MINNEAPOLIS GRAIN EXCHANGE

E AMINING FUTURES AND OPTIONS

FUTURES AND OPTIONS FUTURES AND OPTIONS FUTURES AND OPTIONS FUTURES AND OPTIONS FUTURES AND OPTIONS

FUTURES AND OPTIONS FUTURES AND OPTIONS FUTURES AND OPTIONS INTRODUCTION: THE POWER OF CHOICE 2

SECTION I: HISTORY History of MGEX 3

SECTION II: THE FUTURES MARKET Futures Contracts 4 The Participants 4 Exchange Services 5 TEST Sections I & II 6 Answers Sections I & II 7

SECTION III: HEDGING AND THE BASIS The Basis 8 Short Hedge Example 9 Long Hedge Example 9 TEST Section III 10 Answers Section III 12

SECTION IV: THE POWER OF OPTIONS Definitions 13 Options and Futures Comparison Diagram 14 Option Prices 15 Intrinsic Value 15 Time Value 15 Time Value Cap Diagram 15 Options Classifications 16 Options Exercise 16 TABLE OF CONTENTS Deltas 16 MINNEAPOLIS GRAIN EXCHANGE Examples 16 130 Grain Exchange Building TEST Section IV 18 400 South 4th Street Answers Section IV 20 Minneapolis, MN 55415 www.mgex.com SECTION V: OPTIONS STRATEGIES [email protected] Option Use and Price 21 800.827.4746 612.321.7101 Hedging with Options 22 Fax: 612.339.1155 TEST Section V 23 Answers Section V 24 equal opportunity employer CONCLUSION © 1991 Minneapolis Grain Exchange 25 Revised 2001 GLOSSARY 26

Nothing herein should be construed as a trading recommendation of the Minneapolis Grain Exchange. The information in this publica- tion is taken from sources believed to be reliable, but it is not guar- anteed by the Minneapolis Grain Exchange as to accuracy or com- pleteness and is intended for purposes of information and educa- tion only. The Rules and Regulations of the Exchange should be consulted as the authoritative source on all current contract specifi- cations and regulations. THE POWER OF CHOICE A BRIEF HISTORY OF THE MGEX

How do commercial buyers and sellers of volatile commodities protect themselves MGEX was first established in 1881 as a centralized marketplace for price discovery from the ever-changing and unpredictable nature of today’s business climate? and price protection. They use a practice called hedging. This time-tested practice has become a standard in many industries. Hedging can be defined as taking offsetting positions in Initially called the Minneapolis Chamber of Commerce, the Exchange was established related markets. for several reasons. In the late 1800s, grain buyers and producers faced the difficult task of simply locating one another and, once they met, bitter disputes frequently erupted But hedging is not only for commercial firms. In fact, hedging with MGEX because there were no standardized weighing, measuring or grading practices. (Minneapolis Grain Exchange) futures and options also can provide producers a com- Furthermore, the cost of consumer goods, such as flour and bread, were at the mercy of petitive advantage by allowing them to “lock-in” a purchase price or a selling price. violent price swings due to supplies that were either too large or too small.

This guide’s purpose is to eliminate the mystery and confusion that often surround Once established, the Exchange set standardized bushel weights that allowed for futures and options markets, and help readers acquire the basic skills necessary to rec- faster, more accurate measures, and quality and inspection procedures were institut- ognize and evaluate business opportunities that incorporate the use of these tools.* ed to minimize questionable trade practices.

This workbook explains: Today, MGEX creates a fair and efficient trading environment for buyers and sellers I SECTION 2 INTRODUCTION 3 How cash and futures markets function at its landmark building in downtown Minneapolis. The Exchange enforces rules gov- What basis is and why it is important in hedging erning trade activity, collects margin deposits from clearing members and provides The advantages and disadvantages of hedging with options versus sampling and weighing services for its membership. Additionally, MGEX operates its hedging with futures own clearinghouse that matches and clears trades for all Exchange trading activity. The most appropriate options strategy to accomplish a specific goal How to calculate the dollars and cents outcome of any given strategy, MGEX is the only authorized futures market for hard red spring wheat, white wheat, depending on the movement of the underlying futures price white shrimp, black tiger shrimp, cottonseed and Twin Cities electricity futures and options. Additionally, MGEX will soon begin trading cash-settled corn and soybean futures and options based on the National Corn Index (NCI) and National Soybean Index (NSI), respectively. MGEX also boasts the largest cash grain market in the *None of the material presented herein is intended to be, nor should it be construed, as trading advice. world. Nearly 1 million bushels of grain including wheat, barley, oats, rye, flax, corn These materials are offered solely for the purpose of information and education. and soybeans change hands each day. THE FUTURES MARKET

