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AlphaOne About Us |
Futures 101 Understanding Opportunities and Risks in Futures Trading Table of Contents:
Futures markets have been described as
continuous auction markets and as clearing houses for the latest information about supply
and demand. They are the meeting places of buyers and sellers of an ever-expanding list of
commodities that today includes agricultural products, metals, petroleum, financial
instruments, foreign currencies and stock indexes. Trading has also been initiated in
options on futures contracts, enabling option buyers to participate in futures markets
with known risks. Notwithstanding the rapid growth and
diversification of futures markets, their primary purpose remains the same as it has been
for nearly a century and a half, to provide an efficient and effective mechanism for the
management of price risks. By buying or selling futures contracts--contracts that
establish a price level now for items to be delivered later--individuals and businesses
seek to achieve what amounts to insurance against adverse price changes. This is called
hedging. Volume has increased from 14 million
futures contracts traded in 1970 to 179 million futures and options on futures contracts
traded in 1985. Other futures market participants are
speculative investors who accept the risks that hedgers wish to avoid. Most speculators
have no intention of making or taking delivery of the commodity but, rather, seek to
profit from a change in the price. That is, they buy when they anticipate rising prices
and sell when they anticipate declining prices. The interaction of hedgers and speculators
helps to provide active, liquid and competitive markets. Speculative participation in
futures trading has become increasingly attractive with the availability of alternative
methods of participation. Whereas many futures traders continue to prefer to make their
own trading decisions--such as what to buy and sell and when to buy and sell--others
choose to utilize the services of a professional trading advisor, or to avoid day-to-day
trading responsibilities by establishing a fully managed trading account or participating
in a commodity pool which is similar in concept to a mutual fund. For those individuals who fully understand
and can afford the risks which are involved, the allocation of some portion of their
capital to futures trading can provide a means of achieving greater diversification and a
potentially higher overall rate of return on their investments. There are also a number of
ways in which futures can be used in combination with stocks, bonds and other investments.
Speculation in futures contracts, however,
is clearly not appropriate for everyone. Just as it is possible to realize substantial
profits in a short period of time, it is also possible to incur substantial losses in a
short period of time. The possibility of large profits or losses in relation to the
initial commitment of capital stems principally from the fact that futures trading is a
highly leveraged form of speculation. Only a relatively small amount of money is required
to control assets having a much greater value. As we will discuss and illustrate, the
leverage of futures trading can work for you when prices move in the direction you
anticipate or against you when prices move in the opposite direction. It is not the purpose of this material to
suggest that you should--or should not--participate in futures trading. That is a decision
you should make only after consultation with your broker or financial advisor and in light
of your own financial situation and objectives. Intended to help provide you with the kinds
of information you should first obtain--and the questions you should seek answers to--in
regard to any investment you are considering: * Information about the investment itself
and the risks involved * How readily your investment or position
can be liquidated when such action is necessary or desired * Who the other market participants are * Alternate methods of participation * How prices are arrived at * The costs of trading * How gains and losses are realized * What forms of regulation and protection
exist * The experience, integrity and track
record of your broker or advisor * The financial stability of the firm with
which you are dealing In sum, the information you need to be an
informed investor. The frantic shouting and signaling of bids
and offers on the trading floor of a futures exchange undeniably convey an impression of
chaos. The reality however, is that chaos is what futures markets replaced. Prior to the
establishment of central grain markets in the mid-nineteenth century, the nation's farmers
carted their newly harvested crops over plank roads to major population and transportation
centers each fall in search of buyers. The seasonal glut drove prices to giveaway levels
and, indeed, to throwaway levels as grain often rotted in the streets or was dumped in
rivers and lakes for lack of storage. Come spring, shortages frequently developed and
foods made from corn and wheat became barely affordable luxuries. Throughout the year, it
was each buyer and seller for himself with neither a place nor a mechanism for organized,
competitive bidding. The first central markets were formed to meet that need. Eventually,
contracts were entered into for forward as well as for spot (immediate) delivery.
So-called forwards were the forerunners of present day futures contracts. Spurred by the need to manage price and
interest rate risks that exist in virtually every type of modern business, today's futures
markets have also become major financial markets. Participants include mortgage bankers as
well as farmers, bond dealers as well as grain merchants, and multinational corporations
as well as food processors, savings and loan associations, and individual speculators. Futures prices arrived at through
competitive bidding are immediately and continuously relayed around the world by wire and
satellite. A farmer in Nebraska, a merchant in Amsterdam, an importer in Tokyo and a
speculator in Ohio thereby have simultaneous access to the latest market-derived price
quotations. And, should they choose, they can establish a price level for future
delivery--or for speculative purposes--simply by having their broker buy or sell the
appropriate contracts. Images created by the fast-paced activity of the trading floor
notwithstanding, regulated futures markets are a keystone of one of the world's most
orderly envied and intensely competitive marketing systems. Should you at some time decide
to trade in futures contracts, either for speculation or in connection with a risk
management strategy, your orders to buy or sell would be communicated by phone from the
brokerage office you use and then to the trading pit or ring for execution by a floor
broker. If you are a buyer, the broker will seek a seller at the lowest available price.
If you are a seller, the broker will seek a buyer at the highest available price. That's
what the shouting and signaling is about. In either case, the person who takes the
opposite side of your trade may be or may represent someone who is a commercial hedger or
perhaps someone who is a public speculator. Or, quite possibly, the other party may be an
independent floor trader. In becoming acquainted with futures markets, it is useful to
have at least a general understanding of who these various market participants are, what
they are doing and why.
The details of hedging can be somewhat
complex but the principle is simple. Hedgers are individuals and firms that make purchases
and sales in the futures market solely for the purpose of establishing a known price
level--weeks or months in advance--for something they later intend to buy or sell in the
cash market (such as at a grain elevator or in the bond market). In this way they attempt
to protect themselves against the risk of an unfavorable price change in the interim. Or
hedgers may use futures to lock in an acceptable margin between their purchase cost and
their selling price. Consider this example: A jewelry manufacturer will need to buy
additional gold from his supplier in six months. Between now and then, however, he fears
the price of gold may increase. That could be a problem because he has already published
his catalog for a year ahead. To lock in the price level at which gold is
presently being quoted for delivery in six months, he buys a futures contract at a price
of, say, $350 an ounce. If, six months later, the cash market price
of gold has risen to $370, he will have to pay his supplier that amount to acquire gold.
However, the extra $20 an ounce cost will be offset by a $20 an ounce profit when the
futures contract bought at $350 is sold for $370. In effect, the hedge provided insurance
against an increase in the price of gold. It locked in a net cost of $350, regardless of
what happened to the cash market price of gold. Had the price of gold declined instead of
risen, he would have incurred a loss on his futures position but this would have been
offset by the lower cost of acquiring gold in the cash market. The number and variety of hedging
possibilities is practically limitless. A cattle feeder can hedge against a decline in
livestock prices and a meat packer or supermarket chain can hedge against an increase in
livestock prices. Borrowers can hedge against higher interest rates, and lenders against
lower interest rates. Investors can hedge against an overall decline in stock prices, and
those who anticipate having money to invest can hedge against an increase in the over-all
level of stock prices. And the list goes on. Whatever the hedging strategy, the common
denominator is that hedgers willingly give up the opportunity to benefit from favorable
price changes in order to achieve protection against unfavorable price changes.
