Opportunity AND Risk

An Educational Guide to Trading Futures and Options on Futures National Futures Association is a congressionally authorized self-regulatory organization of the United States futures industry. Its mission is to provide innovative regulatory programs and services that protect and ensure integrity.

NFA has prepared this book as part of its continuing public education efforts to pro- Opportunity vide information to potential investors. The booklet provides a necessary overview of AND the opportunities and risks in trading futures and options on futures by presenting impor- tant information that investors need to know before they invest. Risk

PUBLISHER National Futures Association 200 West Madison Street, Suite 1600 An Educational Guide to , 60606-3447 800-621-3570 • www.nfa.futures.org Trading Futures DESIGN and Lenz Design • Chicago, Illinois • www.lenzdesign.com

ILLUSTRATION Options on Futures Philip Nicholson • Varberg, Sweden • www.illustrations.se

© 2006 National Futures Association All Rights Reserved.

No part of this book may be reproduced, stored, or transmitted by any means, including electronic, mechanical, photocopying, recording, or otherwise, without written permission from National Futures Association. The publica- tion is designed to provide accurate and authoritative information in regard to the subject matter covered. While great care was taken in the preparation of this book, National Futures Association disclaims any legal responsibility for any errors or omissions and disclaims any liability for losses or damages incurred through the use of the information in the book. If legal advice, financial advice, or other expert assistance is required, the services of a competent professional person should be sought. Opportunity AND Risk

Introduction ...... 6 How to Participate in Futures Trading ...... 38 Trade Your Own Accounts ...... 40 How the Markets are Regulated ...... 10 Have Someone Manage Your Account ...... 42 12 Conducting Business with a Registered Firm ...... Use a Trading Advisor ...... 44 Participate in a Commodity Pool ...... 46 Introduction to Futures Trading ...... 14 Establishing an Account ...... 50 Futures Contracts...... 14 How are Quoted...... 16 Introduction to Options on Futures ...... 52 17 The Market Participants...... The Arithmetic of Premiums ...... 54 17 Hedgers ...... Intrinsic ...... 54 19 Speculators ...... Time Value ...... 55 20 The Process of Discovery...... Understanding Options Transaction Fees ...... 56 21 Minimum Price Changes ...... Leverage ...... 58 21 Daily Price Limits...... Calculating the Break-Even Price ...... 58 22 Limits...... Factors Affecting the Choice of an Option ...... 62 23 Daily Close ...... After You Buy an Option ...... 64 The Arithmetic of Futures Trading ...... 24 Offset the Option ...... 64 Leverage ...... 24 Continue to Hold the Option ...... 66 Margins...... 27 Exercise the Option ...... 66 Basic Trading Strategies...... 30 Who Writes Options and Why ...... 68 Buying (Going ) to Profit from an Expected Price Increase .... 30 Selling (Going ) to Profit from an Expected Price Decrease.... 32 If a Dispute Should Arise ...... 72 Spreads ...... 34 Stop Orders ...... 36 Glossary of Terms ...... 75

Additional Resources ...... 93

4 5 Introduction Opportunity and Risk: An Educational Guide mortgage bankers Introduction bonds dealers

For nearly a century and Just as the types of instru- a half, futures markets have ments traded on futures exchanges have evolved, so has fulfilled an important eco- the method of trading those nomic function—provid- instruments. Until the 1990s, individual ing an efficient and effec- futures trading was conducted primarily on the floor of the investors tive mechanism for the exchanges.Traders crowded into management of price risks. trading “pits” or “rings”, shouting grain Beginning with agricultural and signaling bids and offers to merchants each other.This type of trading, futures contracts traded on known as open-outcry, resulted the in competitive, organized price farmers in 1865, the U.S. futures discovery. lending institutions markets now list an ever- In the 1990s, exchanges intro- Who Trades? duced electronic trading on cer- expanding number of tain contracts during off- as well as grain merchants, lend- hedgers seek to avoid. Most instruments, including met- exchange hours. Since then, elec- ing institutions and individual speculators have no intention of als, energy, financial instru- tronic trading has expanded to speculators.By buying or selling making or taking delivery of ments, foreign , include side-by-side futures contracts—contracts the commodity. They seek and electronic trading, as well as that establish a price level now instead to profit from a change indexes, prediction contracts that are exclusively for items to be delivered later— in the price. That is, they buy markets and event future s. traded electronically. Futures individuals and businesses seek when they anticipate rising Additionally, the industry trading has truly become a 24 to achieve what amounts to prices and sell when they antic- hours a day, seven days a week against adverse price ipate declining prices. The introduced trading in financial marketplace. changes.This is called hedging. interaction of hedgers and options on futures con- speculators helps to provide Participants in today’s futures Other futures market partici- active, liquid and competitive tracts in 1982. markets include mortgage bankers pants are speculative investors markets. as well as farmers, dealers who accept the price risks that

6 7 Introduction Opportunity and Risk: An Educational Guide

Speculative participation in The pages which follow are futures trading has become in futures intended to help provide you We have also included a increasingly widespread with with the kinds of information Glossary at the back of this contracts, however, is the availability of alternative you should obtain—and the Guide for easy reference.In fact, methods of participation. clearly not appropriate for questions you should seek we suggest that you become Whereas many futures traders everyone. Just as it is possi- answers to—before making any familiar with some of the terms continue to prefer to make their ble to realize substantial decisions to trade futures inc luded in the Glossary before own trading decisions—such as and/or options on futures. continuing. profits in a short period of what to buy and sell and when Topics covered include: It is not the purpose of this to buy and sell—others choose time, it is also possible to Guide to suggest that you to utilize the services of a pro- I The regulatory incur substantial losses in should—or should not—partici- fessional trading advisor, or to structure of the a short period of time. pate in futures and/or options avoid day-to- respon- futures industry on futures trading.That is a deci- sibilities by establishing a fully The possibility of large profits sion you should make only after managed trading account or or losses in relation to the initial I How to conduct a consultation with your broker participating in a commodity commitment of capital stems background check or financial advisor and in light pool which is similar in concept principally from the fact that of a futures firm of your own financial situation to a . futures trading is a highly lever- and objectives. aged form of speculation.Only a I How futures For those individuals who relatively small amount of contracts are traded Finally, this Guide focuses fully understand and can afford money is required to contlro primarily on exchange-traded the risks which are involved,the assets having a much greater I The costs of trading futures and options on futures allocation of some portion of value. As we will discuss and contracts. For information their capital to futures trading illustrate, the leverage of futures I How gains and regarding off-exchange foreign can provide a means of achiev- trading can work for you when losses are realized (forex) futures and ing greater diversification and a prices move in the direction options, consult the NFA potentially higher overall rate of you anticipate or against you I How options on brochure “Trading in the Off- return on their investments. when prices move in the oppo- futures are traded Exchange Foreign Currency There are also a number of ways site direction. Market:What Investors Need to in which futures can be used in I How to resolve Know.” The brochure is avail- combination with , bonds futures-related able free of charge on NFA’s and other investments. disputes Web site (www.nfa.futures.org).

8 9 How the Markets are Regulated Opportunity and Risk: An Educational Guide How the Markets CFTC are Regulated NFA Exchanges

The U.S. futures industry ment powers of the CFTC are has experienced unprece- similar to those of other major federal regulatory agencies, The CFTC provides government oversight for the entire futures industry. dented growth in trading including the power to seek All U.S. futures Exchanges operate as a self-regulatory organizations, volume over the past sever- criminal prosecution by the governing their floor brokers, traders and member firms. And NFA regulates every firm or individual who conducts futures Department of Justice where al years, reflecting the high trading business with public customers. circumstances such level of trust and confi- action. Regulatory Relationships dence that customers have National Futures Associ ation in the marketplace. This (NFA). The same legislation that fail to comply with financial ble, subject to CFTC oversight, and record-keeping requirements for monitoring the business confidence is due in part to authorized the creation of “reg- istered futures associations,”giv- can, if circumstances warrant, be conduct and financial responsi- a strong, effective regulato- ing the futures industry the permanently barred from engag- bility of their member ry structure that safeguards opportunity to create a nation- ing in any futures-related busi- firms. Violations of exchange market integrity and pro- wide self-regulatory organiza- ness with the public. rules can result in substantial fines, suspension or revocation tion. NFA is the industrywide, U.S. futures exchanges and tects investors.This regula- of trading privileges, and loss of self-regulatory organization for organizations. or clearing corpora- tory structure has three the U.S. futures industry. NFA’s Commission Merchants (FCMs) tion membership. main components. mission is to develop rules, pro- which are members of an grams and services that safe- exchange are subject to not Although the various regula- The Commodity Futures guard market integrity, protect only CFTC and NFA regulation tory organizations in the futures Trading Commission (CFTC). In investors and help its Members but also to regulation by the industry have their own specif- 1974 Congress established the meet their regulatory responsi- exchang es and clearing organi- ic areas of authority, together CFTC, a federal regulatory bilities. Firms and individuals zations of which they are mem- they form a regulatory partner- agency with jurisdiction over that violate NFA rules of profes- bers. Exchange and clearing ship that oversees all industry futures trading. The enforce- sional ethics and conduct or corporation staffs are responsi- participants.

10 11 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Conducting Business with a Registered Firm

Membership in NFA is mandatory, assuring that everyone conducting busi- ness with the public on the U.S. futures exchanges— more than 4,000 firms and 55,000 associates—must adhere to the same high standards of professional conduct. You can quickly verify whether a particular tion concerning all current and A BASIC background check will tell firm or person is currently former CFTC registrants, includ- everything you need to know about the standing registered with the CFTC ing name, business address and of your financial firm or advisor (www.nfa.futures.org) registration history in the and is an NFA Member futures industry. BASIC also Sometimes the firm will have Members if the case went to through NFA’s Background contains information concern- no disciplinary history, but one hearing and an award was Affiliation Status Infor- ing disciplinary actions taken by or more of the principals or issued after January 1, 1990. NFA, the CFTC and all the U.S. salespeople may have been dis- You will also find summary mation Center (BASIC), futures exchanges. If you are ciplined while working at data concerning the number of found on NFA’s Web site researching a firm, you should other firms. cases filed by investors against registered firms and individu- (www.nfa.futures.org). also conduct a background In addition,BASIC gives you als with the CFTC reparations check of all the individuals list- details concerning NFA arbitra- BASIC contains current and program. ed as principals of the firm, as tion matters involving disputes historical registration informa- well as the firm’s salespeople. between investors and NFA 12 13 Introduction to Futures Trading Opportunity and Risk: An Educational Guide Introduction to Since delivery on futures Cash futures con- Futures Trading contracts is the exception tracts are precisely that, con- rather than the rule, why do tracts which are settled in cash Futures Contracts most contracts even have a rather than by delivery at the delivery provision? There are time the contract expires. Stock A is a futures contracts very few actual- two reasons. One is that it offers index futures contracts, for ly result in delivery. Not many legally binding agreement buyers and sellers the opportu- example, are settled in cash on speculators have the desire to nity to take or make delivery of the basis of the index number to buy or sell a commodity take or make delivery of 5,000 the physical commodity if they used for the final settlement. or at a bushels of or 112,000 so choose. More importantly, There is no provision for deliv- pounds of . Rather, the vast later date. Futures contracts however, the fact that buyers ery of the shares of stock that majority of speculators in futures and sellers can take or make make up the various indexes. are standardized according markets choose to realize their delivery helps to assure that That would be impractical. to the quality, quantity and gains or losses by buying or sell- futures prices will accurately With a cash settlement contract, ing offsetting futures contracts delivery time and location reflect the cash market value of convergence is automatic. prior to the delivery date. the commodity at the time the for each commodity. The Futures prices are established Selling a contract that was contract expires—i.e., that only variable is price. through competitive bidding previously purchased liquidates futures and cash prices will and are immediately and contin- a futures position in exactly the eventually converge. It is con- There are two types of uously relayed around the world same way, for example, that sell- vergence that makes hedging an futures contracts, those that by wire and satellite. A farmer ing 100 shares of IBM stock liq- effective way to obtain protec- provide for physical delivery of in Nebraska, a merchant in uidates an earlier purchase of tion against an adverse price a particular commodity or item Amsterdam,an importer inTokyo 100 shares of IBM stock. movement in the cash market. and those which call for a cash and a speculator in Ohio have Similarly, a futures contract that settlement. The month during simultaneous access to the latest was initially sold can be liquidat- which delivery or settlement is market-derived price quotations. ed by an offsetting purchase. In to occur is specified. For exam- And, should they choose, they either case, the resulting gain or ple, a July futures contract is can establish a price level for loss is the difference between one providing for delivery or future delivery—or for specula- the buying price and the selling settlement in July. tive purposes—simply by having price less transaction costs their broker buy or sell the It should be noted that even (commissions and fees). in the case of delivery-type appropriate contracts.