Before the development of futures markets, cash grain Cash-settled futures contracts offer no delivery Floor traders are market participants who physical- deliver the physical product, the clearinghouse is respon- traders faced seasonal supply difficulties, including short- alternative for buyers and sellers of the contracts. ly trade in the pits at the exchange, either on the floor or sible for assigning that delivery to the buyer in the market ages in the winter and surpluses at harvest. To avoid sub- On the final trading day, all open positions are offset on an electronic trading platform. Both hedgers and spec- holding the oldest long position. sequent violent price movements caused by these supply to an index specified by the listing exchange and defined ulators can be floor traders. In the futures industry, margin must be deposited imbalances, traders began to contract for the future deliv- in the contract trading rules. For more information on • Locals trade solely for their own account and are with the clearinghouse. Margin is a specific sum of money ery of grain. These “forward contracts” evolved to become MGEX’s upcoming cash-settled corn and soybean futures most often classified as speculators. a trader must have in an account to insure the integrity of present day futures contracts and became the prevalent and options, contact MGEX or visit www.mgex.com. • Brokers are licensed by the federal government to the contract. This money acts as a performance bond and risk management tool for grain buyers and sellers. execute orders for customer accounts. They may be protects the marketplace against a contract default. If a THE PARTICIPANTS employed by a specific company to execute trades trader’s account balance falls below the required mini- FUTURES CONTRACTS Hedgers are risk averse and use futures as protec- for the company or they may be part of a company mum level, additional funds must be deposited. Futures contracts spell out the conditions of the transac- tion, or insurance, against unfavorable price moves. (called a brokerage) that has many customers Conversely, accounts realizing a gain will see an increase tion, such as quality, expiration date, and the quantity of Hedgers protect themselves by taking an opposite posi- placing trades. in their margin balance. This daily process of account set- commodity (for example 5,000 bushels). However, the con- tion in the futures market to their exposed position in the tlement is referred to as “marked to market.” tract price is negotiated among futures market partici- cash commodity. By doing so, a loss in the cash market is EXCHANGE SERVICES Initial margin is the amount each participant must pants. In all futures markets, prices are determined offset by corresponding gain in the futures market. Membership deposit in an account at the time an order is placed to buy through open outcry auction in the trading pit or via elec- Hedging will be explored in detail in Section III. MGEX is a not-for-profit membership association. There or sell a futures contract. Maintenance margin is the min- tronic trading systems. MGEX futures and options strategies can be cus- are 393 memberships, or seats, and the price fluctuates imum amount of money, per outstanding futures contract, Bids and offers are out in the open for every trader to tomized in a number of ways and offer hedgers the ability to: with supply and demand. Each member applicant is care- that must be maintained in the margin account at all SECTION II SECTION 4 SECTION II see, whether in the pit or via an electronic trading system, • Establish purchase and/or sales prices in advance of fully screened for proper financial standing, character and times. A call from the clearinghouse for additional funds is 5 and every trader has an equal opportunity to participate in a physical transactions integrity before a purchase is approved. Membership known as margin call. trade. A trader who purchases a futures contract is said to be • Offer fixed forward pricing to customers information, including current seat prices, is posted on the Commodity market margins differ from stock market going “long” the futures and the seller “short” the futures. • Lock-in profit margins MGEX web site. margins. In the securities market, margin is considered a The other components of a futures contract fall into • Establish a minimum selling price while maintaining An elected board of directors governs the exchange, down payment for the purchase of common stock. two classes: the ability to participate in increasing prices and member committees oversee specific duties of Commodity market margins are deposited with a broker to Deliverable futures contracts are legally binding • Establish a maximum purchase price while exchange operations. provide contract integrity and are in no way intended as a agreements to deliver or take delivery of a specific maintaining the ability to participate in decreasing prices down payment toward the purchase of actual commodities. quantity and quality of a specific commodity or instrument Speculators trade to capitalize on potential profit Clearinghouse Because of the effectiveness of MGEX clearing pro- at a predetermined place and time in the future. opportunities generated by a fluctuating market and, by The MGEX clearinghouse is responsible for the daily settle- cedures, no customer has ever incurred a loss due to For example, if futures traders were instructed to buy doing so, accept risk that hedgers wish to avoid. ment of all clearing firm accounts. Furthermore, the clearing- default on any contract traded at the exchange. one “September 03” hard red spring wheat futures con- Speculators play a vital role in futures trading by providing house acts as a buyer to every seller, and seller to every tract, they would enter into an agreement to purchase market liquidity, which allows hedgers to buy and sell the buyer in the market. It also collects margin. Market Regulation 5,000 bushels of hard red spring wheat to be delivered in contracts they desire at current market prices. Speculators The clearinghouse plays a key role when options are The market regulation department oversees futures trad- September 2003. attempt to buy low and sell high, or sell high and buy low. exercised and futures are delivered. For example, if a ing to ensure that rules of the MGEX and regulatory agen- Futures contracts can result in the delivery of the (Futures contracts can be sold without ownership, as long clearing member holding a long position exercises an cies, such as the Commodity Futures Trading Commission physical commodity, or as in most cases, the contract can as the short position is offset by a purchase before the last option, the clearinghouse assigns the exercised option to (CFTC), are observed. It audits futures trades, investigates be offset by an offsetting purchase or sale. Actual delivery trading day of the contract.) a clearing member holding a short option position. The rule violations and reviews member firm financial state- occurs in less than 1% of all contracts traded. result of an option exercise is the creation of a futures ments. position at the option’s strike price. Once the futures mar- The CFTC is the federal regulator and overseer of ket position is established, it can be offset by an opposing futures and options contracts on U.S. futures exchanges. purchase or sale, or through the delivery process during MGEX works with the CFTC to monitor the marketplace to the designated delivery period (the exception is for cash- prevent commodity price distortions and market manipula- settled contracts). If a futures contract seller decides to tions and to protect customer rights. TEST SECTIONS I AND II

QUESTIONS ANSWERS

1) Futures prices are discovered by... 6) Speculators... 1) e a) MGEX a) Increase liquidity Forces of supply and demand influence pit traders who use the method of open out- b) Electronic auction b) Facilitate hedging opportunities cry auction to determine fair market prices. This may also be done via auctions con- c) Open outcry auction c) Profit from buying low and selling high ducted on an exchange’s electronic trading system. Neither the exchange, nor the reg- d) The C.F.T.C. d) Facilitate price discovery ulating body dictate prices. e) Both b and c e) All of the above 2) e 2) Futures contracts can be... 7) Of the following, which is NOT a function of the Futures contracts have many uses, including all answers listed in this question. a) Delivered MGEX clearinghouse? b) Used as protection against large price swings a) Aiding in the process of price discovery 3) b c) Countered by an offsetting purchase or sale b) Acting as a buyer to every seller and seller Prior to the introduction of futures markets, academic research showed that cash d) Both a and c to every buyer market prices were subject to large price movements. Contracting for the future deliv- e) All of the above c) Collecting margin ery of a commodity tends to make prices less volatile. d) Settling each firm’s account each day 3) How do futures markets affect underlying e) Both c and d 4) b commodity prices? Exposure to risk in the cash markets is countered by a directly opposite position in the a) Increase volatility 8) Futures contracts evolved from... futures market. b) Decrease volatility a) Stock markets