Were you to speculate in futures contracts,
the person taking the opposite side of your trade on any given occasion could be a hedger
or it might well be another speculator--someone whose opinion about the probable direction
of prices differs from your own. The arithmetic of speculation in futures
contracts--including the opportunities it offers and the risks it involves--will be
discussed in detail later on. For now, suffice it to say that speculators are individuals
and firms who seek to profit from anticipated increases or decreases in futures prices. In
so doing, they help provide the risk capital needed to facilitate hedging. Someone who expects a futures price to
increase would purchase futures contracts in the hope of later being able to sell them at
a higher price. This is known as "going long." Conversely, someone who expects a
futures price to decline would sell futures contracts in the hope of later being able to
buy back identical and offsetting contracts at a lower price. The practice of selling
futures contracts in anticipation of lower prices is known as "going short." One
of the attractive features of futures trading is that it is equally easy to profit from
declining prices (by selling) as it is to profit from rising prices (by buying). Persons known as floor traders or locals,
who buy and sell for their own accounts on the trading floors of the exchanges, are the
least known and understood of all futures market participants. Yet their role is an
important one. Like specialists and market makers at securities exchanges, they help to
provide market liquidity. If there isn't a hedger or another speculator who is immediately
willing to take the other side of your order at or near the going price, the chances are
there will be an independent floor trader who will do so, in the hope of minutes or even
seconds later being able to make an offsetting trade at a small profit. In the grain
markets, for example, there is frequently only one-fourth of a cent a bushel difference
between the prices at which a floor trader buys and sells. Floor traders, of course, have no guarantee
they will realize a profit. They may end up losing money on any given trade. Their
presence, however, makes for more liquid and competitive markets. It should be pointed
out, however, that unlike market makers or specialists, floor traders are not obligated to
maintain a liquid market or to take the opposite side of customer orders. Reasons for Buying futures contracts
Reasons for Selling futures contracts Hedgers To lock in a price and thereby
obtain protection against rising prices To lock in a price and thereby obtain
protection against declining prices Speculators and floor Traders To profit
from rising prices To profit from declining prices There are two types of futures contracts,
those that provide for physical delivery of a particular commodity or item and those which
call for a cash settlement. The month during which delivery or settlement is to occur is
specified. Thus, a July futures contract is one providing for delivery or settlement in
July. It should be noted that even in the case of
delivery-type futures contracts,very few actually result in delivery.* Not many
speculators have the desire to take or make delivery of, say, 5,000 bushels of wheat, or
112,000 pounds of sugar, or a million dollars worth of U.S. Treasury bills for that
matter. Rather, the vast majority of speculators in futures markets choose to realize
their gains or losses by buying or selling offsetting futures contracts prior to the
delivery date. Selling a contract that was previously purchased liquidates a futures
position in exactly the same way, for example, that selling 100 shares of IBM stock
liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract
that was initially sold can be liquidated by an offsetting purchase. In either case, gain
or loss is the difference between the buying price and the selling price. Even hedgers generally don't make or take
delivery. Most, like the jewelry manufacturer illustrated earlier, find it more convenient
to liquidate their futures positions and (if they realize a gain) use the money to offset
whatever adverse price change has occurred in the cash market. * When delivery does occur it is in the
form of a negotiable instrument (such as a warehouse receipt) that evidences the holder's
ownership of the commodity, at some designated location. Since delivery on futures contracts is the
exception rather than the rule, why do most contracts even have a delivery provision?
There are two reasons. One is that it offers buyers and sellers the opportunity to take or
make delivery of the physical commodity if they so choose. More importantly, however, the
fact that buyers and sellers can take or make delivery helps to assure that futures prices
will accurately reflect the cash market value of the commodity at the time the contract
expires--i.e., that futures and cash prices will eventually converge. It is convergence
that makes hedging an effective way to obtain protection against an adverse change in the
cash market price.* * Convergence occurs at the expiration of
the futures contract because any difference between the cash and futures prices would
quickly be negated by profit-minded investors who would buy the commodity in the
lowest-price market and sell it in the highest-price market until the price difference
disappeared. This is known as arbitrage and is a form of trading generally best left to
professionals in the cash and futures markets. Cash settlement futures contracts are
precisely that, contracts which are settled in cash rather than by delivery at the time
the contract expires. Stock index futures contracts, for example, are settled in cash on
the basis of the index number at the close of the final day of trading. There is no
provision for delivery of the shares of stock that make up the various indexes. That would
be impractical. With a cash settlement contract, convergence is automatic. The Process of Price Discovery Futures prices increase and decrease
largely because of the myriad factors that influence buyers' and sellers' judgments about
what a particular commodity will be worth at a given time in the future (anywhere from
less than a month to more than two years). As new supply and demand developments occur
and as new and more current information becomes available, these judgments are reassessed
and the price of a particular futures contract may be bid upward or downward. The process
of reassessment--of price discovery--is continuous. Thus, in January, the price of a July
futures contract would reflect the consensus of buyers' and sellers' opinions at that time
as to what the value of a commodity or item will be when the contract expires in July. On
any given day, with the arrival of new or more accurate information, the price of the July
futures contract might increase or decrease in response to changing expectations. Competitive price discovery is a major
economic function--and, indeed, a major economic benefit--of futures trading. The trading
floor of a futures exchange is where available information about the future value of a
commodity or item is translated into the language of price. In summary, futures prices are
an ever changing barometer of supply and demand and, in a dynamic market, the only
certainty is that prices will change. Once a closing bell signals the end of a
day's trading, the exchange's clearing organization matches each purchase made that day
with its corresponding sale and tallies each member firm's gains or losses based on that
day's price changes--a massive undertaking considering that nearly two-thirds of a million
futures contracts are bought and sold on an average day. Each firm, in turn, calculates
the gains and losses for each of its customers having futures contracts. Gains and losses on futures contracts are
not only calculated on a daily basis, they are credited and deducted on a daily basis.