14 15 Introduction to Futures Trading Opportunity and Risk: An Educational Guide

FUTURES The Monetary units per Lifetime Open Crude Oil Future Exchange quantity High Low Date Open High Low Settle Change Interest $80 Market AGRICULTURAL Corn CBT ¢ / bushel 302 ¾ 217 ¼ Jul 06 238 ¼ 243 238 ¼ 240 + 2 576,182 CBT ¢ / bushel 736 485 Jul 06 606 612 604 ¾ 606 + 1 ½ 225,894 70 Meal CBT $ / ton 227.00 158.70 Jul 06 180.00 181.50 178.20 178.80 -- .70 93,312 Participants CBT ¢ / lb 26.57 19.61 Jul 06 25.10 25.35 25.01 25.28 + .20 162,452 Wheat CBT ¢ / bushel 418 ¼ 268 ¾ Jul 06 384 ¾ 389 ½ 383 ½ 384 ½ -- ¼ 240,326 60 Winter Wheat KC ¢ / bushel 474 ½ 342 Jul 06 468 ½ 472 ½ 465 465 ¼ -- 2 ¾ 83,750 CBT ¢ / bushel 270 ½ 133 ¼ Jul 06 189 190 ¼ 187 ½ 189 -- ¼ 8,505 Rough CBT $ / CWT 9.210 6.900 Jul 06 8.460 8.560 8.450 8.545 + .085 5,695 50 $ Should you at some time In either case, the person In newspaper financial sections decide to trade in futures who takes the opposite side of your trade may be or may repre- contracts, either for specu- How Prices are Quoted sent someone who is a commer- lation or in connection cial hedger or perhaps someone who is a public speculator. Or, rencies; and in points and per- with a risk management Futures prices are usual- quite possibly, the other party centages of a point for financial ly quoted the same way strategy,your orders to buy may be an independent . instruments. Cash settled index or sell will be communicat- In becoming acquainted with prices are quoted in the contract prices are quoted in futures markets, you should terms of an index number,usual- ed from the brokerage underlying cash market. have at least a general under- ly stated to two decimal points. office you use to the appro- standing of who these various That is, in dollars, cents, and Be certain you understand the priate trading pit or elec- market participants are, what sometimes fractions of a cent, price quotation system for the tronic trading platform for they are doing and why. per bushel, pound or ounce; particular futures contract you also in dollars, cents and incre- are considering. execution. If you are a Hedgers ments of a cent for foreign cur- buyer, your order will seek The details of hedging can be a seller at the lowest avail- somewhat complex but the principle is simple. Hedgers are On financial services websites able price. If you are a sell- individuals and firms that make er, your order will seek a purchases and sales in the SOYBEANS Delayed Futures -09:20 - Monday, 8 May futures market for the purpose ( Go to Daily )( Profile ) (Click on Contract for Chart) buyer at the highest avail- Contract Last Change Open High Low Prev. Stl. Time able price. Market fluctua- of establishing a known price May ‘06 (SK06) 594-4 +3-6 597-0 601-4 593-0 590-6 05/05/06 level—weeks or months in Jul ‘06 (SN06) 606-4 +2-6 609-4 614-4 605-0 603-6 05/05/06 tion is a process of finding Aug ‘06 (SQ06) 612-0 +3-0 615-0 619-0 611-0 609-0 05/05/06 advance—for something they Sep ‘06 (SU06) 615-4 +2-2 620-0 622-0 614-0 613-2 05/05/06 fair prices for both buyers later intend to buy or sell in the Nov ‘06 (SX06) 625-2 +3-0 627-4 631-0 623-4 622-2 05/05/06 cash market (such as at a grain Jan ‘07 (SF07) 632-2 +3-0 636-0 636-0 632-0 629-2 05/05/06 and sellers. Mar ‘07 (SH07) 639-0 +4-0 641-0 644-0 636-0 635-0 05/05/06 16 May ‘07 (SK07) 640-0 +3-0 641-0 643-0 638-0 637-0 05/05/06 17 Jul ‘07 (SN07) 643-0 +3-0 645-0 647-0 643-0 640-0 05/05/06 Introduction to Futures Trading Opportunity and Risk: An Educational Guide

elevator or in the ). provided insurance against an Whatever the hedging strategy, The arithmetic of specula- In this way they attempt to pro- increase in the price of . It the common denominator is tion in futures contracts— tect themselves against the locked in a net cost, that hedgers willingly give up including the opportunities it risk of an unfavorable price the opportunity to benefit from offers and the risks it involves— regardless of what hap- change in the interim. favorable price changes in order will be discussed in detail later pened to the cash market Consider this example: to achieve protection against on. For now, just know that price of gold. Had the price of unfavorable price changes. speculators are individuals and A jewelry manufacturer will gold declined instead of risen, he firms who seek to profit from need to buy additional gold from would have incurred a loss on his anticipated increases or his supplier in six months. Between futures position, but this would decreases in futures prices.In so now and then, however,he fears the have been offset by the lower cost of doing, they help provide the price of gold may increase. That acquiring gold in the cash market. risk capital needed to facilitate could be a problem because he has hedging. The number and variety of already published his catalog for hedging possibilities are practi- Someone who expects a the year ahead. cally limitless. A feeder futures price to increase would purchase futures contracts in the To lock in the price level at can against a decline in hope of later being able to sell which gold is presently being quot- livestock prices and a meat packer or supermarket them at a higher price.This ed for delivery in six months, he chain can hedge against an is known as “going long.” buys a futures contract at a price of increase in livestock Conversely, someone who $550 an ounce. prices. Borrowers can Speculators expects a futures price to decline would sell futures contracts in If, six months later, the cash hedge against higher Were you to speculate in interest rates, and the hope of later being able to market price of gold has risen, he futures contracts, the person lenders against lower buy back identical and offsetting will have to pay his supplier that taking the opposite side of your interest rates.In addi- contracts at a lower price. The increased amount to acquire gold. trade on any given occasion tion, investors can practice of selling futures con- could be a hedger or it might However, the extra cost may be off- hedge against tracts in anticipation of lower well be a speculator—someone set by a corresponding profit when a decline in prices is known as “going short.” whose opinion about the proba- the futures contract bought at $550 stock prices. One of the unique features of ble direction of prices may dif- is sold for $570. In effect, the hedge futures trading is that one can ini- fer from your own. tiate a transaction with a sale as well as with a purchase. 18 19 Introduction to Futures Trading Opportunity and Risk: An Educational Guide

Reasons for Reasons for BUYING SELLING futures contracts futures contracts in response to changing expecta- contracts youplantotrade. tions. As the term indicates, You’ll also need to know how a HEDGERS To lock in a price To lock in a price futures markets “discover”—or price change of any given and thereby and thereby reflect—cash market prices. amount will affect the value of obtain protection obtain protection They do not set them. the contract. against rising against declining cash prices cash prices Competitive price discovery Daily Price Limits is a major economic function— SPECULATORS To profit from To profit from and, indeed, a major economic Exchanges establish daily rising futures prices declining future prices benefit—of futures trading. In price limits for trading in some summary, futures prices are an futures contracts.The limits are ever changing barometer of sup- stated in terms of the previous ply and demand and, in a dynam- day’s closing price plus and The Process of Price Discovery ic market, the only certainty is minus so many cents or dollars that prices will change. per trading unit. Once a futures Futures prices increase ments are reassessed, and the price has increased by its daily and decrease largely because price of a particular futures con- Minimum limit, there can be no trading at tract may be bid upward or Price Changes any higher price until the next of the myriad factors that downward. The process of trading session. Conversely, Exchanges establish the min- influence buyers’and sellers’ reassessment—of price discov- once a futures price has imum amount that the price can ery—is continuous. declined by its daily limit, there judgments about what a par- fluctuate upward or downward. can be no trading at any lower ticular commodity will be Thus, in January, the price of This is known as the “tick.” For price until the next session. a July futures contract would example, each tick for grain is worth at a given time in the Thus, if the daily limit for a reflect the consensus of buyers’ .0025¢ per bushel. On a 5,000 particular grain is currently 10¢ future (anywhere from less and sellers’ opinions at that time bushel futures contract, that’s a bushel and the previous day’s than a month to more than as to what the value of a com- $12.50. On a gold futures con- settlement was $3.00, there can- modity or item will be when the tract, the tick is 10¢ per ounce, two years). not be trading during the cur- contract expires in July. On any so one tick on a 100 ounce con- rent day at any price below 2.90 As new supply and demand given day,with the arrival of new tract is $10.You’ll want to famil- or above 3.10. The price is developments occur and as new or more accurate information, iarize yourself with the mini- allowed to increase or decrease and more current information the price of the July futures con- mum price fluctuation—the by the limit amount each day. becomes available, these judg- tract might increase or decrease tick size—for whatever futures

20 21 Introduction to Futures Trading Opportunity and Risk: An Educational Guide

tion at will.In this event,possible Daily alternative strategies should be Close For some contracts, daily discussed with a broker. price limits are eliminated At the end of a day’s trad- during the month in which Position Limits ing, the exchange’s clearing the contract expires.Because Although the average trader organization matches each prices can become particu- is unlikely to ever approach them, ex changes and the CFTC clearing firm’s purchases larly volatile during the expi- establish limits on the maxi- For example, if a speculator were to ration month (also called the made that day with corre- mum speculative position that have a $300 profit as a result of the any one person can have at one sponding sales and tallies “delivery” or “spot” month), day’s price changes, that amount time in any one futures con- each clearing firm’s gains or persons lacking experience would be immediately creditedo t tract. The purpose is to prevent losses based on that ses- in futures trading may wish one buyer or seller from being his brokerage account and, unless to liquidate their positions able to exert undue influence sion’s price changes—a required for other purposes, could prior to that time.At the very on the price in either the estab- massive undertaking consid- be withdrawn. On the other hand, if least, they should trade cau- lishment or liquidation of posi- ering that several million the day’s price changes had resulted tions. Position limits are stated tiously and with an under- futures contracts are bought in a $300 loss, his account would be in number of contracts or total immediately debited for that standing of the risks which units of the commodity. and sold on an average day. amount. may be involved. The easiest way to obtain the Each firm, in turn, calculates The process just described is types of information just dis- the gains and losses for known as a daily cash settlement Daily price limits set by the cussed is to ask your broker or each of its customers having and is an important feature exchanges are subject to change. other advisor to provide you of futures trading. As will be They can, for example, be with a copy of the contract spec- futures contracts. seen when we discuss increased or decreased on suc- ifications for the specific futures Gains and losses on futures requirements (see page 26), it is cessive days. Because of daily contracts you are thinking about contracts are not only calculat- also the reason a customer who price limits, there may be occa- trading. You can also obtain the ed on a daily basis, they are incurs a loss on a futures posi- sions when it is not possible to information from the exchange credited and deducted by the tion may b e called on to deposit liquidate an existing futures posi- where the contract is traded. clearing firm on a daily basis. additional funds to his account.

