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 investors and ensure market 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 Chicago, Illinois 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 Commodity Trading Advisor . .44 Participate in a Commodity Pool . .46 Introduction to Futures Trading ............................ 14 Establishing an Account . .50 Futures Contracts........................................ 14 How Prices are Quoted.................................... 16 Introduction to Options on Futures .........................52 17 The Market Participants................. .................. The Arithmetic of Option Premiums . .54 17 Hedgers ............................................ Intrinsic Value . .54 19 Speculators ......................................... Time Value . .55 20 The Process of Price Discovery.............................. Understanding Options Transaction Fees . .56 21 Minimum Price Changes .............................. Leverage . .58 21 Daily Price Limits.................................... Calculating the Break-Even Price . .58 22 Position 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 Long) to Profit from an Expected Price Increase .... 30 Selling (Going Short) 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 Chicago Board of Trade 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 currencies, include side-by-side open outcry 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 stock 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 insurance 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 specu lative investors markets. as well as farmers, bond 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 Speculation 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 included 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-day trading 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 mutual fund. 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-excha nge foreign can provide a means of achiev- trading can work for you when losses are realized currency (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 stocks, 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