Thus, if a speculator were to have, say, a $300 profit as a result of the day's price
changes, that amount would be immediately credited to his brokerage account and, unless
required for other purposes, could be withdrawn. On the other hand, if the day's price
changes had resulted in a $300 loss, his account would be immediately debited for that
amount. The process just described is known as a
daily cash settlement and is an important feature of futures trading. As will be seen when
we discuss margin requirements, it is also the reason a customer who incurs a loss on a
futures position may be called on to deposit additional funds to his account. The Arithmetic of Futures Trading To say that gains and losses in futures
trading are the result of price changes is an accurate explanation but by no means a
complete explanation. Perhaps more so than in any other form of speculation or investment,
gains and losses in futures trading are highly leveraged. An understanding of
leverage--and of how it can work to your advantage or disadvantage--is crucial to an
understanding of futures trading. As mentioned in the introduction, the
leverage of futures trading stems from the fact that only a relatively small amount of
money (known as initial margin) is required to buy or sell a futures contract. On a
particular day, a margin deposit of only $1,000 might enable you to buy or sell a futures
contract covering $25,000 worth of soybeans. Or for $10,000, you might be able to purchase
a futures contract covering common stocks worth $260,000. The smaller the margin in
relation to the value of the futures contract, the greater the leverage. If you speculate in futures contracts and
the price moves in the direction you anticipated, high leverage can produce large profits
in relation to your initial margin. Conversely, if prices move in the opposite direction,
high leverage can produce large losses in relation to your initial margin. Leverage is a
two-edged sword. For example, assume that in anticipation of
rising stock prices you buy one June S&P 500 stock index futures contract at a time
when the June index is trading at 1000. And assume your initial margin requirement is
$10,000. Since the value of the futures contract is $250 times the index, each 1 point
change in the index represents a $250 gain or loss. Thus, an increase in the index from 1000 to
1040 would double your $10,000 margin deposit and a decrease from 1000 to 960 would wipe
it out. That's a 100% gain or loss as the result of only a 4% change in the stock index! Said another way, while buying (or selling)
a futures contract provides exactly the same dollars and cents profit potential as owning
(or selling short) the actual commodities or items covered by the contract, low margin
requirements sharply increase the percentage profit or loss potential. For example, it can
be one thing to have the value of your portfolio of common stocks decline from $100,000 to
$96,000 (a 4% loss) but quite another (at least emotionally) to deposit $10,000 as margin
for a futures contract and end up losing that much or more as the result of only a 4%
price decline. Futures trading thus requires not only the necessary financial resources
but also the necessary financial and emotional temperament. An absolute requisite for anyone
considering trading in futures contracts--whether it's sugar or stock indexes, pork
bellies or petroleum--is to clearly understand the concept of leverage as well as the
amount of gain or loss that will result from any given change in the futures price of the
particular futures contract you would be trading. If you cannot afford the risk, or even
if you are uncomfortable with the risk, the only sound advice is don't trade. Futures
trading is not for everyone. As is apparent from the preceding
discussion, the arithmetic of leverage is the arithmetic of margins. An understanding of
margins--and of the several different kinds of margin--is essential to an understanding of
futures trading. If your previous investment experience has
mainly involved common stocks, you know that the term margin--as used in connection with
securities--has to do with the cash down payment and money borrowed from a broker to
purchase stocks. But used in connection with futures trading, margin has an altogether
different meaning and serves an altogether different purpose. Rather than providing a down payment, the
margin required to buy or sell a futures contract is solely a deposit of good faith money
that can be drawn on by your brokerage firm to cover losses that you may incur in the
course of futures trading. It is much like money held in an escrow account. Minimum margin
requirements for a particular futures contract at a particular time are set by the
exchange on which the contract is traded. They are typically about five percent of the
current value of the futures contract. Exchanges continuously monitor market conditions
and risks and, as necessary, raise or reduce their margin requirements. Individual
brokerage firms may require higher margin amounts from their customers than the
exchange-set minimums. There are two margin-related terms you
should know: Initial margin and maintenance margin. Initial margin (sometimes called original
margin) is the sum of money that the customer must deposit with the brokerage firm for
each futures contract to be bought or sold. On any day that profits accrue on your open
positions, the profits will be added to the balance in your margin account. On any day
losses accrue, the losses will be deducted from the balance in your margin account. If and when the funds remaining available
in your margin account are reduced by losses to below a certain level--known as the
maintenance margin requirement--your broker will require that you deposit additional funds
to bring the account back to the level of the initial margin. Or, you may also be asked
for additional margin if the exchange or your brokerage firm raises its margin
requirements. Requests for additional margin are known as margin calls. Assume, for example, that the initial
margin needed to buy or sell a particular futures contract is $2,000 and that the
maintenance margin requirement is $1,500. Should losses on open positions reduce the funds
remaining in your trading account to, say, $1,400 (an amount less than the maintenance
requirement), you will receive a margin call for the $600 needed to restore your account
to $2,000. Before trading in futures contracts, be
sure you understand the brokerage firm's Margin Agreement and know how and when the firm
expects margin calls to be met. Some firms may require only that you mail a personal
check. Others may insist you wire transfer funds from your bank or provide same-day or
next-day delivery of a certified or cashier's check. If margin calls are not met in the
prescribed time and form, the firm can protect itself by liquidating your open positions
at the available market price (possibly resulting in an unsecured loss for which you would
be liable). Even if you should decide to participate in
futures trading in a way that doesn't involve having to make day-to-day trading decisions
(such as a managed account or commodity pool), it is nonetheless useful to understand the
dollars and cents of how futures trading gains and losses are realized. And, of course, if
you intend to trade your own account, such an understanding is essential. Dozens of different strategies and
variations of strategies are employed by futures traders in pursuit of speculative
profits. Here is a brief description and illustration of several basic strategies. Buying (Going Long) to Profit from an Expected Price Increase Someone expecting the price of a particular
commodity or item to increase over from a given period of time can seek to profit by
buying futures contracts. If correct in forecasting the direction and timing of the price
change, the futures contract can later be sold for the higher price, thereby yielding a
profit.* If the price declines rather than increases, the trade will result in a loss.
Because of leverage, the gain or loss may be greater than the initial margin deposit. For example, assume it's now January, the
July soybean futures contract is presently quoted at $6.00, and over the coming months you
expect the price to increase. You decide to deposit the required initial margin of, say,
$1,500 and buy one July soybean futures contract. Further assume that by April the July
soybean futures price has risen to $6.40 and you decide to take your profit by selling.
Since each contract is for 5,000 bushels, your 40-cent a bushel profit would be 5,000
bushels x 40 cents or $2,000 less transaction costs. Price per bushel Value
of 5,000 bushel contract January Buy 1 July soybean futures contract
$6.00 $30,000 April Sell 1 July soybean futures contract
$6.40 $32,000 Gain $.40 $2,000 * For simplicity examples do not
take into account commissions and other transaction costs. These costs are important,
however, and you should be sure you fully understand them.Suppose, however, that rather
than rising to $6.40, the July soybean futures price had declined to $5.60 and that, in
order to avoid the possibility of further loss, you elect to sell the contract at that
price. On 5,000 bushels your 40-cent a bushel loss would thus come to $2,000 plus
transaction costs. Price per bushel Value
of 5,000 bushel contract January Buy 1 July soybean futures contract
$6.00 $30,000 April Sell 1 July bean futures contract
$5.60 $28,000 Loss $.40 $2,000 Note that the loss in this example exceeded your $1,500 initial margin. Your broker would then call upon you, as needed, for additional margin funds to cover the loss.