22 23 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Leverage can Each tick is $ The Arithmetic work to realize a $50 gain swift profit June S&P of Futures 500 E-mini $1,000 stock index or 25% Trading % profit Leverage 1,420 +2% To say that gains and losses in Initial $4,000 futures trading are the result of 1,400 Investment Leverage can as -2% price changes is an accurate easily deliver 1,380 explanation but by no means a great losses complete explanation. Perhaps -$1,000 more so than in any other form of or 25% speculation or investment, gains leverage loss and losses in futures trading are Each tick is highly leveraged. An understand- a $50 loss ing of leverage—and of how it can work to your advantage or Small movements in % create big changes in $ disadvantage—is crucial to an understanding of futures trading. $200,000.The smaller the margin For example, assume that in antic- $1,000 profit (20 x $50) and a The leverage of futures trading in relation to the value of the ipation of rising stock prices you buy decrease from 1400 to 1380 would futures contract, the greater the stems from the fact that only a rel- one June S&P 500 E-mini stock index be a $1,000 loss on your $4,000 mar- leverage will be. atively small amount of money futures contract at a time when the gin deposit. That’s a 25 percent gain (known as initial margin) is If you speculate in futures con- June index is trading at 1400. And or loss as the result of less than a 2 required to buy or sell a futures tracts and the price moves in the assume your initial margin require- percent change in the stock index. contract. On a particular day, a direction you anticipated, high ment is $4,000. Since the value of the margin deposit of only $1,000 leverage can produce large profits Said another way, while buy- might enable you to buy or sell in relation to your initial margin. futures contract is 50 times the index, ing (or selling) a futures contract a futures contract covering Conversely, if prices move in the each one point change in the index provides exactly the same dollars $25,000 worth of soybeans. Or opposite direction, high leverage represents a $50 gain or loss. and cents profit potential as for $20,000, you might be able owning (or selling short) the can produce large losses in rela- Thus, an increase in the index to purchase a futures contract tion to your initial margin. actual or items cov- from 1400 to 1420 would produce a covering common stocks worth Leverage is a two-edged sword. ered by the contract, low margin 24 25 How the Markets are Regulated Opportunity and Risk: An Educational Guide

requirements sharply increase Margins futures trading. It is much like the percentage profit or loss money held in an escrow As is apparent from the pre- potential. account. ceding discussion, the arith- Futures trading, therefore, metic of leverage is the arith- Minimum margin require- requires not only the necessary metic of margins. An under- ments for a particular futures financial resources but also the standing of margins—and of the contract at a particular time are necessary emotional tempera- several different kinds of mar- set by the exchange on which ment. For example, it can be gin—is essential to an under- the contract is traded. They are one thing to have the value of standing of futures trading. typically about five percent of your portfolio of common stocks the current value of the futures If your previous investment decline from $200,000 to contract. experience has mainly involved $190,000 (a five percent loss) but common stocks, you know that Exchanges continuously moni- quite another,at least emotionally, the term margin—as used in tor market conditions and risks to deposit $20,000 as margin and connection with securities— and, as necessary, raise or reduce end up losing half of it as the result has to do with the cash down their margin requirements. of only a five percent decline. payment and money borrowed Individual brokerage firms may from a broker to purchase require higher margin amounts stocks. But used in connection from their customers t han the with futures trading, margin has exchange-set minimums. an altogether different meaning There are two margin-related It is essential for anyone considering trading in futures con- and serves an altogether differ- terms you should know: Initial tracts—whether it’s sugar or stock indexes, pork bellies or ent purpose. margin and maintenance margin. —to clearly understand the concept of leverage as Rather than providing a Initial margin (sometimes down payment, the margin well as the amount of gain or loss that will result from any called original margin) is the sum required to buy or sell a futures of money that the customer must given change in the futures price of the particular futures con- contract is solely a deposit of deposit with the brokerage firm tract you would be trading. If you cannot afford the risk, or good faith money that can be for each futures contract to be drawn on by your brokerage even if you are uncomfortable with the risk, the only sound bought or sold. On any day that firm to cover losses that you profits accrue on your open posi- advice is don’t trade. Futures trading is not for everyone. may incur in the course of tions, the profits will be added to

26 27 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Before trading in futures Initial Margin Needed contracts, be sure you $2,000 Assume, for example, that the ini- understand the brokerage Margin tial margin needed to buy or sell a par- firm’s Margin Agreement Maintenance Margin Call Requirement ticular futures contract is $2,000 and and know how and when $600 that the maintenance margin require- $1,500 the firm expects margin ment is $1,500. Should losses on open calls to be met. Some firms positions reduce the funds remaining If Your Account Drops to may require only that you in your trading account to $1,400 (an mail a personal check. $1,400 amount less than the maintenance requirement), you will receive a mar- Others may insist you wire gin call for the $600 needed to restore transfer funds from your your account to $2,000. or provide same-day margin or next-day delivery of a certified or cashier’s check. If margin calls are not met

the balance in your margin ment—your broker will require in the prescribed time and account. On any day losses that you deposit additional funds form, the firm can protect accrue,the losses will be deduct- to bring the account back to the itself by liquidating your ed from the balance in your mar- level of the initial margin. You open positions at the avail- gin account. may also be asked for additional margin if the exchange or your able market price (possibly If and when the funds remain- brokerage firm raises its margin resulting in a loss for which ing available in your margin requirements. Requests for addi- account are reduced by losses to you would be liable). tional margin are known as below a certain level—known as margin calls. the maintenance margin require-

28 29 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Basic For example, assume it’s now Trading January, the July soybean futures Strategies contract is presently quoted at $6.00 a bushel, and over the coming Even if you should months you expect the price to decide to participate in increase. You decide to deposit the futures trading in a way required initial margin of $1,000 and buy one July soybean futures that doesn’t involve having contract. Further assume that by to make day-to-day trading April the July soybean futures price decisions (such as a man- has risen to $6.40, and you decide aged account or commodi- Buying (Going Long) to take your profit by selling. Since to Profit from an ty pool), it is nonetheless each contract is for 5,000 bushels, Expected Price your 40-cent a bushel profit would useful to understand the Increase be 5,000 bushels x 40¢ or $2,000 dollars and cents of how Someone expecting the less transaction costs. futures trading gains and price of a particular commodity losses are realized. If you or item to increase over a given Price Per Value of 5,000 period of time can seek to prof- Bushel Bushel Contract intend to trade your own it by buying futures contracts. If account, such an under- correct in forecasting the direc- January Buy 1 July soybean $6.00 $30,000 standing is essential. tion and timing of the price futures contract change, the futures contract can April Sell 1 July soybean $6.40 $32,000 Dozens of different strategies later be sold for the higher futures contract and variations of strategies are price, thereby yielding a profit.* employed by futures traders in If the price declines rather than GAIN $ .40 $ 2,000 pursuit of speculative profits. increases, the trade will result in Here is a brief description and a loss. Because of leverage, the illustration of several basic gain or loss may be greater than *For simplicity, examples do not take into account commissions strategies. the initial margin deposit. and other transaction costs.These costs are important, however, and you should be sure you fully understand them. 30 31 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Price Per Value of 5,000 Bushel Bushel Contract For example, assume that in original selling price. On the 40,000 January your research or other pound contract, that’s a gain of 5¢ x January Buy 1 July soybean $6.00 $30,000 available information indicates a 40,000 lbs. or $2,000 less transac- futures contract probable decrease in cattle prices tion costs. April Sell 1 July soybean $5.60 $28,000 over the next several months. In the futures contract hope of profiting, you deposit an ini- tial margin of $700 and sell one LOSS $ .40 $ 2,000 April live cattle futures contract at a price of, say, 85¢ a pound. Each Suppose, however, that rather cover the projected losses contract is for 40,000 pounds, than rising to $6.40, the July soy- marked to the settlement price. meaning each 1¢ a pound change in bean futures price had declined to Selling (Going Short) price will increase or decrease the $5.60 and that, in order to avoid the to Profit from an value of the futures contract by possibility of further loss, you elect Expected Price $400. If, by March, the price has to sell the contract at that price. On Decrease declined to 80¢ a pound, an offset- 5,000 bushels your 40-cent a bushel The only way going short to ting futures contract can be pur- loss would thus come to $2,000 plus profit from an expected price chased at 5¢ a pound below the transaction costs. decrease differs from going long Note that the loss in this to profit from an expected price example exceeded your $1,000 increase is the sequence of the Price Per Value of 40,000 initial deposit. Your broker trades. Instead of first buying a Pound Pound Contract would then call upon you, as futures contract, you first sell a needed, for additional funds to futures contract. If, as expected, January Sell 1 April live cattle 85¢ $34,000 cover the loss. Had you not off- the price declines,a profit can be futures contract set the position and the soybean realized by later purchasing an March Buy 1 April live cattle 80¢ $32,000 contract was open in your offsetting futures contract at the futures contract account, your broker would ask lower price. The gain per unit will be the amount by which the you to deposit more margin GAIN 5¢ $ 2,000 funds into your account to purchase price is below the ear- lier selling price. 32 33 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Price Per Value of 40,000 Pound Pound Contract As an illustration, assume it’s Assume time and events prove now November, that the March you right and that, by February, the January Sell 1 April live cattle 85¢ $34,000 CBOT mini Wheat futures price is March futures price has risen to futures contract presently $3.50 a bushel and the $3.60 and May futures price is March Buy 1 April live cattle 90¢ $36,000 May CBOT mini Wheat futures price $3.75, a difference of 15¢. By liqui- futures contract is presently $3.55 a bushel, a differ- dating both contracts at this time, ence of 5¢. Your analysis of market you can realize a net gain of 10¢ a LOSS 5¢ $ 2,000 conditions indicates that, over the bushel. Since each contract is 1,000 next few months, the price differ- bushels, the total gain is $100. Assume you were wrong. Instead Spreads ence between the two contracts will of decreasing, the April live cattle While most speculative widen to become greater than 5¢. To futures price increases to 90¢ a futures transactions involve a profit if you are right, you could sell pound by the time in March when simple purchase of futures the March futures contract (the you eventually liquidate your short contracts to profit from an lower priced contract) and buy the expected price increase—or futures position through an offset- May futures contract (the higher an equally simple sale to profit ting purchase. The outcome would priced contract). from an expected price be as shown above. decrease—numerous other Spread In this example, the loss of possible strategies exist. 5¢ a pound on the future trans- Spreads are one example. November Sell March Buy March action resulted in a total loss of A spread, at least in its sim- Mini Wheat Mini Wheat the $2,000 plus transaction plest form, involves buying one @ 3.50 bu. @ 3.55 bu. 5¢ costs. futures contract and selling February Buy March Sell March another futures contract. The Mini Wheat Mini Wheat purpose is to profit from an @ 3.60 bu. @ 3.75 bu. 15¢ expected change in the relation- ship between the purchase $.10 LOSS $.20 GAIN price of one and the selling price of the other. Net gain = 10¢ per bushel Gain on 1,000 bushel contract = $100