c) Push prices higher b) Financial contracts 5) e II SECTION 6 SECTION II 7 d) Push prices lower c) Performance bonds Any group interested in protecting the price of grain from falling or rising will find d) Forward contracts hedging a practical tool. 4) Hedging in the futures market... e) Option markets a) Is highly speculative 6) e b) Involves taking a position in the futures market 9) A futures market participant might receive a Speculators play a vital role in a futures market. which is opposite to one’s cash market position margin call if... c) Involves taking a position in the futures market a) He is long futures contracts and prices rise 7) a which is identical to one’s cash market position b) He is long futures contracts and prices fall Clearing is not involved in the price discovery process. d) Both a and b c) He is short futures contracts and prices rise d) He is short futures contracts and prices fall 8) d 5) Of the following, who could benefit from hedging e) Both a and d The first members of MGEX traded forward contracts in the late 1800s. with futures contracts? f) Both b and c a) Farmers 9) f b) Country elevator operators 10) Initial margins on futures contracts function... A futures market loss, caused by both b and c, may trigger a margin call. c) Flour millers a) As a performance bond d) Soybean oil mill b) As a down payment 10) a e) All of the above c) The same as stock market margins Margin insures the integrity of each trade. d) As an extension of credit e) As maintenance margin HEDGING WITH FUTURES AND THE BASIS

Virtually every business faces the risk of price fluctuation, whether it’s the price of The following examples illustrate how basis and hedging are used by specific agri- raw materials it purchases or the price of products it produces. To offset price risk, cultural groups. businesses rely on hedging strategies to control costs and protect profit margins. The short hedge Hedging is the process of taking a futures market position to counterbalance vulner- A short hedge typically locks in a sales price for a commodity. For example, on March abilities in the cash market. It is based on the premise that cash and futures prices 1, prices reach a level where a farmer knows he can make a profit on his spring wheat move in concert with one another. This is true because cash and futures prices are crop that is yet to be planted. Rrather than take the chance that prices will fall, he influenced by the same external factors. Therefore, purchasing futures contracts that decides to hedge a portion of the crop using futures. To lock in a price he establishes oppose one’s cash market position will diminish the volatility of net return. a “short hedge” by selling MGEX hard red spring wheat futures contracts.

BASIS On October 1, the farmer decides to lift his hedge and sell his now harvested wheat in Basis is the difference between the cash price of a commodity at a certain location the cash market. Futures prices have declined during this period so he’s able to buy back and its futures price. his futures contracts at a price less than what he originally sold them for, establishing a profit that offsets the lower price he will receive in the cash wheat market. For example: If the… In this case, futures prices fell further than cash prices, which increased the futures Cash price = $4.00 market profit and strengthened the basis. A strengthening basis benefits the short And the… hedger. Conversely, a weaker-than-expected basis reduces the effectiveness of a Futures price = $4.25 short hedge.

Then the… III SECTION 8 SECTION III 9 Basis = -25 cents (cash – futures = basis) The long hedge A long hedge typically locks in a purchase price for a commodity. For example, a pro- Basis reflects: ducer has contracted to take delivery of a shipment of cattle three months in the Transportation costs between local market places and the pricing point specified future. He made the contract based on current feed prices, which would allow him to by the futures contract; finish feeding the cattle and make a decent profit. To protect against higher feed Storage and/or handling costs until the delivery month of the futures contract; prices between now and when the cattle are delivered, he buys one MGEX National Quality factors such as protein premiums, foreign material, test weight, Corn Index futures contract. damage etc.; Overall supply and demand for commodities; and When the cattle arrive, the producer lifts the hedge by selling the futures contracts Market expectations. he had purchased earlier, and he simultaneously purchases the corn he needs in the Basis is a reflection of local or regional supply and demand factors rather than world cash market. If prices had increased during this period, the gain on the futures mar- conditions. Basis may fluctuate and change direction with some frequency, but basis ket position offsets the higher cash market price. In addition, in this case, futures risk is much less volatile than price risk because basis represents the difference prices rose further than cash prices, which increased the futures market profit and between two prices that move in the same general pattern. Therefore, most hedgers weakened the basis. A weakening basis benefits the long hedger. Conversely, a look to offset price risk even if it means taking on basis risk. stronger-than-expected basis reduces the effectiveness of a long hedge.

The level of the basis is often referred to as “strong” or “weak.” A strengthening basis becomes more positive. For example, if your local basis goes from 10 cents over the futures to 30 cents over, the basis is strengthening. Conversely, a weakening basis becomes more negative, such as when it moves from 30 cents over the futures to 10 cents over. TEST SECTION III 3) It is April 1. A farmer anticipates he will have 10,000 bushels of spring wheat to sell in October, and the cash price today is $3.60/bu. The farmer decides to hedge. His broker confirms his order to sell two MGEX QUESTIONS December spring wheat futures contracts filled at $3.40/bu.

1) What is the basis change in the following examples? On October 1, the farmer buys back two futures contracts at $3.10/bu and sells his wheat to a local eleva- From: To: Basis change: tor for $3.45/bu. 20 cents under the futures 15 cents under + 5 cents 10 cents over 5 cents over ______CASH FUTURES BASIS 5 cents over 5 cents under ______a)April 1 Cash price Sell ___December ______is ______contracts at ______2) It is November 1. A producer has agreed to take delivery of feeder cattle in March. Based on the current futures prices for March corn, he knows he can make a profit on the cattle, and he knows he will need b)Oct. 1 Cash price Buy___ December ______10,000 bushels to provide the feed for the cattle. He could enter into a cash contract that would ensure him is ______contracts at ______$2.40/bu. He decides to hedge instead and his broker confirms his order to buy two MGEX March National Corn Index futures contracts filled at $2.30/bu. c)Result ______loss/gain ______loss/gain ______change