Selling (Going short) to profit from an expected price decrease The only way going short to profit from an
expected price decrease differs from going long to profit from an expected price increase
is the sequence of the trades. Instead of first buying a futures contract, you first sell
a futures contract. If, as expected, the price declines, a profit can be realized by later
purchasing an offsetting futures contract at the lower price. The gain per unit will be
the amount by which the purchase price is below the earlier selling price. For example,
assume that in January your research or other available information indicates a probable
decrease in cattle prices over the next several months. In the hope of profiting, you
deposit an initial margin of $2,000 and sell one April live cattle futures contract at a
price of, say, 65 cents a pound. Each contract is for 40,000 pounds, meaning each 1 cent a
pound change in price will increase or decrease the value of the futures contract by $400.
If, by March, the price has declined to 60 cents a pound, an offsetting futures contract
can be purchased at 5 cents a pound below the original selling price. On the 40,000 pound
contract, that's a gain of 5 cents x 40,000 lbs. or $2,000 less transaction costs. Price per pound Value of
40,000 pound contract January Sell 1 April livecattle futures
contract 65 cents $26,000 March Buy 1 April live cattle futures
contract 60 cents $24,000< Gain 5 cents $2,000 Assume you were wrong. Instead of
decreasing, the April live cattle futures price increases--to, say, 70 cents a pound by
the through an offsetting purchase. The outcome would be as follows: Price per pound Value of
40,000 pound contract January Sell 1 April live cattle futures
contract 65 cents $26,000 March Buy 1 April live cattle futures
contract 70 cents $28,000 Loss 5 cents $2,000 In this example, the loss of 5 cents a
pound on the futures transaction resulted in a total loss of the $2,000 you deposited as
initial margin plus transaction costs. While most speculative futures transactions
involve a simple purchase of futures contracts to profit from an expected price
increase--or an equally simple sale to profit from an expected price decrease--numerous
other possible strategies exist. Spreads are one example. A spread, at least in its
simplest form, involves buying one futures contract and selling another futures contract.
The purpose is to profit from an expected change in the relationship between the purchase
price of one and the selling price of the other. As an illustration, assume it's now
November, that the March wheat futures price is presently $3.10 a bushel and the May wheat
futures price is presently $3.15 a bushel, a difference of 5 cents. Your analysis of
market conditions indicates that, over the next few months, the price difference between
the two contracts will widen to become greater than 5 cents. To profit if you are right,
you could sell the March futures contract (the lower priced contract) and buy the May
futures contract (the higher priced contract). Assume time and events prove you right and
that, by February, the March futures price has risen to $3.20 and May futures price is
$3.35, a difference of 15 cents. By liquidating both contracts at this time, you can
realize a net gain of 10 cents a bushel. Since each contract is 5,000 bushels, the total
gain is $500. November Sell March wheat Buy May
wheat Spread $3.10 Bu. $3.15 Bu. 5 cents February Buy March wheat Sell May wheat
$3.20 $3.35 15 cents $.10 loss $.20 gain
Net gain 10 cents Bu. Gain on 5,000 Bu.
contract $500 Had the spread (i.e. the price difference)
narrowed by 10 cents a bushel rather than widened by 10 cents a bushel the transactions
just illustrated would have resulted in a loss of $500. Virtually unlimited numbers and
types of spread possibilities exist, as do many other, even more complex futures trading
strategies. These, however, are beyond the scope of an introductory booklet and should be
considered only by someone who well understands the risk/reward arithmetic involved. Participating in Futures Trading Now that you have an overview of what
futures markets are, why they exist and how they work, the next step is to consider
various ways in which you may be able to participate in futures trading. There are a
number of alternatives and the only best alternative--if you decide to participate at
all--is whichever one is best for you. Also discussed is the opening of a futures trading
account, the regulatory safeguards provided participants in futures markets, and methods
for resolving disputes, should they arise. At the risk of oversimplification, choosing
a method of participation is largely a matter of deciding how directly and extensively
you, personally, want to be involved in making trading decisions and managing your
account. Many futures traders prefer to do their own
research and analysis and make their own decisions about what and when to buy and sell.
That is, they manage their own futures trades in much the same way they would manage their
own stock portfolios. Others choose to rely on or at least consider the recommendations of
a brokerage firm or account executive. Some purchase independent trading advice. Others
would rather have someone else be responsible for trading their account and therefore give
trading authority to their broker. Still others purchase an interest in a commodity
trading pool. There's no formula for deciding. Your decision should, however, take into
account such things as your knowledge of and any previous experience in futures trading,
how much time and attention you are able to devote to trading, the amount of capital you
can afford to commit to futures, and, by no means least, your individual temperament and
tolerance for risk. The latter is important. Some individuals
thrive on being directly involved in the fast pace of futures trading, others are unable,
reluctant, or lack the time to make the immediate decisions that are frequently required.