34 35 How the Markets are Regulated Opportunity and Risk: An Educational Guide

Had the spread (the price dif- to experience losses on both of For example, were you to pur- be possible to execute your ference) narrowed by 10¢ a the futures contracts involved chase a crude oil futures contract at order at any price. In addition, bushel rather than widened by (that is, on both legs of the $61 a barrel and wished to limit although it happens infrequent- 10¢ a bushel, the transactions spread). ly, it is possible that markets your loss to $1 a barrel, you might just illustrated would have may be lock limit for more than Virtually unlimited numbers place a stop order to sell an offset- resulted in a loss of $100. one day, resulting in substantial and types of spread possibilities ting contract if the price should fall losses to futures traders who Because of the potential of exist, as do many other, even to $60 a barrel. If andwhen the may find it impossible to liqui- one leg of the spread to hedge more complex futures trading market reaches whatever price you date losing futures positions. against price loss in the other strategies. These, however, are leg and because gains and loss- beyond the scope of an intro- specify, a stop order becomes an Subject to the kinds of limita- es occur only as the result of a ductory booklet and should be order to execute the desired trade. tions just discussed, stop orders change in the price differ- considered only by someone There can be no guarantee, can nonetheless provide a use- ence—rather than as a result of who fully understands the however, that it will be possible ful tool for the futures trader a change in the overall level of risk/reward arithmetic involved. under all market conditions to who seeks to limit his losses. futures prices—spreads are execute the order at the price In addition to providing a often considered more conser- specified. In an active, volatile way to limit losses, stop orders vative and less risky than hav- market, the market price may be can also be employed to protect ing an outright long or short declining (or rising) so rapidly profits. futures position. In general, that there is no opportunity to this may be the case. liquidate your position at the For instance, if you have bought Stop Orders crude oil futures at $61 a barrel and It should be recognized, stop price you have designated.It though, that the loss from a A stop order is an order is important to understand each the price is now at $64 a barrel, you spread can be as great as—or placed with your broker to buy exchange’s rules and regulations might wish to place a stop order to even greater than—that which or sell a particular futures con- as to the type of orders permitted sell if and when the price declines to might be incurred in having an tract if and when the price and the nuances of each. $63. This (again subject to the outright futures position. An reaches a specified level. Stop In the event that prices have described limitations of stop orders) orders are often used by futures adverse widening or narrowing risen or fallen in a market that could protect $2 of your existing $3 of the spread during a particular traders in an effort to limit the utilizes a maximum daily limit, profit while still allowing your posi- time period may exceed the amount they might lose if the and there is presently no trading tion to benefit from any continued change in the overall level of futures price moves against in the contract (known as a increase in price. futu res prices, and it is possible their position. “lock limit” market), it may not

36 37 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

Futures Commission Merchants (FCMs) How to Participate are brokerage firms doing business with the public. Introducing in Futures Trading Brokers (IBs) Commodity act as independent salespeople, Pool Operators soliciting customer accounts (CPOs) which are traded through FCMs. Now that you have an Choosing a method of partic- manage combined funds, much like a mutual fund. Commodity Trading overview of what futures ipating in the futures markets is largely a matter of deciding how Advisors (CTAs) markets are, why they exist directly and extensively you, offer trading advice to individuals, organizations and how they work, the personally, want to be involved and commodity pools. next step is to consider var- in making trading decisions and managing your account. Many ious ways in which you futures traders prefer to do their Categories and Makeup of NFA Members may be able to participate own research and analysis and make their own decisions about in futures trading.There are There’s no form ula for decid- quently required. Some recog- what and when to buy and sell. a number of alternatives ing. Your decision should, how- nize and accept the fact that That is, they manage theirn ow ever, take into account such futures trading all but inevitably and the only best alterna- futures trades in much the same things as your knowledge of and involves having some losing way they would manage their tive—if you decide to par- any previous experience in trades. Others lack the neces- own stock portfolios. Others ticipate at all—is whichev- futures trading, how much time sary disposition or discipline to choose to rely on or at least con- and attention you are able to acknowledge that they were er one is best for you. In sider the recommendations of a devote to trading, the amount of wrong on this particular occa- brokerage firm or account exec- addition to describing sev- capital you can afford to com- sion and liquidate the position. utive. Some purchase independ- eral possibilities, the pages mit to futures, and, perhaps ent trading advice. Others Many experienced traders most importantly, your individ- that follow suggest ques- would rather have someone else suggest that, of all the things ual temperament and tolerance be responsible for trading their you need to know before trad- tions you should ask and for risk. Some individuals thrive account and therefore give trad- ing in futures contracts, one of information you should on being directly involved in the ing authority to their broker or the most import ant is to know fast pace of futures trading. obtain before making a a trading advisor. Still others yourself. This can help you Others are unable, reluctant, or purchase an interest in a com- make the right decision about decision. lack the time to make the imme- modity trading pool. whether to participate at all diate decisions that are fre- and, if so, in what way. 38 39 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

Trade Your An individual trading account Own Account can be opened either directly It bears repeating, that with an FCM or through an IB. you should never partici- Whichever course you choose, pate in futures trading This involves opening the account itself will be carried unless the capital you your individual trading by an FCM, as will your money. IBs do not accept or handle cus- account and—with or would commit is risk capi- tomer funds but most offer a tal. That is, capital you can without the recommenda- variety of trading-related servic- afford to lose. It should be tions of the brokerage es. FCMs are required to main- tain the funds and property of capital over and above that firm—making your own their customers in segregated needed for necessities, trading decisions. You futures business with the public accounts, separate from the emergencies, savings and will also be responsible must be registered with the firm’s own money, if used for achieving your long-term for assuring that adequate CFTC as Futures Commission trading futures or options on investment objectives. You Merchants (FCMs) or Introducing futures on an exchange. funds are on deposit with Brokers (IBs) and must be In addition to the particular should also understand Members of NFA. the brokerage firm for services a firm provides, you that, because of the lever- margin purposes, or that Different firms offer different should also discuss the com- age involved in futures, the such funds are promptly services. Some, for example, missions and trading costs that profit and loss fluctuations have extensive research depart- will be involved.And, as men- provided as needed. may be wider than in most ments and can provide current tioned, clearly understand how information and analysis con- the firm requires that any mar- types of investment activity Practically all of the major cerning market developments gin calls be met. Remember, brokerage firms you are familiar and you may be required to as well as specific trading sug- you should always conduct with, and many you may not be gestions. Others tailor their a background check on the cover deficiencies due to familiar with, have departments services to clients who prefer to firm using NFA’s BASIC losses over and above what or even separate divisions to make market judgments and system on NFA’s Web site you had expected to com- serve clients who want to allo- arri ve at trading decisions on (www.nfa.futures.org) or cate some portion of their invest- mit to futures. their own. Still others offer vari- contact NFA’s Information ment capital to futures trading. ous combinations of these and Center toll-free at 800-621-3570. All brokerage firms conducting other services. 40 41 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

Have Someone is acceptable. Others tailor their Manage Your trading to a client’s objectives. Account In either case, obtain enough information and ask enough questions to assure yourself that A managed account is also Although an account manag- your money will be managed in er is likely to be managing the your individual account.The a way that’s consistent with accounts of other persons at the your goals. major difference is that you same time,there is no sharing of give someone else—an gains or losses of other cus- account manager—written tomers. Trading gains or losses in your account will result sole- Discuss fees. In addition power of attorney to make ly from trades which were made to commissions on trades and execute decisions about for your account. made for your account, what and when to trade. He Many FCMs and IBs accept it is not uncommon for or she will have discre- managed accounts. In most account managers to instances, the amount of money tionary authority to buy or charge a management fee, needed to open a managed Finally,take note of whether sell for your account or will account is larger than the amount and/or there may be some the account management agree- contact you for approval to required to establish an account arrangement for the man- ment includes a provision to you intend to trade yourself. make trades he or she sug- ager to participate in the automatically liquidate posi- Different firms and account man- net profits th at his manage- tions and close out the account gests. You, of course, remain agers, however, have different if and when losses exceed a cer- fully responsible for any loss- requirements and the range can ment produces. These tain amount.And, of course, you es which may be incurred be quite wide. Be certain to read charges are required to be should know and agree on what and understand all of the litera- fully disclosed in advance. will be done with profits, and and, as necessary, for meet- ture and agreements you receive Make sure you know about what, if any,restrict ions apply to ing margin calls, including from the broker. withdrawals from the account. every charge to be made to making up any deficiencies Some account managers your account and what that exceed your margin have their own trading approaches and accept only each charge is for. deposits. clients to whom that approach 42 43 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

Use a Commodity CFTC Regulations require same questions you would ask Trading Advisor that CTAs provide their cus- of any account manager you are considering. tomers, in advance, with Most CTAs must be regis- As the term implies, a Internet or through the what is called a Disclosure Commodity Trading Advisor mail. Some provide a fre- tered as such with the CFTC, Document. Read it carefully and registered CTAs that (CTA) is an individual (or quently updated hot-line or and ask the CTA to explain accept authority to manage firm) that, for a fee, provides Web site you can access for any points you don’t under- customer accounts must also be Members of NFA. advice on commodity trad- current information and stand. If your money is You can verify whether an ing, including specific trad- trading advice. important to you, so is the advisor is registered and an ing recommendations such information contained in Even though you may trade NFA Member by conducting a as when to establish a par- on the basis of an advisor’s rec- the Disclosure Document! background check using NFA’s ticular long or short posi- ommendations, you will need to BASIC system on NFA’s Web open your own account with, site (www.nfa.futures.org) or tion and when to liquidate and send your margi n payments The prospectus-like docu- by calling NFA toll-free at that position. Generally, to directly to,an FCM.CTAs cannot ment contains information 800-621-3570. help you choose trading accept or handle their cus- about the advisor, his experi- strategies that match your tomers’ funds unless they are ence and his current (and any also registered as FCMs. previous) performance records. tradin g objectives, advisors Some CTAs offer managed If you use an advisor to manage offer analysis and judg- accounts, with the advisor des- your account, he must first ments as to the prospective ignated in writing to make and obtain a signed acknowledg- ment from you that you have rewards and risks of the execute trading decisions on a discretionary basis.The account received and understood the trades they suggest. Trading itself, however, must still be Disclosure Document.As in any recommendations may be with an FCM and in your name. method of participating in futures trading, discuss and communicated by phone, understand the advisor’s fee electronically via the arrangements. And if he will be managing your account, ask the