On March 1, the producer offsets (sells) his NCI futures position at $2.50/bu and purchases his corn locally d)Is this a short or long hedge? ______Did the basis strengthen or weaken? ______at $2.45/bu. e)Actual cash sale price $______CASH FUTURES BASIS Futures gain or loss $______a)Nov. 1 Cash price Buy ____ March contracts ______Gross price received $______/bu is ______at ______SECTION III SECTION 10 SECTION III 4) It is October 1. A farmer has 100,000 bushels of soybeans in on-farm storage. He wants to capture the 11 b)March 1 Buy cash corn Sell ____ March contracts ______carry in the market and he could enter into a cash contract that would ensure him $5.00/bu for April deliv- at ______at ______ery. However, he looks at his record of basis and realizes the basis component of this price is extremely weak. As a result, he decides to hedge only the futures component of the price and he places an order to c)Result ______loss/gain ______loss/gain ______change sell 20 MGEX May National Soybean Index contracts at $5.60/bu.

d)Is this a short or long hedge? ______Did the basis strengthen or weaken? ______On April 1, the farmer offsets (buys) his NSI futures position at $5.70/bu and sells his soybeans locally at $5.35/bu. e)Actual cash purchase price $______Futures gain or loss $______CASH FUTURES BASIS Gross price paid $______/bu a)October 1 Cash price Sell ___ May contracts ______is ______at ______

b)April 1 Sell cash soybeans Buy ___ May contracts ______at ______at ______

c)Result ______loss/gain ______loss/gain ______change

d)Is this a short or long hedge? ______Did the basis strengthen or weaken? ______

e)Actual cash sales price $______Futures gain or loss $______Gross price paid $______/bu ANSWERS THE POWER OF OPTIONS

1) Hedging with futures provides protection against volatile CALLS from .20 under to .15 under = +.05 price movements by “locking in” desired price levels. At the A call option may be bought or sold. If you believe the from .10 over to .05 over = –.05 same time, however, hedgers do not fully benefit if prices market will rise you can buy a call and assume the right to from .05 over to .05 under = –.10 move in their favor. Furthermore, exposure to a loss in the purchase the futures at the strike price. If you believe futures market subjects the hedger to possible margin calls. prices will fall or remain stable, you might sell or “write” 2) As a result, options have become popular hedging tools a call. An option seller is obligated to abide by the con- a) Nov. 1 cash price: $2.40; Buy 2 contracts at $2.30; basis is +10 cents/bu because they provide hedgers with limited risk, unlimited tract if the buyer chooses to purchase futures by “exercis- b) March 1 cash price is $2.45; Sell 2 contracts at $2.50; basis is -5 cents/bu profit potential and no possibility of margin call (this is true ing” his call option. c) Result: 5 cents/bu loss; 20 cents/bu gain; -15 cents/bu only for option buyers). d) This is a long hedge; the basis weakened. Option buyers have the right, but not the obligation, PUTS e) Actual cash purchase price: $2.45 to buy or sell a futures contract at a predetermined price A put option may be bought or sold. If you believe the mar- Futures gain: 20 cents/bu within a specified time period. A call option gives the pur- ket will fall, you may buy a put option and obtain the right Gross price paid: $2.25/bu chaser the right, but not the obligation, to buy a futures to sell at the strike price until expiration. If you forecast the contract. A put option gives the options contract owner market will remain steady or rise, you may sell, or write, a 3) the right, but not the obligation, to sell a futures contract. put and assume the obligation to buy at the strike price if a) April 1 cash price: $3.60; Sell 2 contracts at $3.40/bu; basis is +20 cents the buyer exercises his option at any time until expiration. b) October 1 cash price: $3.45; Buy 2 contracts at $3.10/bu; basis is +35 cents Option components include: (See diagram on the next page.) c) Result: 15 cent/bu loss; 30 cent/bu gain; basis: +15 cents/bu Quantity

The number of bushels defined in a contract—typically IV SECTION 12 SECTION III d) This is a short hedge; basis strengthened NAKED OPTIONS 13 e) Actual cash sale price: $3.45 5,000 bushels per contract in grain futures. A naked option transaction is one that is not offset by an Futures gain or loss: 30 cents Delivery Month opposite cash or futures market position. Selling “naked” Gross price received: $3.75/bu The month in which delivery is to be made in accordance with calls and puts involves assuming unlimited risk in a futures contract. Options typically expire in the month pre- exchange for a premium. On the other hand, buying naked 4) ceding the delivery month of the underlying futures contract. calls and puts risks only the amount of premium paid for a) October 1 cash price: $5.00; Sell 20 May contracts at $5.60; basis is -60 cents Underlying Futures the option. Therefore, option purchasers are not required b) April 1 cash price is $5.35; Buy 20 contracts at $5.70; basis is -35 cents The specific futures contract that conveys the right to be to post margin money on long positions. c) Result: 35 cents/bu gain; 10 cents/bu loss; basis: +25 bought (in case of a call) or sold (in case of a put) by exer- d) This is a short hedge; the basis strengthened. cising an option. OPTION BUYER’S ALTERNATIVES e) Actual cash sale price: $5.35 Strike Price (exercise price) Once an option is purchased, an option buyer, or holder, Futures loss: 10 cents The price at which buyers of calls (puts) may choose to has three alternatives prior to expiration: 1) make an off- Gross price paid: $5.25/bu exercise their right to purchase (sell) the underlying setting sale and receive the current premium, 2) exercise futures contract. the right to acquire a long or short position in the futures Premium market, or 3) do nothing and let the option expire worth- This is the price of an option, and it is determined through less. To choose the most appropriate strategy, we must open outcry or electronic trading. first develop a clear understanding of how options are priced. The following pages take a closer look at option pricing. OPTION PRICES COMPARISION Similar to an insurance policy, buyers of options on futures • Volatility OF FUTURES CONTRACT TO are charged a premium. In return for this premium they All else kept equal, the more volatile the futures price, the receive protection against adverse price moves while higher the option’s premium. There is a higher demand for OPTION ON FUTURES CONTRACT retaining the opportunity to benefit if prices move in a price protection if there are wide price swings in the favorable direction. futures market. Therefore, the price of obtaining insurance An option premium is comprised of two elements: via options becomes more costly. FUTURES Time value is calculated as premium minus intrinsic Seller short Buyer long intrinsic value, and time value (extrinsic value). CONTRACT value. Intrinsic value Intrinsic value is the amount of money that can be realized For example: by exercising an option. A call option has intrinsic value if Let’s say March futures are trading at $4.00/bu and March its strike price is below the futures price. If its strike price $3.50 calls are purchased for 60 cents per bushel. is above the futures price, it has no intrinsic value. • Premium = 60 cents/bu Conversely, a put option has intrinsic value if its strike • Strike price = $3.50 OPTIONS price is above the futures price, and no intrinsic value if its • Underlying futures price = $4.00 • Intrinsic value (futures – strike) = PutON FUTURES Call strike price is below the futures price. For example: $4.00 – $3.50 = $0.50 CONTRACT If the futures price is $3.50, • Time value = (premium – intrinsic) =