Some recognize and accept the fact that futures trading all but inevitably involves having
some losing trades. Others lack the necessary disposition or discipline to acknowledge
that they were wrong on this particular occasion and liquidate the position. Many experienced traders thus suggest that,
of all the things you need to know before trading in futures contracts, one of the most
important is to know yourself. This can help you make the right decision about whether to
participate at all and, if so, in what way. In no event, it bears repeating, should you
participate in futures trading unless the capital you would commit its risk capital. That
is, capital which, in pursuit of larger profits, you can afford to lose. It should be
capital over and above that needed for necessities, emergencies, savings and achieving
your long-term investment objectives. You should also understand that, because of the
leverage involved in futures, the profit and loss fluctuations may be wider than in most
types of investment activity and you may be required to cover deficiencies due to losses
over and above what you had expected to commit to futures. This involves opening your individual
trading account and--with or without the recommendations of the brokerage firm--making
your own trading decisions. You will also be responsible for assuring that adequate funds
are on deposit with the brokerage firm for margin purposes, or that such funds are
promptly provided as needed. Practically all of the major brokerage firms you are familiar
with, and many you may not be familiar with, have departments or even separate divisions
to serve clients who want to allocate some portion of their investment capital to futures
trading. All brokerage firms conducting futures business with the public must be
registered with the Commodity Futures Trading Commission (CFTC, the independent regulatory
agency of the federal government that administers the Commodity Exchange Act) as Futures
Commission Merchants or Introducing Brokers and must be Members of National Futures
Association (NFA, the industrywide self-regulatory association). Different firms offer
different services. Some, for example, have extensive research departments and can provide
current information and analysis concerning market developments as well as specific
trading suggestions. Others tailor their services to clients who prefer to make market
judgments and arrive at trading decisions on their own. Still others offer various
combinations of these and other services. An individual trading account can be opened
either directly with a Futures Commission Merchant or indirectly through an Introducing
Broker. Whichever course you choose, the account itself will be carried by a Futures
Commission Merchant, as will your money. Introducing Brokers do not accept or handle
customer funds but most offer a variety of trading-related services. Futures Commission
Merchants are required to maintain the funds and property of their customers in segregated
accounts, separate from the firm's own money. Along with the particular services a firm
provides, discuss the commissions and trading costs that will be involved. And, as
mentioned, clearly understand how the firm requires that any margin calls be met. If you
have a question about whether a firm is properly registered with the CFTC and is a Member
of NFA, you can (and should) contact NFA's Information Center toll-free at 800-621-3570
(within Illinois call 800-572-9400). Have Someone Manage Your Account A managed account is also your individual
account. The major difference is that you give someone else--an account manager--written
power of attorney to make and execute decisions about what and when to trade. He or she
will have discretionary authority to buy or sell for your account or will contact you for
approval to make trades he or she suggests. You, of course, remain fully responsible for
any losses which may be incurred and, as necessary, for meeting margin calls, including
making up any deficiencies that exceed your margin deposits. Although an account manager
is likely to be managing the accounts of other persons at the same time, there is no
sharing of gains or losses of other customers. Trading gains or losses in your account
will result solely from trades which were made for your account. Many Futures Commission
Merchants and Introducing Brokers accept managed accounts. In most instances, the amount
of money needed to open a managed account is larger than the amount required to establish
an account you intend to trade yourself. Different firms and account managers, however,
have different requirements and the range can be quite wide. Be certain to read and
understand all of the literature and agreements you receive from the broker. Some account
managers have their own trading approaches and accept only clients to whom that approach
is acceptable. Others tailor their trading to a client's objectives. In either case,
obtain enough information and ask enough questions to assure yourself that your money will
be managed in a way that's consistent with your goals. Discuss fees. In addition to
commissions on trades made for your account, it is not uncommon for account managers to
charge a management fee, and/or there may be some arrangement for the manager to
participate in the net profits that his management produces. These charges are required to
be fully disclosed in advance. Make sure you know about every charge to be made to your
account and what each charge is for. While there can be no assurance that past performance
will be indicative of future performance, it can be useful to inquire about the track
record of an account manager you are considering. Account managers associated with a
Futures Commission Merchant or Introducing Broker must generally meet certain experience
requirements if the account is to be traded on a discretionary basis. Finally, take note
of whether the account management agreement includes a provision to automatically
liquidate positions and close out the account if and when losses exceed a certain amount.
And, of course, you should know and agree on what will be done with profits, and what, if
any, restrictions apply to withdrawals from the account. Use a Commodity Trading Advisor As the term implies, a Commodity Trading
Advisor is an individual (or firm) that, for a fee, provides advice on commodity trading,
including specific trading recommendations such as when to establish a particular long or
short position and when to liquidate that position. Generally, to help you choose trading
strategies that match your trading objectives, advisors offer analyses and judgments as to
the prospective rewards and risks of the trades they suggest. Trading recommendations may
be communicated by phone, wire or mail. Some offer the opportunity for you to phone when
you have questions and some provide a frequently updated hotline you can call for a
recording of current information and trading advice. Even though you may trade on the
basis of an advisor's recommendations, you will need to open your own account with, and
send your margin payments directly to, a Futures Commission Merchant. Commodity Trading
Advisors cannot accept or handle their customers funds unless they are also registered as
Futures Commission Merchants. Some Commodity Trading Advisors offer managed accounts. The
account itself, however, must still be with a Futures Commission Merchant and in your
name, with the advisor designated in writing to make and execute trading decisions on a
discretionary basis. CFTC Regulations require that Commodity Trading Advisors provide
their customers, in advance, with what is called a Disclosure Document. Read it carefully
and ask the Commodity Trading Advisor to explain any points you don't understand. If your
money is important to you, so is the information contained in the Disclosure Document! The
prospectus-like document contains information about the advisor, his experience and, by no
means least, his current (and any previous) performance records. If you use an advisor to
manage your account, he must first obtain a signed acknowledgment from you that you have
received and understood the Disclosure Document. As in any method of participating in
futures trading, discuss and understand the advisor's fee arrangements. And if he will be
managing your account, ask the same questions you would ask of any account manager you are
considering. Commodity Trading Advisors must be registered as such with the CFTC, and
those that accept authority to manage customer accounts must also be Members of NFA. You
can verify that these requirements have been met by calling NFA toll-free at 800-621-3570
(within Illinois call 800-572-9400). Another alternative method of participating
in futures trading is through a commodity pool, which is similar in concept to a common
stock mutual fund. It is the only method of participation in which you will not have your
own individual trading account. Instead, your money will be combined with that of other
pool participants and, in effect, traded as a single account. You share in the profits or
losses of the pool in proportion to your investment in the pool. One potential advantage
is greater diversification of risks than you might obtain if you were to establish your
own trading account. Another is that your risk of loss is generally limited to your
investment in the pool, because most pools are formed as limited partnerships. And you
won't be subject to margin calls.Bear in mind, however, that the risks which a pool incurs
in any given futures transaction are no different than the risks incurred by an individual
trader. The pool still trades in futures contracts which are highly leveraged and in
markets which can be highly volatile. And like an individual trader, the pool can suffer
substantial losses as well as realize substantial profits. A major consideration,
therefore, is who will be managing the pool in terms of directing its trading. While a
pool must execute all of its trades through a brokerage firm which is registered with the
CFTC as a Futures Commission Merchant, it may or may not have any other affiliation with
the brokerage firm. Some brokerage firms, to serve those customers who prefer to
participate in commodity trading through a pool, either operate or have a relationship
with one or more commodity trading pools. Other pools operate independently. A Commodity
Pool Operator cannot accept your money until it has provided you with a Disclosure
Document that contains information about the pool operator, the pool's principals and any
outside persons who will be providing trading advice or making trading decisions. It must
also disclose the previous performance records, if any, of all persons who will be
operating or advising the pool lot, if none, a statement to that effect). Disclosure
Documents contain important information and should be carefully read before you invest
your money. Another requirement is that the Disclosure Document advise you of the risks
involved. In the case of a new pool, there is frequently a provision that the pool will
not begin trading until (and unless) a certain amount of money is raised. Normally, a time
deadline is set and the Commodity Pool Operator is required to state in the Disclosure
Document what that deadline is (or, if there is none, that the time period for raising,
funds is indefinite). Be sure you understand the terms, including how your money will be
invested in the meantime, what interest you will earn (if any), and how and when your
investment will be returned in the event the pool does not commence trading. Determine
whether you will be responsible for any losses in excess of your investment in the pool.