44 45 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

Participate in a risks incurred by with a Disclosure Document Commodity Pool an individual that contains information trader. The pool about the pool operator, the still trades in pool’s principals and any out- Another alternative futures contracts side persons who will be pro- method of participating in which are highly leveraged and viding trading advice or making futures trading is through a in markets which can be highly trading decisions. It must also commodity pool, which is volatile. And like an individual disclose the previous perform- trader, the pool can suffer sub- ance records, if any, of all per- similar in concept to a stantial losses.A major considera- sons who will be operating or mutual tion, therefore, is who will be advising the pool (or, if none, fund. It is the only method managing the pool in terms of a statement to that effect). directing its trading. Disclosure Documents contain of participation in which important information and While a pool must execute you will not have your own should be carefully read before all of its trades through a bro- you invest your money. Ano- individual trading account. if you were to establish kerage firm which is registered ther requirement is that the Instead,your money will be your own trading account. with the CFTC as an FCM,it may Disclosure Document advise or may not have any other affili- combined with that of Another is that your risk of you of the risks involved. ation with the brokerage firm. other pool participants loss is generally limited to Some brokerage firms, to serve In the case of a new pool, and, in effect, traded as a your investment in the those customers who prefer to there is frequently a provision participate in commodity trad- that the pool will not begin trad- sing le account.You in pool, because most pools ing through a pool, either oper- ing until (and unless) a certain the profits or losses of the are formed as limited part- ate or have a relationship with amount of money is raised. pool in proportion to your nerships. And you won’t be one or more commodity trading Normally, a time deadline is set investment in the pool. subject to margin calls. pools. Other pools operate inde- and the CPO is required to state pendently. in the Disclosure Document One potential advantage is what that deadline is (or,if there Bear in mind, however, that In most instances, a is none, that the time period for greater diversification of the risks which a pool incurs in raising funds is indefinite). Be risks than you might obtain any given futures transaction (CPO) cannot accept your sure you understand the terms, are no different than the risks money until it has provided you

46 47 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

including how your money will Determine whether you will be invested in the meantime, be responsible for any losses in what interest you will earn (if excess of your investment in the costs any), and how and when your pool. If so, this must be indicated investment will be returned in prominently at the beginning of the event the pool does not the pool’s Disclosure Document. fees co mmence trading. restrictions

Ask about fees and other costs,including what,if any, initial charges will be made against your investment for disclosures organizational or administrative expenses. Such informa- tion should be noted in the Disclosure Document. You With a few exceptions, should also determine from the Disclosure Document how CPOs must be registered the pool’s operator and advisor are compensated. with the CFTC and be Members of NFA. You can Understand, too, the procedure for redeeming your shares verify that these require- in the pool, any restrictions that may exist, and provisions ments have been met by for liquidating and disso lving the pool if more than a certain conducting a background percentage of the capital were to be lost. search on NFA’s BASIC system at NFA’s Web site Ask about the pool operator’s general trading philosophy, (www.nfa.futures.org) or by what types of contracts will be traded, whether they will be contacting NFA toll-free at 800-6 21-3570. day-traded, etc.

48 49 How to Participate in Futures Trading Opportunity and Risk: An Educational Guide

Establis hing obligations as well as the rights an Account and obligations of the firm with which you are dealing before you enter into any futures trans- At the time you apply to action. If you have questions establish a futures trading about exactly what any provi- account, you can expect to sions of the Agreement mean, be asked for certain infor- don’t hesitate to ask. A good and continuing relationship can mation beyond simply your exist only if both parties have, name, address and phone from the outset, a clear under- number. The requested standing of the relationship. information will generally Nor should you be hesitant to ask, in advance, what services include (but not necessari- you will be getting for the trad- ly be limited to) your ing commissions the firm income, net worth, what charges.As indicated earlier, not all firms offer identical services, previous investment or and not all clients ha ve identical At a minimum, the person or Just as you wouldn’t consider futures trading experience needs. If it is important to you, firm who will handle your buying a car or a house without for example, you might inquire you have had, and any account is required to provide carefully reading and under- about the firm’s research capa- other information needed you with risk disclosure docu- standing the terms of the con- bility and whatever reports it ments or statements specified tract, neither should you estab- in order to advise you of makes available to clients. Other by the CFTC and obtain written lish a trading account without subjects of inquiry could be the risks involved in trad- acknowledgment that you have first reading and understanding how transaction and statement ing futures contracts. You received and understood them. the Account Agreement and all information will be provided, other documents supplied by will also be required to pro- Opening a futures account is a and how your orders will be your broker.It is in your interest vide proof of identity to serious decision and should obvi- handled and executed. and the firm’s interest that you ously be approached as such. comply with federal law. clearly know your rights and

50 51 Introduction to Options on Futures Opportunity and Risk: An Educational Guide Introduction to Options on Futures

Although futures contracts during the life of the option. A Options on futures contracts have been traded on U.S. put option conveys to the option can offer a wide range of invest- However, options trading buyer the right to sell a particu- ment opportunities. is a speculative investment exchanges since 1865, lar futures contract at a stated options on futures contracts price at any time during the life and should be treated as were not introduced until of the option. such. Even though the pur- 1982.There are two styles chase of options on futures contracts limits your poten- of options—American and tial losses to the amount of European. For the purposes the investment,it is nonethe- of this discussion, we will less possible to lose your focus on American-style entire investment in a short options. period of time. And for An option on a futures con- investors who sell rather tract gives the option buyer the than buy options, there may right—but not the obligation— be no limit at all to the size to buy or sell a particular futures contract at a stated price at any of potential losses. time prior to a specified date. There are two types of options: calls and puts. A call option conveys to the option buyer the right to pur- chase a particular futures con- tract at a stated price at any time

52 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

The Arithmetic An option that currently has consensus opinion as to the of Option intrinsic value is said to be “in- likelihood of the option’s the-money” (by the amount of increasing in value prior to its Premiums its intrinsic value). An option expiration. that does not cur rently have The three principal factors intrinsic value is said to be There are two, known as intrin- that affect an option’s time An option premium is either “at-the-money” or “out-of- sic value and time value. The value are: the price paid by the buyer the-money.” premium is the sum of these. of the option and received Intrinsic Time For example, at a time when a Time Premium = + by the seller of the option. Value Value U.S. Treasury bond futures contract Value At the time you purchase a is trading at 120-00, a call option particular option, its premi- Intrinsic Value with a strike price of 123-00 would um cost may be $1,000. A be “out-of-the-money” by $3,000. Intrinsic value is the amount Time to Expiration month or so later, the same of money that could currently Time Value Time remaining until expiration. option may be worth only be realized by exercising the 1 option at its strike price and liq- Options also have time value. Time value declines as the $800 or $700 or $600. Or it uidating the acquired futures In fact, if a given option has no option approaches expiration. could be worth $1,200 or position at the present price of intrinsic value—currently “out- At expiration, it will no longer have any time value. (This is $1,300 or $1,400. the futures contract of-the-money”—its premium will consist entirely of time why an option is said to be a Since an option is something For example, at a time when a value. wasting asset.) that most people buy with the U.S. Treasury bond futures contract Time value is the amount 2 Relationship between the intention of eventually liqui- is trading at a price of 120-00, a option buyers are prese ntly will- option strike price and the cur- dating (hopefully at a higher call option conveying the right to ing to pay (and option sellers rent price of the underlying price), it’s important to have at purchase the futures contract at a are willing to accept)—over and futures contract. The further an least a basic understanding of option is removed from being below-the-market strike price of above any intrinsic value the the major factors which influ- worthwhile to exercise—the 115-00 would have an intrinsic option may have—for the spe- ence the premium for a particu- cific rights that a given option further “out-of-the-money” it value of $5,000. lar option at a particular time. conveys. It reflects, in effect, a is—the less time value it is like- ly to have.

54 55 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

3 .The more volatile a Understanding option investment, you should You should fully understand market is, the more likely it is Options be aware that: what a firm’s commission that a price change may eventu- charges will be and how I ally make the option worth- Transaction Fees Commission can be they’re calculated. If the charged on a per-trade while to exercise. Thus, the charges seem high—either on or a round-turn basis, option’s time value and premi- a dollar basis or as a percent- Before you decide to buy covering both the pur- um are generally higher in age of the option premium— and/or sell (write) options, chase and sale. volatile markets. you might want to seek com- I you should understand the Commission charges can parison quotes from one or differ significantly from two other firms.If a firm seeks other costs involved in the one brokerage firm to to justify an unusually high transaction—commissions another. + commission charge on the I and fees. Some firms charge com- basis of its services or per- missions per option formance record, you might Commission is the amount of transaction and others want to ask for a detailed – money, per option purchased or charge a percentage of explanation or documentation sold,that is paid to the brokerage the option premium, in writing. In addition to com- firm for its services,including the usually subject to a cer- missions, some firms will execution of the order on the tain minimum charge. include a separate charge for trading floor of the exchange. I Commission charges exchange and NFA fees. The commission charge increas- based on a percentage of es the cost of purchasing an the premium can be sub- option and reduces the sum of stantial, particularly if money received from selling an the option is one that option. In both cases, the premi- has a high premium. = um and the commission should I Commission charges be stated separately. can have a major impact on your chances of mak- Each firm is free to set its ing a profit.A high com- own commission charges, but mission charge reduces the charges must be fully dis- your potential profit closed in a manner th at is not and increases your misleading.In considering an potential loss.

56 57 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

Leverage have expired worthless, and the would have lost 100 Just as in futures trading, percent of his investment plus leverage plays an important role any commissions and fees. in trading options on futures. The premium paid for an option Example: It’s January and Option Calculating the $63.00 is only a small percentage of the Break-Even Price the 1,000 barrel April crude oil Strike Price value of the assets covered by futures contract is currently trading Premium .95 the underlying futures contract. Before purchasing any at around $62.50 a barrel. + option, it’s essential to deter- Therefore, even a small change Expecting a potentially significant Commission in the futures contract price can mine precisely what the under- increase in the futures price over the & Transaction + .05 result in a much larger percent- lying futures price must be in next several months, you decide to Costs age profit—or a much large per- order for the option to be prof- buy an April crude oil call option centage loss—in relation to the itable at expiration (or whenev- Break-Even $64.00 prem ium. Consider the follow- er you choose to offset it). The with a strike price of $63. Assume Price ing example: calculation isn’t difficult.All you the premium for the option is 95¢ a need to know to figure a given An investor pays $200 for a barrel and that the commission and option’s break-even price is the 100-ounce gold call option with a other transaction costs are $50, following: strike price of $500 an ounce at a which amounts to 5¢ a barrel. time when the gold futures price is I The option’s strike price; Before investing, you need to $500 an ounce. If, at expiration, the I The premium cost; and know how much the April crude oil futures price has risen to $503 (an futures price must increase by expi- I Commission and other increase of less than one percent), ration in order for the option to transaction costs. the option value will increase by break even or a net profit $300 (a gain of 150 percent on your after expenses. The answer is that Use the following formula to original investment of $200). the futures price must increase to determine the break-even price But always remember that $64.00 for you to break even and for a call option if you are the leverage is a two-edged sword.In to above $64.00 for you to realize purchaser: the above example, unless the any profit. futures price at expiration had Option Commission & Break been above the option’s $500 Strike +Option + Transaction = Even Price Premium Costs Price strike price, the option would

58 59 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

The option will exactly break Example: The price of gold is even if the April crude oil futures currently about $500 an ounce, but price at expiration is $64.00 a during the next few months you barrel. For each $1 a barrel the think there may be a sharp decline. price is above $64.00, the option To profit from the price decrease if will yield a profit of $1,000. Option you are right, you consider buying a $495.00 If the futures price at expiration is put option with a strike price of Strike Price $64.00 or less, there will be a loss. $495 an ounce. The option would Premium – 3.70 But in no event can the loss exceed give you the right to sell a specific the $1,000 total of the premium, gold futures contract at $495 an Commission commission and transaction costs. & Transaction – .50 ounce at any time prior to the expi- Costs ration of the option. The arithmetic for determin- ing the break-even price for pur- Assu me the premium for the put Break-Even $490.80 Price chasing a put option is the same option is $3.70 an ounce ($370 in as for a call option except that total) and the commission and instead of adding the premium, transaction costs are $50 (equal to The option will exactly break even at commission and transaction 50¢ an ounce). costs to the strike price, you expiration if the futures price is subtract them. For the option to break even at $490.80 an ounce. For each $1 an expiration, the futures price must ounce the futures price is below Option Commission Break $490.80 it will yield a profit of $100. Strike ––Option & Transaction = Even decline to $490.80 an ounce or Price Premium Costs Price lower. If the futures price at expiration is above $490.80, there will be a loss. But in no case can the loss exceed $420—the sum of the pre- mium ($370) plus commission and other transaction costs ($50).