And the call option strike price is $3.30, $0.60 – $0.50 = $0.10 IV SECTION 14 SECTION IV 15 Then the intrinsic value is 20 cents (futures price – call The call options buyer has acquired the right to buy strike price = intrinsic value) March futures at $3.50. March futures are currently priced Or: at $4.00, and the buyer paid 60 cents for this right. If the futures price is $2.80, Buyer Seller (writer) Buyer Seller (writer) And the put option strike price is $3.00, Remember, a call option only has intrinsic value if the strike price is right to sell obligated to right to buy obligated to Then the intrinsic value is 20 cents (put strike price – less than the futures price. Conversely, a put option only has intrinsic futures price = intrinsic value) value if the strike price is above the futures price. futures buy futures futures sell futures if he contract if if he contract if Time Value chooses to option is chooses to option is Time value is the amount that an option premium exceeds Expiration Month Guideline its intrinsic value. It reflects two primary elements: exercise exercised exercise exercised • Time remaining until expiration Holding all else equal, an option premium will be higher the longer the time before its expiration. This is because futures prices have a longer time period during which to fluctuate and there is a higher probability for options to move in-the-

• BUYER PAYS PREMIUM money. An option is in-the-money if it has intrinsic value. PREMIUM TIME VALUE • SELLER COLLECTS PREMIUM Time value of an option decays to zero as expiration 9 8 7 6 5 4 3 2 1 0 approaches. simply because there will be no time remaining. Time Remaining Until Expiration (Months)

