The right to buy or sell the commodity futures contract.
- The price at which the commodity futures contract will be bought or sold.
Terms to Know
The value of a commodity futures contract ultimately is tied to the underlying product or instrument via each contract's specifications. Not all contracts specify physical delivery, in which the underlying product is transferred to the commodity futures contract buyer by the seller. A number of commodity futures contracts are cash settled. Cash settlement allows those who take or make delivery to exchange cash rather than a physical good.
Most of those who participate in the commodity futures or options markets can be categorized broadly into one of two groups – hedgers and speculators – depending on whether they are there to transfer risk or accept risk. Brokers are intermediaries who carry out buying and selling instructions from hedgers or speculators.
Hedgers are market participants who want to transfer risk. They can be producers or consumers. A producer hedger wants to transfer the risk that prices will decline by the time a sale is made. A consumer hedger wants to transfer the risk that prices will increase before a commodity futures purchase is made.
A speculator takes a position in the commodity futures or options market in the hope of generating profit. If a speculator takes a long position and the market price goes up, the position is profitable. Likewise, profits accrue on a short position as market prices drop.
What is margin?
Futures performance bond, or good faith money, also known as margin money, work differently than margins in the stock market. For stocks, if you do not pay in full, the amount you do pay is known as margin and you borrow the rest. The government sets the maximum amount you can borrow.
In futures, however, your performance bond is not partial payment of the product at all, but an amount posted with the exchange to ensure performance in case the market moves against you in the future. In effect, your maximum possible next day's losses are escrowed in advance. Because no one knows which way the market will move, both buyers and sellers post performance bonds. The net result is great confidence among all parties that their gains will be there if the market moves in their favor, because those gains come directly and immediately from those taking the opposite side of the market.
A margin call is made by the exchange when an account's value goes below maintenance minimums which are set by the exchanges. The amount of the margin call will be the amount that is needed to bring the account value back to the maximum maintenance level; which is the initial margin level needed to put the trade on.
More on Options
An option is the right, but not the obligation, to buy or sell an underlying commodity futures contract at a specified price. For example, you could purchase an option to buy a November Swiss franc futures contract at 88 Ë per Swiss franc (an option to buy is a “call” option).
What do you do once you buy the Swiss franc option? You watch price movement. Suppose the November Swiss franc futures price rises above 88 Ë . You could exercise the option and assume a long November Swiss franc futures contract. You would have bought a futures contract at 88 Ë that you could sell immediately at the higher price. But you don't have to. With prices above 88 Ë , your option would have increased in value, so you could choose to offset it by selling back the same option at a profit. If the futures price falls below 88 Ë , the option would have decreased in value. Then you can simply forget about it and let it expire, losing the money you paid for it.
Puts and calls
There are special names for options, depending on whether the option is for the right to buy or the right to sell a futures contract.
A put option is the right, but not the obligation, to sell a commodity futures contract at a particular price.
A call option is the right, but not the obligation, to buy a commodity futures contract at a particular price.
How do we remember what direction the put and call represents? One way is to remember it is that we call someone up and put someone down. Get it? Call up, put down.
Much of the trading futures and options contracts are conducted in trading pits on an exchange floor via a system known as “open outcry”. This public auction system, dating to the beginning of organized futures markets, ensures that trades are executed at the market's best prevailing price.
How to read prices
Finding futures and options prices is fairly easy. But how do you decipher what you see or hear? Although the amount of information published by a source often differs, here are some standard terms you'll need to know:
- The average price at which the first bids and offers were made or the first transactions were completed.
- Top bid or top price at which a contract was traded during the trading period.
- Lowest offer or the lowest price at which a contract was traded during the trading period.
- Settlement price
- The official daily closing price.
- Net change
- The amount of increase or decrease from the previous trading period's settlement price.
- The highest price or bid and the lowest price or offer highs and lows reached in the lifetime of a futures contract or a specific delivery month.
- The number of contracts traded (one side of each trade only) for each delivery month during the trading period.
- Open interest
- The accumulated total of all currently outstanding contracts (one side only). Refers to unliquidated purchases and sales.
The Trading Plan
A well-organized trading plan and the discipline to follow it are essential elements of a successful trading program. That's because futures and options on futures are not long-term investments that you can just buy and forget. They require monitoring on a daily (or even an hourly) basis because of the large impact a small price move can have on your account. Your futures and options broker is crucial in helping you to develop your plan and to stay alert to important market changes.
Short and Long Positioning
In commodity futures and options you can buy and sell your commodity futures and options in whatever order you want; it's just as easy to sell and buy back low, as it is to buy low and sell at a higher price. If you think commodity futures prices are going up, establish a “long” (buy) position, and if you think commodity futures prices are going down, initiate a “short” (sell) position.
The initial margin requirement is relatively small compared to the value of the contract, and the resulting leverage can lead to quick and substantial profits or losses. (In fact, it's possible to lose more than the amount of money you've deposited.) A good rule of thumb when investing in commodity futures is to use only funds that you can afford to lose without affecting your lifestyle. And, only a portion of these should be devoted to any one trade. Remember, not every commodity futures trade will be a “winner”. Some very successful commodity traders may only “win” on 30-40% of their trades. The key is to cut your losses short, and to let your profits run.
The Leverage of Futures Markets
In the commodity futures markets, leverage means that you need only commit a little money to control a lot of product. When you initiate a commodity futures position, you usually only put up an initial margin of about 5% to 10% of the value of the commodity futures position.
Here's how quickly a substantial move can occur: In April and May of 1994, June live cattle futures plunged $11 per hundredweight (cwt.) over 32 trading days as the number and weight of cattle on feed increased. A trader who sold a June cattle contract at $74/cwt. on a margin of $700 earned close to $4,400 as prices fell to $63/cwt. ($11 gain/cwt., x 400 cwt.,) for a return of 628% on the initial investment in little more than a month.
Conversely, when supermarkets featured more beef just prior to the July 4 th holiday, a trader could have bought an August live cattle contract at $62/cwt. and sold that contract back in mid-July for $69/cwt., for a gain of close to $2,800 on an initial margin of $700, or a 400% return. (Of course, remember that it's just as easy to sustain a loss, as it is to realize a gain in these markets.)
Is Futures Trading for you?
Do YOU have what it takes? Is futures trading for YOU?
- Can you make decisions under pressure?
- Are you competitive?
- Would you like an intellectual hobby?
If you believe that you have the patience and drive to enter into the commodity futures markets, contact the professionals at Midwest Futures, Inc. for further information on how to get started, today!