60 61 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

Factors Affecting the tract or an option on a June become worthwhile to exer- that are out-of-the-money do not Choice of an Option futures contract. cise. For example, the right to normally respond to changes in buy a crude oil futures contract the underlying futures price the If you expect a price Bear in mind that the length of at $61 a barrel is more valuable same as options that are at-the- increase, you’ll want to consider an option (such as whether it has than the right to buy a crude oil money or in-the-money. the purchase of a call option. If three months to expiration or six futures contract at $62 a barrel. you expect a price decline, months) is an important variable Generally speaking,premiums you’ll want to consider the pur- affecting the cost of the option. Conversely,a put option with for out-of-the-money options chase of a put option. However, An option with more time com- a higher exercise price will havelengthdo not reflect, on a dollar for in addition to price expecta- mands a higher premium. a higher premium cost than a dollar basis, changes in the tions, there are two other fac- put option with a lower exercise underlying futures price. The tors that affect the choice of price. For example, the right to change in option option: The option strike price strikesell a crude oil futures contract value is usually less. at $62 a barrel is more valuable Indeed, a change I The amount of time The relationship between the until the expiration of strike price of an option and the than the right to sell a crude oil in the underlying the option (time value); current price of the underlying futures contract at $61 a barrel. futures price could have and futures contract is, along with priceWhile the choice of a call little effect, I The option strike price the length of the option, a major option or put option will be dic- or even (intrinsic value). factor affecting the option premi- tated by your price expectations no effect um. At any given time there may and your choice of expiration at all, on be trading in options with a month by when you look for the the value of The length of an option half dozen or more strike expected price change to occur, the option. This prices—some of them below the the choice of strike price is One of the attractive features could be the case current price of the underlying somewhat more complex. of options is that they allow if, for instance, futures contract and some of That’s because the strike price time for your price expectations the option re- them above. will influence not only the to be realized. The more time mains deeply out- A call option with a lower option’s premium cost but also you allow, the greater likelihood of-the-money strike price will have a higher how the value of the option, the option could eventually after the price premium cost than a call option once purchased, is likely to become profitable. This could change or if with a higher strike price respond to subsequent changes influence your decision about expiration is because the lower strike price in the underlying futures con- whether to buy, for example, an near. option on a March futures con- will more likely and more quickly tract price. Specifically, options

62 63 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

After You Example: In anticipation of rising Buy an Option sugar prices, you bought a call option on a sugar futures contract. The pre- mium cost was $950 and the commis- At any time prior to the In active markets, there are sion and transaction costs were $50. expiration of an option, usually other investors who are Sugar prices have subsequently risen willing to pay for the rights your and the option now commands a pre- you can: option conveys. How much mium of $1,250. By liquidating the they are willing to pay (it may I Offset the option; option at this price, your net gain is be more or less than you paid) I Continue to hold the will depend on (1) the current $250. That’s the selling price of option; or futures price in relation to the $1,250 minus the $950 premium I Exercise the option. option’s strike price, (2) the paid for the option minus $50 in com- length of time still remaining mission and transaction costs. until expiration of the option Offset the Option Premium paid for option $ 950 and (3) market volatility. Premium received when option is liquidated $ 1,250 Liquidating an option in the Net profit or loss, after Increase in premium $ 300 same marketplace where it was allowance for commission Less transaction costs $ 50 bought is the most frequent charges and other transaction method of realizing option prof- costs, will be the difference Net profit $ 250 its. Liquidating an option prior between the premium you paid to its expiration for whatever to buy the option and the pre- You should be aware, howev- Assuming, though, that value it may still have is also a mium you receive when you liq- er, that there is no guarantee that there’s still an active market, the way to reduce your loss (by uidate the option. there will actually be an active price you get when you liqui- re covering a portion of your market for the option at the time date will depend on the investment) in case the futures you decide you want to liqui- option’s premium at that time. price hasn’t performed as you date. If an option is too far Premiums are arrived at through expected it would, or if the removed from being worthwhile open competition between buy- price outlook has changed. to exercise or if there is too little ers and sellers accord ing to the time remaining until expiration, rules of an exchange. there may not be a market for the option at any price. 64 65 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

Continue to Hold Exercise the Option the Option hold The second alternative you You can also exercise the have after you buy an option is option at any time prior to the exercise to hold an option right up to the expiration of the option. It does final date for exercising or liqui- not have to be held until expira- dating it.This means that even if tion. It is essential to under- offset the price change you’ve antici- stand, however, that exercising pated doesn’t occur as soon as an option on a futures contract you expected—or even if the means that you will acquire But there are both costs Even if you were to exercise price initially moves in the either a long or short position in and significant risks involved in an option with the intention of opposite direction—you can the underlying futures con- acquiring a position in the promptly liquidating the futures continue to hold the option if tract—a long futures position if futures market. For one thing, position acquired through exer- you still believe the market will you exercise a call and a short the broker will require a margin cise, there’s the risk that the prove you right. If you are futures position if you exercise deposit to provide protection futures price which existed at wrong, you will have lost the a put. against possible fluctnuations i the moment may no longer be opportunity to limit your losses the futures price. And if the available by the time you are through offset. On the other Example: You’ve bought a call futures price moves adversely able to liquidate the futures hand, the most you can lose by option with a strike price of 70¢ a to your position, you could be position. Futures prices can and called upon—perhaps even often do change rapidly. continuing to hold the option is pound on a 40,000 pound live cattle the sum of the premium and within hours—to make addi- futures contract. The futures price For all these reasons, only a tional margin deposits. There is transaction costs. This is why it small percentage of option has risen to 75¢ a pound. Were you no upper limit to the extent of is sometimes said that option buyers elect to realize option to exercise the option, you would these margin calls. buyers have the advantage of trading profits by exercising an acquire a long cattle futures position staying power. You should be Secondly, unlike buying an option. Most choose the alter- aware, however, that options at 70¢ with a “paper gain” of 5¢ a option, which limits potential native of having the broker off- typically decline in value as they pound ($2,000). And if the futures losses, a futures position has set—i.e., liquidate—the option approach expiration. (See “Time price were to continue to climb, so potentially unlimited risk. The at its currently quoted premi- Value” on page 55). would your gain. further the futures price moves um value. against your position, the larger your loss.

66 67 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

Who Sells (Writes) Example: At a time when the Options and Why March U.S. Treasury Bond futures price is 125-00, an investor expect- ing stable or lower futures prices Up to now, we have dis- The attraction of option writ- (meaning stable or higher interest cussed only the buying of ing to some investors is the rates) earns a premium of $400 by opportunity to receive the pre- writing a call option with a strike options.But it stands to rea- mium that the option buyer price of 129. If the futures price at son that when someone pays. An option buyer antici- expiration is below 129-00, the call pates that a change in the buys an option, someone will expire worthless and the option option’s underlying futures else sells it. In any given price at some point in time writer will retain the entire $400 transaction, the seller may prior to expiration will make premium. His profit will be that be someone who previous- the option worthwhile to exer- amount less the transaction costs. cise. An option writer, on the ly bought an option and is other hand, anticipates that While option writing can be now liquidating it. Or the such a price change won’t a profitable activity, it is also an seller may be an individual occur—in which event the extremely high risk activity. In option will expire worthless who is participating in the fact, an option writer may have and he will retain the entire an unlimited risk. Except for the type of investment activity amount of the option premium premium received for writing known as options writing. that was received for wri ting the option, the writer of an the option. option stands to lose any amount the option is in-the- money at the time of expiration (unless he has liquidated his option position in the meantime by making an offsetting pur- chase).

68 69 Introduction to Options on Futures Opportunity and Risk: An Educational Guide

In the previous example, an late a break-even price. For the investor earned a premium of writer of a call, the break-even $400 by writing a U.S.Treasury price is the option strike price Bond call option with a strike plus the net premium received price of 129. If, by expiration, after transaction costs. For the Option writing as an investment is absolutely inappropri- the futures price has climbed writer of a put, the break-even ate for anyone who does not fully understand the nature above the option strike price by price is the option strike price more than the $400 premium minus the premium received and the extent of the risks involved and who cannot afford received, the investor will incur after transaction costs. the possibility of a potentially unlimited loss. It is also possi- a loss.For instance,if the futures An option writer’s potential ble in a market where prices are changing rapidly that an price at expiration has risen to profit is limited to the amount option writer may have no ability to control the extent of 131-00, the loss will be $1,600. of the premium less t ransaction That’s the $2,000 the option is his losses. Option writers should be sure to read and thor- costs.The option writer’s poten- in-the-money less the $400 pre- oughly understand the Risk Disclosure Statement that is tial losses may be unlimited.And mium received for writing the an option writer may need to provided to them. option (not incl uding transac- deposit funds necessary to tion costs). cover losses as often as daily. As you can see from this example, option writers as well as option buyers need to calcu-

70 71 If a Dispute Should Arise Opportunity and Risk: An Educational Guide If a Dispute

Shoud Arise The best way to resolve a

All but a small percentage disagreement is of transactions involving through direct regulated futures and discussions by options on futures contracts the parties take place without prob- involved. lems or misunderstandings. However, in any business in which millions of contracts are traded each day, occa- There are several advantages: If a hearing is required, sional disagreements are In many circumstances, it it can generally be I inevitable. Obviously, the may be possible to seek resolu- It tends to be faster and scheduled at a time tion through the exchange less expensive than the best way to resolve a dis- and place convenient where the futures contracts other alternatives. for both parties. agreement is through direct were traded or to file a claim for I You have a choice of I Unless you wish to do discussions by the parties reparations with the CFTC. selecting industry or so, you do not have to Unless you have signed a pre- non-industry related involved. Failing this, how- employ an attorney. dispute arbitration agreement, arbitrators. ever, participants in futures you can also file a claim in I You do not necessarily For a plain language expla- markets have several alter- court. However, most investors have to know what the nation of the arbitration pro- natives (unless some partic- choose to resolve the disagree- law is to successfully gram and how it works, write ment through the arbitration prove your claim. or phone NFA for a copy of ular method has been program conducted by National I In some cases, it may be Arbitration: A Way to Resolve agreed to in advance). Futures Association. possible to conduct arbi- Futures-Related Disputes. This tration entirely through free booklet is also available on written submissions. NFA’s Web site. 72 73 Glossary Opportunity and Risk: An Educational Guide

In Closing

This booklet ends where it Hopefully, the preceding began, with the statement pages have helped to provide a better understanding of the that it is not our intention to opportunities and the risks suggest either that you alike, as well as an understand- Glossary of Terms should or should not partic- ing of what futures markets are, how they work, who uses them, ipate in futures markets. alternative methods of partici- Low margins, high leverage, pation and, by no means least, frequently volatile prices, the vital economic function which futures markets perform. and the continuing needs of Trading Futures In no way, it should be hedgers to manage the price and emphasized, should anything uncertainties inherent in discussed herein be considered Options on Futures their business create oppor- trading advice or recommenda- tions. That should be provided tunities to realize potentially by your broker or advisor. substantial profits. But for Similarly,your broker or advisor- each such opportunity, as well as the exchanges where there is commensurate risk. futures contracts are traded-are your best sources for additional, Trading futures and options more detailed information on futures, as stated at the about futures trading. outset, is not for everyone.