–Source: “Introduction to Commodity Trading,” Chicago Board of Trade Commodities Institute OPTIONS CLASSIFICATIONS Long Call Short Call There are three options categories: For instance, let’s say we are given an option with Buying a call option results in a long call position. Let’s say a market participant took the opposite side of the In-the-money delta = 1.0, at a time when the futures price is $3.80 and Producers, for example, take long call positions when they long call trade. He receives a premium of 10 cents/bu to An in-the-money option always has intrinsic value. For the premium is 50 cents/bu. If the futures price increases buy calls to replace cash grain supplies. It establishes a sell a $3.00 call. He profits by the full amount of the pre- example, a call option is “in-the-money” if the option to $3.90, the premium for an option with delta = 1.0 would long position in the market with limited downside risk. mium as long as the futures price remains at or below strike price is below the underlying futures price. A put increase to 60 cents/bu. Similarly, a delta of 0.5 indicates If a long call position is taken, how is its value deter- $3.00. Potential losses are unlimited if futures prices rise. option is in-the-money if the option strike price is that a 10-cent change in the underlying futures price will mined at expiration? Let’s say a call option was purchased For example: above the underlying futures price. result in a 5-cent change in the premium price. for 10 cents with a strike price of $3.00. Any futures price Futures are: profit/loss At-the-money In most cases, option premiums have a delta less at $3.00/bu or less will result in a loss equal to the 10- $2.90/bu 10-cent/bu profit If the option strike price and the underlying futures price than one but greater than zero. This is because at-the- cent premium. At a futures price of $3.10, the transaction $3.00/bu 10-cent/bu profit are equal, the option is at-the-money. An at-the-money money and out-of-the-money options are less sensitive to breaks even. Subsequent gains are unlimited if futures $3.10/bu breakeven option has no intrinsic value. fluctuations in futures contracts than in-the-money prices continue to rise. $3.20/bu 10-cent/bu loss Out-of-the-money options. In general, the further an option is out-of-the- For example: $3.30/bu 20-cent/bu loss An out-of-the-money option has no intrinsic value. A call money, the smaller its delta. An understanding of deltas Futures are: profit/loss option is “out-of-the-money” if the option strike price is can be useful when choosing an option strategy. $2.90/bu 10-cent/bu loss Short Put above the underlying futures price. A put option is out-of- $3.00/bu 10-cent/bu loss Selling a put with a premium of 10 cents/bu at a strike the-money if the option strike price is below the underly- EXAMPLES $3.10/bu breakeven price of $3.00 looks like this: ing futures price. Exercising in-the-money options at expiration $3.20/bu 10-cent/bu gain For example: If an individual holds a March call option with a strike $3.30/bu 20-cent/bu gain Futures are: profit/loss Options exercise price of $3.40, he owns the right to buy March futures at $2.70/bu 20-cent/bu loss SECTION IV SECTION 16 SECTION IV Option buyers may exercise their right to acquire a long $3.40/bu. If the March futures price rises to $3.50 at Long Put $2.80/bu 10-cent/bu loss 17 (long call) or short position (long put) in the futures market options expiration, he holds the right to buy a contract for A long put is used in many forward pricing strategies. For $2.90/bu breakeven at the option strike price, if that option is in-the-money. An $3.40 that can be immediately sold for $3.50. The option example, a producer might buy a put during March to lock $3.00/bu 10-cent/bu profit option can be exercised at any time prior to that option’s holder has the opportunity to gain the option’s intrinsic in a price for his crop to be harvested in the fall. This posi- $3.10/bu 10-cent/bu profit expiration date. Options contracts typically expire in the value of 10 cents/bu. Further, if the premium paid was less tion protects the producer from downward moves in the month preceding the delivery month of the underlying than 10 cents/bu, the buyer has profited from the transac- market while still leaving open the opportunity to benefit Remember, option sellers must maintain a minimum margin balance in futures contract. The exception is options on cash-settled tion. should prices rise. their account! futures contracts which generally expire simultaneous to Out-of-the-money options at expiration If a long put position is established, how is its value the underlying futures contracts. Suppose a July put option with a strike price of $2.80 was determined at expiration? Let’s say a put option was pur- purchased. At the option’s expiration, the July futures chased for 10 cents with a strike price of $3.00. Any Deltas price is $3.80, and the option is $1.00 out of the money. As futures price at $3.00/bu or more will result in a loss equal An option’s delta represents the amount its premium will a result, the option holder lets this option expire worthless to the 10-cent premium. At a futures price of $2.90, the change for a given change in the underlying futures price. and forfeits the premium paid. transaction breaks even. Subsequent gains are unlimited A deep in-the-money option whose value is comprised if futures prices continue to fall. solely of intrinsic value (no time value) may have a delta For example: close to 1.0. This means the relationship between the Futures are: profit/loss underlying futures price of an option and its premium is $2.70/bu 20-cent/bu profit one-to-one. For each 1-cent move in the futures the option $2.80/bu 10-cent/bu profit premium will move 1 cent as well. $2.90/bu breakeven $3.00/bu 10-cent/bu loss $3.10/bu 10-cent/bu loss TEST SECTION IV QUESTIONS 15) A put has a strike price of $2.30. 1) A long call option is: 7) An option buyer can: The underlying futures price is $2.60. a) The right to buy the underlying futures contract a) Exercise the option The intrinsic value is ______. b) The right to sell the underlying futures contract b) Sell the option c) The obligation to buy the underlying futures contract c) Let the option expire 16) A put has a strike price of $3.90. d) The obligation to sell the underlying futures contract d) All of the above The underlying futures price is $3.17. The intrinsic value is ______. 2) Every option transaction involves: 8) As the underlying futures price goes up: a) Exercise a) The value of the call option rises 17) A put, with a strike price of $3.10, was bought at b) Delivery b) The value of the put option rises 5 cents. The underlying futures price is currently c) Both a put and a call c) The value of the call option falls $3.00. d) A buyer and a seller d) Both a and b The intrinsic value is ______. e) All of the above 9) Both option buyers and sellers must 18) Purchasing a Call 3) A $2.60 call option is purchased; to offset it, back option positions by posting margins. If you purchase a call option with a strike price of the buyer would: a) True $2.80 and a premium of 15 cents, what is your prof- a) Sell a $2.60 call b) False it/loss scenario? b) Sell a $2.60 put Futures are at: profit/loss c) Exercise the option 10) To protect against rising corn prices, a $2.60/bu ______feedlot manager could: d) Let the option expire $2.70/bu ______IV SECTION 18 SECTION IV 19 e) None of the above a) Buy a call $2.80/bu ______b) Buy a put $2.90/bu ______4) An option premium is: $3.00/bu ______a) Determined by the exchange 11) When a put option is exercised, the seller $3.10/bu ______b) Set at expiration of a put: c) Determined when exercised a) Is short the underlying futures contract 19) Selling a Put d) Negotiated by open outcry b) Is long the underlying futures contract If you sell a put option with a strike price of $2.80, c) Pays the premium and a premium of 15 cents, what is your profit/loss 5) The difference between an option’s premium and d) Is short the put scenario? its intrinsic value is: e) Is long the put Futures are: profit/loss a) The price of the underlying futures contract $2.60/bu ______b) The strike price 12) A call has a strike price of $3.50. $2.70/bu ______c) The margin The underlying futures price is $4.00. $2.80/bu ______d) Time value The intrinsic value is ______. $2.90/bu ______$3.00/bu ______6) An individual paid 20 cents for a March $2.50 call 13) A call has a strike price of $3.80. when the underlying futures price was $2.60. The underlying futures price is $3.80. The option was: The intrinsic value is ______. a) In-the-money b) Out-of-the-money 14) A call has a strike price of $4.00. c) At-the-money The underlying futures price is $3.86. The intrinsic value is ______. ANSWERS OPTIONS STRATEGIES

1) a. A long call position gives the holder the right to buy futures. Sellers of call options The material in this section illustrates which hedge In a sense, option premiums and option classifica- have an obligation to sell the underlying futures contract at the option strike price. options strategies can be employed to achieve specific tions are analogous to insurance policies with various 2) d. Puts and calls are completely independent transactions; an option transaction price objectives. Options derive their value from their ver- deductible amounts. A higher deductible means a lower requires a buyer and a seller. satility, and success in options trading lies in knowing insurance premium and insurance coverage. Similarly, the 3) a. Offset means to make an opposing purchase or sale of the same option. which strategy helps reach specific objectives. further an option is out-of-the-money, the option premium 4) d. Premium is determined by competition between buyers and sellers in the pit by Before a strategy can be devised, however, hedgers is reduced and the buyer’s coverage decreases. open outcry. must first decide how the option will be used and how 5) d. Premium – intrinsic value = Time value much they’re willing to pay for it. For Example: 6) a. In-the-money. A call option whose strike price is below the futures price is in- Options with a range of strike prices provide various the-money regardless of the premium amount. DELIVERY MONTH strategic alternatives to the trader. Here is an example 7) d. All of the above options are available to the purchaser. In general, the choice between different delivery months that illustrates the complexities of choosing an option 8) a. The value of the call option appreciates. is determined by the time frame required to achieve objec- strike price: 9) b. An option buyer can only lose the amount of the premium price, and therefore he tives. For example, if in May a producer knows he will sell It is harvest and a producer decides to purchase an is not required to post margin. his crop in the fall, he may choose to buy December puts MGEX NCI put option for protection against a possible 10) a. Buy a call to establish a maximum purchase price should cash prices rise. to protect against a price decline before fall. spring corn price decrease. If the May futures price is cur- 11) b. The put option seller acquires a long position in the futures market at the put rently $1.90 and a producer purchases an out-of-the- option strike price. The put option buyer is assigned a short futures position at the put STRIKE PRICE money put for 8 cents/bu with a $1.80 strike price, he will option strike price. There is no formula or rule of thumb when choosing an be protected from any price decrease below $1.72 ($1.80 12) 50 cents appropriate strike price. Since option premiums reflect - .08). But, if he pays 15 cents/bu for an at-the-money put