If so, this must be indicated prominently at the beginning of the pool's Disclosure
Document. Ask about fees and other costs, including what, if any, initial charges will be
made against your investment for organizational or administrative expenses. Such
information should be noted in the Disclosure Document. You should also determine from the
Disclosure Document how the pool's operator and advisor are compensated. Understand, too,
the procedure for redeeming your shares in the pool, any restrictions that may exist, and
provisions for liquidating and dissolving the pool if more than a certain percentage of
the capital were to be lost, Ask about the pool operator's general trading philosophy,
what types of contracts will be traded, whether they will be day-traded, etc. With few
exceptions, Commodity Pool Operators must be registered with the CFTC and be Members of
NFA. You can verify that these requirements have been met by contacting NFA toll-free at
800-621-3570 (within Illinois call 800-572-9400). Firms and individuals that conduct futures
trading business with the public are subject to regulation by the CFTC and by NFA. All
futures exchanges are also regulated by the CFTC. NFA is a congressionally authorized
self-regulatory organization subject to CFTC oversight. It exercises regulatory authority
with the CFTC over Futures Commission Merchants, Introducing Brokers, Commodity Trading
Advisors, Commodity Pool Operators and Associated Persons (salespersons) of all of the
foregoing. The NFA staff consists of more than 140 field auditors and investigators. In
addition, NFA has the responsibility for registering persons and firms that are required
to be registered with the CFTC. Firms and individuals that violate NFA rules of
professional ethics and conduct or that fail to comply with strictly enforced financial
and record-keeping requirements can, if circumstances warrant, be permanently barred from
engaging in any futures-related business with the public. The enforcement powers of the
CFTC are similar to those of other major federal regulatory agencies, including the power
to seek criminal prosecution by the Department of Justice where circumstances warrant such
action. Futures Commission Merchants which are members of an exchange are subject to not
only CFTC and NFA regulation but to regulation by the exchanges of which they are members.
Exchange regulatory staffs are responsible, subject to CFTC oversight, for the business
conduct and financial responsibility of their member firms. Violations of exchange rules
can result in substantial fines, suspension or revocation of trading privileges, and loss
of exchange membership. It is against the law for any person or
firm to offer futures contracts for purchase or sale unless those contracts are traded on
one of the nation's regulated futures exchanges and unless the person or firm is
registered with the CFTC. Moreover, persons and firms conducting futures-related business
with the public must be Members of NFA. Thus, you should be extremely cautious if
approached by someone attempting to sell you a commodity-related investment unless you are
able to verify that the offeror is registered with the CFTC and is a Member of NFA. In a
number of cases, sellers of illegal off-exchange futures contracts have labeled their
investments by different names--such as "deferred delivery," "forward"
or "partial payment" contracts--in an attempt to avoid the strict laws
applicable to regulated futures trading. Many operate out of telephone boiler rooms,
employ high-pressure and misleading sales tactics, and may state that they are exempt from
registration and regulatory requirements. This, in itself, should be reason enough to
conduct a check before you write a check. You can quickly verify whether a particular firm
or person is currently registered with the CFTC and is an NFA Member by phoning NFA
toll-free at 800-621-3570 (within Illinois call 800-572-9400). At the time you apply to establish a
futures trading account, you can expect to be asked for certain information beyond simply
your name, address and phone number. The requested information will generally include (but
not necessarily be limited to) your income, net worth, what previous investment or futures
trading experience you have had, and any other information needed in order to advise you
of the risks involved in trading futures contracts. At a minimum, the person or firm who
will handle your account is required to provide you with risk disclosure documents or
statements specified by the CFTC and obtain written acknowledgment that you have received
and understood them. Opening a futures account is a serious decision--no less so than
making any major financial investment--and should obviously be approached as such. Just as
you wouldn't consider buying a car or a house without carefully reading and understanding
the terms of the contract, neither should you establish a trading account without first
reading and understanding the Account Agreement and all other documents supplied by your
broker. It is in your interest and the firm's interest that you clearly know your rights
and obligations as well as the rights and obligations of the firm with which you are
dealing before you enter into any futures transaction. If you have questions about exactly
what any provisions of the Agreement mean, don't hesitate to ask. A good and continuing
relationship can exist only if both parties have, from the outset, a clear understanding
of the relationship. Nor should you be hesitant to ask, in advance, what services you will
be getting for the trading commissions the firm charges. As indicated earlier, not all
firms offer identical services. And not all clients have identical needs. If it is
important to you, for example, you might inquire about the firm's research capability, and
whatever reports it makes available to clients. Other subjects of inquiry could be how
transaction and statement information will be provided, and how your orders will be
handled and executed. All but a small percentage of transactions
involving regulated futures contracts take place without problems or misunderstandings.
However, in any business in which some 150 million or more contracts are traded each year,
occasional disagreements are inevitable. Obviously, the best way to resolve a disagreement
is through direct discussions by the parties involved. Failing this, however, participants
in futures markets have several alternatives (unless some particular method has been
agreed to in advance). Under certain circumstances, it may be possible to seek resolution
through the exchange where the futures contracts were traded. Or a claim for reparations
may be filed with the CFTC. However, a newer, generally faster and less expensive
alternative is to apply to resolve the disagreement through the arbitration program
conducted by National Futures Association. There are several advantages: You can elect, if you prefer, to have
arbitrators who have no connection with the futures industry. You do not have to allege or prove that any
law or rule was broken only that you were dealt with improperly or unfairly. In some cases, it may be possible to
conduct arbitration entirely through written submissions. If a hearing is required, it can
generally be scheduled at a time and place convenient for both parties. Unless you wish to do so, you do not have
to employ an attorney. For a plain language explanation of the
arbitration program and how it works, write or phone NFA for a copy of Arbitration: A Way
to Resolve Futures-Related Disputes. The booklet is available at no cost. What to Look for in a Futures Contract? Whatever type of investment you are
considering--including but not limited to futures contracts--it makes sense to begin by
obtaining as much information as possible about that particular investment. The more you
know in advance, the less likely there will be surprises later on. Moreover, even among
futures contracts, there are important differences which--because they can affect your
investment results--should be taken into account in making your investment decisions. Delivery-type futures contracts stipulate
the specifications of the commodity to be delivered (such as 5,000 bushels of grain,
40,000 pounds of livestock, or 100 troy ounces of gold). Foreign currency futures provide
for delivery of a specified number of marks, francs, yen, pounds or pesos. U.S. Treasury
obligation futures are in terms of instruments having a stated face value (such as
$100,000 or $1 million) at maturity. Futures contracts that call for cash settlement
rather than delivery are based on a given index number times a specified dollar multiple.