74 75 Glossary Opportunity and Risk: An Educational Guide

Actuals Broker See Cash Commodity. A company or individual that executes futures and options orders on Aggregation behalf of financial and commercial institutions and/or the general public. The policy under which all futures positions owned or controlled by one Bull Market (Bull/Bullish) trader or a group of traders are combined to determine reportable posi- A market in which prices are rising. A market participant who believes tions and speculative limits. prices will move higher is called a “bull.”A news item is considered bull- ish if it is expected to result in higher prices. The simultaneous purchase and sale of similar commodities in different Call Option (American Style) markets to take advantage of a price discrepancy. An option which gives the buyer the right, but not the obligation, to pur- Arbitration chase (“go long”) the underlying futures contract at the strike price on or before the expiration date. The process of resolving disputes between parties by a pers on or persons (arbitrators) chosen or agreed to by them. NFA's arbitration program pro- Carrying Broker vides a forum for resolving futures-related disputes between NFA A member of a futures exchange, usually a clearinghouse member, Members or between Members and customers. through which another firm, broker or customer chooses to clear all or Associated Person (AP) some trades. An individual who solicits orders, customers or customer funds on behalf Cash Commodity of a Futures Commission Merchant, an Introducing Broker, a Commodity The actual physical commodity as distinguished from the futures contract Trading Advisor or a Commodity Pool Operator and who is registered based on the physical commodity. Also referred to as Actuals. with the Commodity Futures Trading Commission. Cash Market At-the-Money Option A place where people buy and sell the actual commodities (i.e., grain ele- An option whose strike price is equal—or approximately equal—to the vator, bank, etc.). current market price of the underlying futures contract. See also Forward (Cash) Contract and Spot. Basis Cash Settlement The difference between the current cash price of a commodity and the A method of settling certain futures or options contracts whereby the mar- futures price of the same commodity. ket participants settle in cash (payment of money rather than delivery of Bear Market (Bear/Bearish) the commodity). A market in which prices are declining. A market participant who Charting believes prices will move lower is called a“bear.”A news item is con- The use of graphs and charts in the of futures markets sidered bearish if it is expected to result in l ower prices. to plot price movements, volume, or other statistical Bid indicators of price movement. See also Technical Analysis. An expression of willingness to buy a commodity at a given price; the opposite of Offer. Churning Board of Trade Excessive trading that results in the broker deriving a profit from commis- sions while disregarding the best interests of the customers. See Contract Market.

76 77 Glossary Opportunity and Risk: An Educational Guide

Circuit Breaker Commodity Pool A system of trading halts and price limits on equities and derivatives An enterprise in which funds contributed by a number of persons are markets designed to provide a cooling-off period during large, intraday combined for the purpose of trading futures or options contracts.The market declines or rises. concept is similar to a mutual fund in the securities industry.Also Clear referred to as a Pool. The process by which a clearinghouse maintains records of all trades Commodity Pool Operator (CPO) and settles margin flow on a daily mark-to-market basis for its clearing An individual or organization which operates and solicits funds for a com- members. modity pool.A CPO may be required to be registered with the CFTC. Clearinghouse Commodity Trading Advisor (CTA) A corporation or separate division of a futures exchange that is responsi- A person who,for compensation or profit,directly or indirectly advises oth- ble for settling trading accounts, collecting and maintaining margin ers as to the advisability of buying or selling futures or commodity options. monies, regulating delivery and reporting trade data. The clearinghouse Providing advice includes exercising trading authority over a customer’s becomes the buyer to each seller (and the seller to each buyer) and account.A CTA may be required to be registered with the CFTC. assumes responsibility for protecting buyers and sellers from financial Confirmation Statement loss by assuring performance on each contract. A statement sent by a Futures Commission Merchant to a customer when Clearing Member a futures or options position has been initiated.The statement shows the A member of an exchange clearinghouse responsible for the financial price and the number of contracts bought or sold. Sometimes combined commitments of its customers.All trades of a non-clearing member must with a Purchase and Sale Statement. be registered and eventually settled through a clearing member. Contract Market Closing Price A board of trade designated by the CFTC to trade futures or options con- See Settlement Price. tracts on a particular commodity. Commonly used to mean any exchange Closing Range on which futures are traded.Also referred to as an Exchange. A range of prices at which futures transactions took place during the Contract Month close of the market. The month in which delivery is to be made in accordance with the terms Commission of the futures contract.Also referred to as Delivery Month. A fee charged by a broker to a customer for executing a transaction. Convergence Commission House The tendency for prices of physical commodities and futures to approach one another, usually during the delivery month. See Futures Commission Merchant. Commodity Exchange Act (CEA) Covered Option A short call or put option position which is covered by the sale or pur- The federal act that provides for federal regulation of futures trading. chase of the underlying futures contract or physical commodity. Commodity Futures Trading Commission (CFTC) The federal regulatory agency established in 1974 that administers the Commodity Exchange Act.The CFTC monitors the futures and options on futures markets in the United States.

78 79 Glossary Opportunity and Risk: An Educational Guide

Cross-Hedging Designated Self-Regulatory Organization (DSRO) Hedging a cash commodity using a different but related futures contract When a Futures Commission Merchant (FCM) is a member of more than when there is no futures contract for the cash commodity being hedged one Self-Regulatory Organization (SRO), the SROs may decide among and the cash and futures market follow similar price trends (e.g., using themselves which of them will be primari ly responsible for enforcing soybean meal futures to hedge fish meal). minimum financial and sales practice requirements.The SRO will be Customer Segregated Funds appointed DSRO for that particular FCM. NFA is the DSRO for all non- exchange member FCMs. See Segregated Account. See also Self-Regulatory Organization. Day Order Disclosure Document An order that if not executed expires automatically at the end of the trad- The statement that some CPOs must provide to customers. It describes ing session on the day it was entered. , fees, performance, etc. Day Trader Discount A speculator who will normally initiate and offset a position within a sin- (1)The amount a price would be reduced to purchase a commodity of gle trading session. lesser grade; (2) sometimes used to refer to the price differences Default between futures of different delivery months, as in the phrase “July is The failure to perform on a futures contract as required by exchange trading at a discount to May,”indicating that the price of the July future rules, such as a failure to meet a margin call or to make or take delivery. is lower than that of May;(3) applied to cash grain prices that are below Deferred Delivery Month the futures price. The distant delivery months in which futures trading is taking place, as Discretionary Account distinguished from the nearby futures delivery month. An arrangement by which the owner of the account gives written power Delivery of attorney to someone else, usually the broker or a Commodity Trading Advisor,to buy and sell without prior approval of the account owner. The transfer of the cash commodity from the seller of a futures contract Also referred to as a Managed Account. to the buyer of a futures contract. Each futures exchange has specific pro- cedures for delivery of a cash commodity.Some futures contracts, such as Electronic Order stock index contracts, are cash settled. An order placed electronically (without the use of a broker) either via the Delivery Month Internet or an electronic trading system. See Contract Month. Electronic Trading Systems Systems that allow participating exchanges to list their products for trading electronically.These systems may replace, supplement or run A financial instrument, traded on or off an exchange, the price of which is along side of the open outcry trading. directly dependent upon the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instru- Equity ments, or any agreed upon pricing index or arrangement. Derivatives 1) The value of a futures trading account if all open positions were involve the trading of rights or obligations based on the underlying prod- offset at the current market price;2) an ownership interest in a com- uct but do not directly transfer that product.They are generally used to pany, such as stock. hedge risk.

80 81 Glossary Opportunity and Risk: An Educational Guide

Exchange See Contract Market. A method of anticipating future price movement using supply and Exercise demand information. The action taken by the holder of a call option if he wishes to purchase Futures Commission Merchant (FCM) the underlying futures contract or by the holder of a put option if he An individual or organization which solicits or accepts orders to buy or wishes to sell the underlying futures contract. sell futures contracts or commodity options and accepts money or other Exercise Price assets from customers in connection with such orders.An FCM must be registered with the CFTC. See Strike Price. Futures Contract Expiration Date A legally binding agreement to buy or sell a commodity or financial instru- Generally the last date on which an option may be exercised. It is not ment at a later date. Futures contracts are normally standardized accord- uncommon for an option to expire on a specified date during the month ing to the quality, quantity and delivery time and location for each com- prior to the delivery month for the underlying futures contracts. modity, with price as the only variable. Extrinsic Value Grantor See Time Value. See Writer. First Notice Day Guaranteed Introducing Broker The first day on which notice of intent to deliver a commodity in fulfill- A Guaranteed Introducing Broker is an IB that has a written agreement ment of an expiring futures contract can be given to the clearinghouse by with a Futures Commission Merchant that obligates the FCM to assume a seller and assigned by the clearinghouse to a buyer.Varies from contract financial and disciplinary responsibility for the performance of the to contract. 1) The value of a futures trading account if all open positions Guaranteed Introducing Broker in connection with futures and options were offset at the current market price; 2) an ownership interest in a customers.A Guaranteed Introducing Broker is not subject to minimum co mpany, such as stock. financial requirements. Hedging An individual who executes orders on the trading floor of an exchange The practice of offsetting the price risk inherent in any cash market posi- for any other person. tion by taking an opposite position in the futures marke t. A long hedge involves buying futures contracts to protect against possible increasing An individual who is a member of an exchange and trades for his own prices of commodities.A short hedge involves selling futures contracts to account on the floor of the exchange. protect against possible declining prices of commodities Forward (Cash) Contract High A contract which requires a seller to agree to deliver a specified cash The highest price of the day for a particular futures or options on futures commodity to a buyer sometime in the future, where the parties expect contract. delivery to occur.All terms of the contract may be customized, in contrast Holder to futures contracts whose terms are standardized. The opposite of a Grantor. Fully Disclosed See also Option Buyer. An account carried by a Futures Commission Merchant in the name of an individual customer; the opposite of an Omnibus Account. 82 83 Glossary Opportunity and Risk: An Educational Guide