13) 0 both time remaining until expiration and intrinsic value, with a strike price of $1.90, he will be protected from any V SECTION 20 SECTION IV 21 14) 0 different options have different levels of risk and reward. price decrease below $1.75 ($1.90 - .15). At-the-money or 15) 0 When choosing an option strike price, some things to con- in-the-money options give better coverage for the farmer’s 16) 73 cents sider are: underlying cash market position. The out-of-the-money 17) 10 cents (premium paid does not affect current intrinsic value) • What price trends do I expect in the future? option, however, is cheaper than the in-the-money option 18) Purchase a Call Am I bullish or bearish? – the most that can be lost if prices increase rather than Futures are: gain/loss • How much risk am I willing to assume for greater decline is the 8-cent premium. $2.60 15 cents/bu loss potential reward? Choosing an appropriate strike price is up to the indi- $2.70 15 cents/bu loss • If I’m a hedger, would I like to pay less for a little vidual option buyer or seller. It is important to be aware $2.80 15 cents/bu loss protection, or more for greater protection? of alternatives and how they affect the potential risks $2.90 5 cents/bu loss It is up to the option buyer to decide how much to spend, and rewards. $3.00 5 cents/bu gain and how much insurance the option will provide. For $3.10 15 cents/bu gain example, an in-the-money put option has a strike price 19) Selling a Put higher than the current market price. Therefore, he must Futures are: gain/loss pay more for the right to sell at a price higher than the cur- $2.60 5 cents/bu loss rent price. The deeper an option is out-of-the-money, the $2.70 5 cents/bu gain smaller its chances of moving in-the-money and becoming $2.80 15 cents/bu gain exercised. It follows that out-of-the-money option premi- $2.90 15 cents/bu gain ums are smaller than in-the-money premiums. $3.00 15 cents/bu gain HEDGING WITH OPTIONS TEST SECTION V The following examples illustrate basic strategies using in the second scenario. Doing nothing exposes the farmer options as a hedge. In these examples, the basis is to market fluctuations. QUESTIONS assumed to be zero. Replacing a crop with call options 1) It is August and a producer expects to harvest a crop in November. The current price is $4.80/bu. To protect against Forward pricing with put options A producer has completed harvest, and now has a deci- falling prices, he decides to purchase put options with a strike price of $4.80 for a premium of 20 cents/bu. Between In March, a producer expects to harvest 5,000 bushels of sion to make. Should he store his grain and hope for high- August and November prices fall to $4.30 and the premium rises to 55 cents/bu. The producer decides to offset his spring wheat in August. He is concerned that prices may er prices, or should he sell the crop? The first step he option position and simultaneously sell his crop (basis = 0). What is his net price? fall between March and August and would like protec- takes is to check the local basis. As it turns out, the basis tion from a price decline, while still benefiting if prices is strong this particular year, holding at 10 cents under the 2) In the previous problem, if prices rise above the $4.80 strike price at expiration, the producer will: should rise. futures. In the previous four years, it had never been a) exercise the option Currently, the MGEX September hard red spring stronger than 20 cents under and had been as low as 33 b) let the option expire worthless and receive the current price less the option premium wheat futures price is $3.50/bu. The producer decides to cents under. c) acquire a short position in the November futures contract purchase the September at-the-money put ($3.50 strike Futures prices, on the other hand, are not strong. As d) earn the option premium price = $3.50 futures price) for a premium of 15 cents. a result, he decides to sell his grain to capture the strong basis and replace it with a call option to give him the 3) If a producer purchases a September put option with a strike price of $3.20, for a premium of 9 cents/bu, and the • If prices fall… opportunity to benefit should futures prices follow their local basis is 20 cents under at the time he sells his crop… Then the producer will earn at least $3.35 for his wheat by seasonal tendency to go higher after harvest. The farmer Calculate the TOTAL RETURN at each of the following futures prices at expiration. exercising his right to sell at $3.50 less the 15- cent pre- is willing to pay this premium because he knows the cost Sep. futures prices TOTAL RETURN of storage and interest will roughly equal the option pre- mium. This is true because falling prices increase the $3.50 ______mium. Regardless of what prices do, the farmer has value of the put option, and the option profit offsets the $3.00 ______SECTION V SECTION

SECTION V reduced his risk to the cost of the option. If he had decid- 22 lower price he receives for his cash wheat. $2.50 ______23 ed to store his crop, he would have been open to unlimit- • If prices rise… ed downside risk in the cash price. Then he will allow his put option to expire because the Here’s what would happen to his position if prices right to sell at $3.50 when the futures price is in excess of rise or fall in the following months: $3.50 is worthless at expiration. But since the cash price has improved, the producer will realize the profit from the • If prices fall… price increase less the premium amount. Then the producer would be out his premium for the call option, but no more than that. By holding a cash position, not For example: only would the producer have incurred storage and interest Assume the futures price rose to $3.80/bu, and the pro- costs, but he also would be exposed to downside risk. ducer allows the option to expire. Selling price = $3.80 • If prices rise… Premium paid = –0.15 Then the producer benefits from market gains without Net selling price = $3.65 incurring storage and interest costs. Once prices rise past Let’s compare the possible outcomes of our options the amount of premium paid for the option, the producer hedge with other familiar alternatives. Assuming the profits for any additional gains. basis remains unchanged at zero, purchasing the put option places a minimum sale price of $3.35 per bushel on the wheat crop, but does not limit the potential profit. Hedging in the futures market “locks in” the $3.50 target price, which would not have allowed the producer to gain CONCLUSION ANSWERS