This is the case, for example, with stock index futures. Whatever the yardstick, it's
important to know precisely what it is you would be buying or selling, and the quantity
you would be buying or selling. Futures prices are usually quoted the same
way prices are quoted in the cash market (where a cash market exists). That is, in
dollars, cents, and sometimes fractions of a cent, per bushel, pound or ounce; also in
dollars, cents and increments of a cent for foreign currencies; and in points and
percentages of a point for financial instruments. Cash settlement contract prices are
quoted in terms of an index number, usually stated to two decimal points. Be certain you
understand the price quotation system for the particular futures contract you are
considering. Exchanges establish the minimum amount that
the price can fluctuate upward or downward. This is known as the "tick" For
example, each tick for grain is 0.25 cents per bushel. On a 5,000 bushel futures contract,
that's $12.50. On a gold futures contract, the tick is 10 cents per ounce, which on a 100
ounce contract is $10. You'll want to familiarize yourself with the minimum price
fluctuation--the tick size--for whatever futures contracts you plan to trade. And, of
course, you'll need to know how a price change of any given amount will affect the value
of the contract. Exchanges establish daily price limits for
trading in futures contracts. The limits are stated in terms of the previous day's closing
price plus and minus so many cents or dollars per trading unit. Once a futures price has
increased by its daily limit, there can be no trading at any higher price until the next
day of trading. Conversely, once a futures price has declined by its daily limit, there
can be no trading at any lower price until the next day of trading. Thus, if the daily
limit for a particular grain is currently 10 cents a bushel and the previous day's
settlement price was $3.00, there can not be trading during the current day at any price
below $2.90 or above $3.10. The price is allowed to increase or decrease by the limit
amount each day. For some contracts, daily price limits are eliminated during the month in
which the contract expires. Because prices can become particularly volatile during the
expiration month (also called the "delivery" or "spot" month), persons
lacking experience in futures trading may wish to liquidate their positions prior to that
time. Or, at the very least, trade cautiously and with an understanding of the risks which
may be involved. Daily price limits set by the exchanges are subject to change. They can,
for example, be increased once the market price has increased or decreased by the existing
limit for a given number of successive days. Because of daily price limits, there may be
occasions when it is not possible to liquidate an existing futures position at will. In
this event, possible alternative strategies should be discussed with a broker Although the average trader is unlikely to
ever approach them, exchanges and the CFTC establish limits on the maximum speculative
position that any one person can have at one time in any one futures contract. The purpose
is to prevent one buyer or seller from being able to exert undue influence on the price in
either the establishment or liquidation of positions. Position limits are stated in number
of contracts or total units of the commodity. The easiest way to obtain the types of
information just discussed is to ask your broker or other advisor to provide you with a
copy of the contract specifications for the specific futures contracts you are thinking
about trading. Or you can obtain the information from the exchange where the contract is
traded. Understanding and Managing the Risks of Futures Trading Anyone buying or selling futures contracts
should clearly understand that the Risks of any given transaction may result in a Futures
Trading loss. The loss may exceed not only the amount of the initial margin but also the
entire amount deposited in the account or more. Moreover, while there are a number of
steps which can be taken in an effort to limit the size of possible losses, there can be
no guarantees that these steps will prove effective. Well-informed futures traders should,
nonetheless, be familiar with available risk management possibilities. Just as different common stocks or
different bonds may involve different degrees of probable risk. and reward at a particular
time, so may different futures contracts. The market for one commodity may, at present, be
highly volatile, perhaps because of supply-demand uncertainties which--depending on future
developments--could suddenly propel prices sharply higher or sharply lower. The market for
some other commodity may currently be less volatile, with greater likelihood that prices
will fluctuate in a narrower range. You should be able to evaluate and choose the futures
contracts that appear--based on present information--most likely to meet your objectives
and willingness to accept risk. Keep in mind, however, that neither past nor even present
price behavior provides assurance of what will occur in the future. Prices that have been
relatively stable may become highly volatile (which is why many individuals and firms
choose to hedge against unforeseeable price changes). There can be no ironclad assurance that, at
all times, a liquid market will exist for offsetting a futures contract that you have
previously bought or sold. This could be the case if, for example, a futures price has
increased or decreased by the maximum allowable daily limit and there is no one presently
willing to buy the futures contract you want to sell or sell the futures contract you want
to buy. Even on a day-to-day basis, some contracts and some delivery months tend to be
more actively traded and liquid than others. Two useful indicators of liquidity are the
volume of trading and the open interest (the number of open futures positions still
remaining to be liquidated by an offsetting trade or satisfied by delivery). These figures
are usually reported in newspapers that carry futures quotations. The information is also
available from your broker or advisor and from the exchange where the contract is traded. In futures trading, being right about the
direction of prices isn't enough. It is also necessary to anticipate the timing of price
changes. The reason, of course, is that an adverse price change may, in the short run,
result in a greater loss than you are willing to accept in the hope of eventually being
proven right in the long run. Example: In January, you deposit initial margin of $1,500 to
buy a May wheat futures contract at $3.30--anticipating that, by spring, the price will
climb to $3.50 or higher. No sooner than you buy the contract, the price drops to $3.15, a
loss of $750. To avoid the risk of a further loss, you have your broker liquidate the
position. The possibility that the price may now recover--and even climb to $3.50 or
above--is of no consolation. The lesson to be learned is that deciding when to buy or sell
a futures contract can be as important as deciding what futures contract to buy or sell.
In fact, it can be argued that timing is the key to successful futures trading. A stop order is an order, placed with your
broker, to buy or sell a particular futures contract at the market price if and when the
price reaches a specified level. Stop orders are often used by futures traders in an
effort to limit the amount they. might lose if the futures price moves against their
position. For example, were you to purchase a crude oil futures contract at $21.00 a
barrel and wished to limit your loss to $1.00 a barrel, you might place a stop order to
sell an off-setting contract if the price should fall to, say, $20.00 a barrel. If and
when the market reaches whatever price you specify, a stop order becomes an order to
execute the desired trade at the best price immediately obtainable. There can be no
guarantee, however, that it will be possible under all market conditions to execute the
order at the price specified. In an active, volatile market, the market price may be
declining (or rising) so rapidly that there is no opportunity to liquidate your position
at the stop price you have designated. Under these circumstances, the broker's only
obligation is to execute your order at the best price that is available. In the event that
prices have risen or fallen by the maximum daily limit, and there is presently no trading
in the contract (known as a "lock limit" market), it may not be possible to
execute your order at any price. In addition, although it happens infrequently, it is
possible that markets may be lock limit for more than one day, resulting in substantial
losses to futures traders who may find it impossible to liquidate losing futures
positions. Subject to the kinds of limitations just discussed, stop orders can nonetheless
provide a useful tool for the futures trader who seeks to limit his losses. Far more often
than not, it will be possible. for the broker to execute a stop order at or near the
specified price. In addition to providing a way to limit losses, stop orders can also be
employed to protect profits. For instance, if you have bought crude oil futures at $21.00
a barrel and the price is now at $24.00 a barrel, you might wish to place a stop order to
sell if and when the price declines to $23.00. This (again subject to the described
limitations of stop orders) could protect $2.00 of your existing $3.00 profit while still
allowing you to benefit from any continued increase in price. Spreads involve the purchase of one futures