In-the-Money Option Long An option that has intrinsic value.A call option is in-the-money if its strike One who has bought futures contracts or options on futures contracts or price is below the current price of the underlying futures contract.A put owns a cash commodity. option is in-the-money if its strike price is above the current price of the Low underlying futures contract. The lowest price of the day for a particular futures or options on futures Independent Introducing Broker contract. An Independent Introducing Broker is an IB subject to minimum capital Maintenance Margin requirements. A set minimum amount (per outstanding futures contract) that a cus- Initial Margin tomer must maintai n in his margin account to retain the futures position. The amount a futures market participant must deposit into a margin See also Margin. account at the time an order is placed to buy or sell a futures contract. Managed Account See also Margin. See Discretionary Account. Intrinsic Value Managed Funds Association (MFA) The amount by which an option is in-the-money. The trade association for the managed funds industry. Introducing Broker (IB) Margin A firm or individual that solicits and accepts commodity futures orders An amount of money deposited by both buyers and sellers of futures con- from customers but does not accept money, securities or property from tracts and by sellers of options contracts to ensure performance of the the customer.All Introducing Brokers must be registered with the CFTC. terms of the contract (the making or taking delivery of the commodity or Last Trading Day the cancellation of the position by a subsequent offse tting trade). Margin The last day on which trading may occur in a given futures or option. in commodities is not a down payment, as in securities, but rather a per- Leverage formance bond. See also Initial Margin, Maintenance Margin and Variation Margin. The ability to control large dollar amounts of a commodity with a com- paratively small amount of capital. Margin Call Limit A call from a clearinghouse to a clearing member,or from a broker or firm to a customer, to bring margin deposits up to a required minimum level. See Position Limit, Price Limit, Variable Limit. Mark-to-Market Liquidate To debit or credit on a daily basis a margin account based on the close of To sell a previously purchased futures or options contract or to buy back that day’s trading session. In this way, buyers and sellers are protected a previously sold futures or options position. Also referred to as Offset. against the possibility of contract default. Liquidity (Liquid Market) Market Order A characteristic of a or with enough units out- An order to buy or sell a futures or options contract at whatever price is standing and enough buyers and sellers to allow large transactions with- obtainable when the order reaches the trading floor. out a substantial change in price. Maximum Price Fluctuation Local See Price Limit. A member of an exchange who trades for his own account.

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Minimum Price Fluctuation Open Interest See Tick. The total number of futures or options contracts of a given commodity Naked Option that have not yet been offset by an opposite futures or option transaction nor fulfilled by delivery of the commodity or option exercise. Each open See Uncovered Option. transaction has a buyer and a seller, but for calculation of open interest, National Futures Association (NFA) only one side of the contract is counted. Authorized by Congress in 1974 and designated by the CFTC in 1982 as Open Outcry a “registered futures association,”NFA is the industrywide self-regulatory A method of public auction for making bids and offers in the trading pits organization of the futures industry. of futures exchanges. Nearby Delivery Month Open Trade Equity The futures contract month closest to expiration.Also referred to as the The unrealized gain or loss on open positions. Spot Month. Opening Range The range of prices at which buy and sell transactions took place during The value of each unit of participation in a commodity pool. Basically a the opening of the market. calculation of assets minus liabilities plus or minus the value of open posi- tions when marked to the market, divided by the total number of out- Option Buyer standing units. The purchaser of either a call or put option.Option buyers receive the Net Performance right, but not the obligation, to assume a futures position.Also referred to as a Holder. An increase or decrease in net asset value exclusive of additions, withdrawals and redemptions. Option Contract Offer A contract which gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or a futures contract at a spe- An indication of willingness to sell a futures contract at a given price; the cific price within a specified period of time. The seller of the option has opposite of Bid. the obligation to sell the commodity or futures contract or to buy it from Offset the option buyer at the exercise price if the option is exercised. See Liquidate. See also Call Option and Put Option. Omnibus Account Option Premium An account carried by one Futures Commission Merchant (FCM) with The price a buyer pays (and a seller receives) for an option. Premiums are another FCM in which the transactions of two or more persons are com- arrived at through the market process. There are two components in bined and carried in the name of the originating FCM rather than of the determining this price—extrinsic (or time) value and intrinsic value. individual customers; the opposite of Fully Disclosed. Option Seller Open See Writer. The period at the beginning of the trading session officially designated Out-of-the-M oney Option by the exchange during which all transactions are considered made“at A call option with a strike price higher or a put option with a strike price the open.”” lower than the current market value of the underlying asset, (i.e., an option that does not have any intrinsic value).

86 87 Glossary Opportunity and Risk: An Educational Guide

Over-the-Counter Market (OTC) Purchase and Sale Statement (P&S) A market where products such as stocks, foreign currencies and other A statement sent by a Futures Commission Merchant to a customer when cash items are bought and sold by telephone,Internet and other electron- a futures or options position has been liquidated or offset.The statement ic means of communication rather than on a designated futures exchange. shows the number of contracts bought or sold, the prices at which the Pit contracts were bought or sold, the gross profit or loss, the commission charges and the net profit or loss on the transaction. Sometimes com- The area on the trading floor where trading in futures or options con- bined with a Confirmation Statement. tracts is conducted by open outcry.Also referred to as a ring. Put Option Pool An option which gives the buyer the right, but not the obligation, to sell See Commodity Pool. the underlying futures contract at a particular price (strike or exercise Position price) on or before a particular date. A commitment, either long or short, in the market. Quotation Position Limit The actual price or the bid or ask price of either cash commodities or The maximum number of speculative futures contracts one can hold as futures or options contracts at a particular time. determined by the CFTC and/or the exchange where the contract is traded. Range Position Trader The difference between the high and low price of a commodity during A trader who either buys or sells contracts and holds them for an extend- a given trading session, week, month, year, etc. ed period of time, as distinguished from a day trader. Regulations (CFTC) Premium The regulations adopted and enforced by the CFTC in order to administer Refers to (1) the price paid by the buyer of an option; (2) the price the Commo dity Exchange Act. received by the seller of an option; (3) cash prices that are above the Reparations futures price; (4) the amount a price would be increased to purchase a The term is used in conjunction with the CFTC’s customer claims proce- better quality commodity ;or (5) a futures delivery month selling at a dure to recover civil damages. higher price than another. Reportable Positions Price Discovery The number of open contracts specified by the CFTC when a firm or The determination of the price of a commodity by the market process. individual must begin reporting total positions by delivery month to the Price Limit authorized exchange and/or the CFTC. The maximum advance or decline, from the previous day's settlement Round Turn price,permitted for a futures contract in one trading session.Also referred A completed futures transaction involving both a purchase and a liquidating to as Maximum Price Fluctuation. sale, or a sale followed by a covering purchase. Rules (NFA) The standards and requirements to which participants who are required to be Members of National Futures Association must subscribe and conform.

88 89 Glossary Opportunity and Risk: An Educational Guide

Scalper Stop Order A trader who trades for small,short-term profits during the course of a An order that becomes a market order when the futures contract reaches trading session, rarely carrying a position overnight. a particular price level. A sell stop is placed below the market, a buy stop Segregated Account is placed above the market. A special account used to hold and separate customers’ assets for trading Strike Price on futures exchanges from those of the broker or firm. The price at which the buyer of a call (put) option may choose to exer- Self-Regulatory Organization (SRO) cise his right to purchase (sell) the underlying futures contract. Also called Exercise Price. Self-regulatory organizations (i.e., the futures exchanges and National Futures Association) enforce minimum financial and sales practice Technical Analysis requirements for their members. An approach to analysis of futures markets which examines pattern s of See also Designated Self-Regulatory Organization. price change, rates of change, and changes in volume of trading, open Settlement Price interest and other statistical indicators. See also Charting. The last price paid for a futures contract on any trading day.Settlement prices are used to determine open trade equity, margin calls and invoice Tick prices for deliveries. The smallest increment of price movement for a futures contract. Also Short referred to as Minimum Price Fluctuation. One who has sold futures contracts or plans to purchase a cash commodity. Time Value Speculator The amount of money options buyers are willing to pay for an option in anticipation that over time a change in the underlying futures price will A market participant who tries to profit from buying and selling futures cause the option to increase in value.In general,an option prem ium is the and options contracts by anticipating future price movements. sum of time value and intrinsic value.Any amount by which an option pre- Speculators assume market price risk and add liquidity and capital to the mium exceeds the option's intrinsic value can be considered time value. futures markets. Also referred to as Extrinsic Value. Spot Uncovered Option Usually refers to a cash market for a physical commodity where the par- A short call or put option position which is not covered by the purchase ties generally expect immediate delivery of the actual commodity. or sale of the underlying futures contract or physical commodity. Spot Month Also referred to as a Naked Option. See Nearby Delivery Month. Underlying Futures Contract Spreading The specific futures contract that the option conveys the right to buy (in The buying and selling of two different delivery months or related case of a call) or sell (in the case of a put). commodities in the expectation that a profit will be made when the Variable Limit position is offset. A price system that allows for larger than normal allowable price move- ments under certain conditions. In periods of extreme volatility, some exchanges permit trading at price levels that exceed regular daily price limits.

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Additional Resources Variation Margin Additional margin required to be deposited by a clearing member firm to the clearinghouse during periods of great market volatility or in the case of high-risk accounts. Commodity Futures Trading Commission Kansas City Board of Trade (KCBT) Three Lafayette Centre 4800 Main St., Suite 64112 Volatility 1155 21st Street, NW (816) 753-7500 A measurement of the change in price over a given time period. Washington, DC 20581 www.kcbt.com (202) 418-5800 Volume www.cftc.gov Grain Exchange (MGE) The number of purchases and sales of futures contracts made during a 400 S. Fourth St. specified period of time, often the total transactions for one trading day. CBOE Futures Exchange (CFE) Minneapolis, MN 55415 Writer 400 S. LaSalle St. (612) 321-7101 Chicago, IL 60605 www.mgex.com A person who sells an option and assumes the potential obligation to sell (312) 786-5 600 (in the case of a call) or buy (in the case of a put) the underlying futures www.cfe.cboe.com NASDAQ OMX Futures Exchange (NFX) contract at the exercise price.Also referred to as an Option Grantor. 1900 Market St. Yield Chicago Climate Futures Exchange (CCFE) Philadelphia, PA 19103 A measure of the annual return on an investment. 400 S. LaSalle St. (215) 496-5000 Chicago, IL 60605 www.nasdaqtrader.com/Micro.aspx?id=PBOToverview (312) 554-3350 www.chicagoclimatex.com North American Derivatives Exchange () 311 S. Wacker Dr., Suite 2675 CME Group Chicago, IL 60606 141 W. Jackson Blvd. (312) 884-0100 Chicago, IL 60604 www.nadex.com (312) 435-3500 www.cmegroup.com OneChicago 141 W. Jackson Blvd., Suite 2240 ICE Futures U.S. (ICE) Chicago, IL 60604 1 North End Avenue (312) 424-8500 New York, NY 10282 www..com (212) 748-4000 www.theice.com

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