contract and the sale of a different futures contract in the hope of profiting from a
widening or narrowing of the price difference. Because gains and losses occur only as the
result of a change in the price difference--rather than as a result of a change in the
overall level of futures prices--spreads are often considered more conservative and less
risky than having an outright long or short futures position. In general, this may be the
case. It should be recognized, though, that the loss from a spread can be as great as--or
even greater than--that which might be incurred in having an outright futures position. An
adverse widening or narrowing of the spread during a particular time period may exceed the
change in the overall level of futures prices, and it is possible to experience losses on
both of the futures contracts involved (that is, on both legs of the spread). What are known as put and call options are
being traded on a growing number of futures contracts. The principal attraction of buying
options is that they make it possible to speculate on increasing or decreasing futures
prices with a known and limited risk. The most that the buyer of an option can lose is the
cost of purchasing the option (known as the option "premium") plus transaction
costs. Options can be most easily understood when call options and put options are
considered separately, since, in fact, they are totally separate and distinct. Buying or
selling a call in no way involves a put, and buying or selling a put in no way involves a
call. The buyer of a call option acquires the
right but not the obligation to purchase (go long) a particular futures contract at a
specified price at any time during the life of the option. Each option specifies the
futures contract which may be purchased (known as the "underlying" futures
contract) and the price at which it can be purchased (known as the "exercise" or
"strike" price). A March Treasury bond 84 call option would convey the right to
buy one March U.S. Treasury bond futures contract at a price of $84,000 at any time during
the life of the option. One reason for buying call options is to profit from an
anticipated increase in the underlying futures price. A call option buyer will realize a
net profit if, upon exercise, the underlying futures price is above the option exercise
price by more than the premium paid for the option. Or a profit can be realized it, prior
to expiration, the option rights can be sold for more than they cost. Example: You expect
lower interest rates to result in higher bond prices (interest rates and bond prices move
inversely). To profit if you are right, you buy a June T-bond 82 call. Assume the premium
you pay is $2,000. If, at the expiration of the option (in May) the June T-bond futures
price is 88, you can realize a gain of 6 (that's $6,000) by exercising or selling the
option that was purchased at 82. Since you paid $2,000 for the option, your net profit is
$4,000 less transaction costs. As mentioned, the most that an option buyer can lose is the
option premium plus transaction costs. Thus, in the preceding example, the most you could
have lost--no matter how wrong you might have been about the direction and timing of
interest rates and bond prices--would have been the $2,000 premium you paid for the option
plus transaction costs. In contrast if you had an outright long position in the underlying
futures contract, your potential loss would be unlimited. It should be pointed out,
however, that while an option buyer has a limited risk (the loss of the option premium),
his profit potential is reduced by the amount of the premium. In the example, the option
buyer realized a net profit of $4,000. For someone with an outright long position in the
June T-bond futures contract, an increase in the futures price from 82 to 88 would have
yielded a net profit of $6,000 less transaction costs. Although an option buyer cannot
lose more than the premium paid for the option, he can lose the entire amount of the
premium. This will be the case if an option held until expiration is not worthwhile to
exercise. Whereas a call option conveys the right to
purchase (go long) a particular futures contract at a specified price, a put option
conveys the right to sell (go short) a particular futures contract at a specified price.
Put options can be purchased to profit from an anticipated price decrease. As in the case
of call options, the most that a put option buyer can lose, if he is wrong about the
direction or timing of the price change, is the option premium plus transaction costs.
Example: Expecting a decline in the price of gold, you pay a premium of $1,000 to purchase
an October 320 gold put option. The option gives you the right to sell a 100 ounce gold
futures contract for $320 an ounce. Assume that, at expiration, the October futures price
has--as you expected-declined to $290 an ounce. The option giving you the right to sell at
$320 can thus be sold or exercised at a gain of $30 an ounce. On 100 ounces, that's
$3,000. After subtracting $1,000 paid for the option, your net profit comes to $2,000. Had
you been wrong about the direction or timing of a change in the gold futures price, the
most you could have lost would have been the $1,000 premium paid for the option plus
transaction costs. However, you could have lost the entire premium. How Option Premiums are Determined Option premiums are determined the same way
futures prices are determined, through active competition between buyers and sellers.
Three major variables influence the premium for a given option: * The option's exercise
price, or, more specifically, the relationship between the exercise price and the current
price of the underlying futures contract. All else being equal, an option that is already
worthwhile to exercise (known as an "in-the-money" option) commands a higher
premium than an option that is not yet worthwhile to exercise (an
"out-of-the-money" option). For example, if a gold contract is currently selling
at $295 an ounce, a put option conveying the right to sell gold at $320 an ounce is more
valuable than a put option that conveys the right to sell gold at only $300 an ounce. *
The length of time remaining until expiration. All else being equal, an option with a long
period of time remaining until expiration commands a higher premium than an option with a
short period of time remaining until expiration because it has more time in which to
become profitable. Said another way, an option is an eroding asset. Its time value
declines as it approaches expiration. * The volatility of the underlying futures contract.
All rise being equal, the greater the volatility the higher the option premium. In a
volatile market, the option stands a greater chance of becoming profitable to exercise. At this point, you might well ask, who
sells the options that option buyers purchase? The answer is that options are sold by
other market participants known as option writers, or grantors. Their sole reason for
writing options is to earn the premium paid by the option buyer. If the option expires
without being exercised (which is what the option writer hopes will happen), the writer
retains the full amount of the premium. If the option buyer exercises the option, however,
the writer must pay the difference between the market value and the exercise price. It
should be emphasized and clearly recognized that unlike an option buyer who has a limited
risk (the loss of the option premium), the writer of an option has unlimited risk. This is
because any gain realized by the option buyer if and when he exercises the option will
become a loss for the option writer. Reward Risk Option Buyer Except for the premium, an
option buyer has the same profit potential as someone with an outright position in the
underlying futures contract. An option maximum loss: is the premium paid for the option Option Writer An option writer's maximum
profit is premium received for writing the option An option writer's loss is unlimited.
Except for the premium received, risk is the same as having an outright position in the
underlying futures contract. The foregoing is, at most, a brief and
incomplete discussion of a complex topic. Options trading has its own vocabulary and its
own arithmetic. If you wish to consider trading in options on futures contracts, you
should discuss the possibility with your broker and read and thoroughly understand the
Options Disclosure Document which he is required to provide. In addition, have your broker
provide you with educational and other literature prepared by the exchanges on which
options are traded. Or contact the exchange directly. A number of excellent publications
are available. In no way, it should be emphasized, should anything discussed herein be
considered trading advice or recommendations. That should be provided by your broker or
advisor. Similarly, your broker or advisor--as well as the exchanges where futures
contracts are traded--are your best sources for additional, more detailed information
about futures trading. Source: National Futures Association;
published here with permission. RISK DISCLOSURE: Futures and Options
trading involves substantial risk of loss and is not suitable for everyone. |
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home | online trading | quotes & charts | news | daily research | free books | special report Please remember that
trading commodity futures and options involves risk of loss and may not be suitable for
everyone’s investment dollars. Only risk capital should be used to trade with. If you
have any questions, please feel free to call or e-mail
us. © 2002 Alpha One Trading. All Rights Reserved. |