Mastering the use of futures and options can be time consuming. This booklet is 1) Cash: April $4.80, August $4.30; Loss 50 cents/bu designed to provide a point from which a workable understanding of futures and Options: Buy put for premium of 20 cents/bu; options markets can be launched. Sell put for premium of 55 cents/bu; gain of 35 cents/bu Selling price = $4.30 If you understand the contents of this workbook, you already have achieved an advan- Option market gain = $0.35 tage over the majority of your competitors, but your skills must be honed by gather- Net selling price = $4.65 ing information from different sources such as futures exchanges, brokerage firms, specialists and seminars. You can find prices, contract specifications, rules and regu- 2) b. The producer would let the option expire and receive the current selling price less the option premium paid. lations, margin requirements and other useful market information on contracts traded at the Minneapolis Grain Exchange at www.mgex.com. 3) Futures price = 3.50 Futures price = 3.00 Futures price = 2.50 Basis = -.20 Basis = -.20 Basis = -.20 It also is important to establish a working relationship with a broker experienced in Premium = -.09 Premium = -.09 Premium = -.09 the complexities of futures and options trading. A broker will answer your questions, Option value = .00 Option value = +.20 Option value = +.70 inform you of new opportunities and keep you abreast of market developments. TOTAL RETURN = 3.21 TOTAL RETURN = 2.91 TOTAL RETURN = 2.91

Futures and options provide numerous strategic choices for those who understand their uses. Acquiring this information can be one of the most worthwhile investments you will ever make. CONCLUSION 24 SECTION V 25 Actuals See Cash Commodity. Carrying Broker A member of a Commission House See Futures Customer Segregated Funds Dual Trading Dual trading occurs Fully Disclosed An account carried Independent Introducing commodities is not a down payment, as in futures exchange, usually a clearinghouse Commission Merchant See Segregated Account. when (1) a floor broker executes customer by the Futures Commission Merchant in the Broker A firm or individual that solicits securities, but rather a performance bond. Aggregation The policy under which member, through which another firm, broker orders and, on the same day, trades for his name of the individual customer; the oppo- and accepts commodity futures orders from See also Initial Margin, Maintenance Margin all futures positions owned or controlled by or customer chooses to clear all or some Commodity Exchange Act Day Order An order that if not execut- own account or an account in which he has site of an Omnibus Account. customers but does not accept money, securi- and Variation Margin. one trader or a group of traders are combined trades. (CEA) The federal act that provides for ed expires automatically at the end of the an interest; or (2) a Futures Commission ties, or property from the customer. Unlike a to determine reporting status and federal regulation of futures trading. trading session on the day it was entered. Merchant carries customer accounts and also Fundamental analysis A Guaranteed Introducing Broker, an Margin Call A call from a clearing- speculative limits. Carrying Charge The cost of stor- trades, or permits its employees to trade, in method of anticipating future price move- Independent Introducing Broker is subject to house to a clearing member, or from a broker ing a physical commodity, such as grain or Commodity Futures Trading Day Trader A speculator who will nor- accounts in which it has a proprietary inter- ment using supply and demand information. minimum capital requirements and can intro- or firm to a customer, to bring margin Arbitrage The simultaneous purchase and metals, over a period of time. The carrying Commission (CFTC) The federal mally initiate and offset a position within a est, also on the same day. duce accounts to any registered Futures deposits up to a required minimum level. sale of similar commodities in different markets charge includes insurance, storage and inter- regulatory agency established in 1974 that single trading session. Futures Commission Commission Merchant. to take advantage of a price discrepancy. est on the invested funds as well as other administers the Commodity Exchange Act. Electronic Order An order placed Merchant (FCM) An individual or Mark-to-Market To debit or credit incidental costs. In interest rate futures mar- The CFTC monitors the futures and options on Default The failure to perform on a electronically (without the use of a broker) organization that solicits or accepts orders to Initial Margin The amount a futures on a daily basis a margin account based on Arbitration The process of settling kets, it refers to the differential between the futures markets in the United States. futures contract as required by exchange either via the Internet or an electronic trading buy or sell futures contracts or commodity market participant must deposit into a margin the close of that day’s trading session. In this disputes between members or between par- yield on a cash instrument and the cost of rules, such as a failure to meet a margin call system. options and accepts money or other assets account at the time an order is placed to buy way, buyers and sellers are protected against ties by a person or persons chosen or agreed the funds necessary to buy the instrument. Commodity Pool An enterprise in or to make or take delivery. from customers in connection with such orders. or sell a futures contract. See also Margin. the possibility of contract default. to by them. NFA’s arbitration program Also referred to as Cost of Carry. which funds contributed by a number of per- Electronic Trading Systems An FCM must be registered with the CFTC. provides a forum for resolving futures-related sons are combined for the purpose of trading Deferred Delivery Month The Systems that allow participating exchanges Intrinsic Value The absolute value Market Order An order to buy or disputes between NFA Members or between Cash Commodity The actual physi- futures or options contracts. The concept is distant delivery months in which futures trad- to list their products for trading after the Futures contract A legally binding of the in-the-money; that is, the amount that sell a futures or options contract at whatever Members and customers. cal commodity as distinguished from the similar to a mutual fund in the securities ing is taking place, as distinguished from the close of the exchange’s open outcry trading agreement to buy or sell a commodity or finan- would be realized if an in-the-money option price is obtainable when the order reaches futures contract based on the physical com- industry. Also referred to as a Pool. nearby futures delivery month. hours (i.e. Chicago Board of Trade’s Project A, cial instrument at a later date. Futures con- were exercised. the trading floor. Associated Person (AP) An modity. Also referred to as Actuals. Chicago Mercantile Exchange’s GLOBEX and tracts are standardized according to the quali- individual who solicits orders, customers or Commodity Pool Operator Delivery The transfer of the cash com- New York Mercantile Exchange’s ACCESS). ty, quantity and delivery time and location for Introducing Broker (IB) See Maximum Price Fluctuation customer funds on behalf of a Futures Cash Market A place where parties (CPO) An individual or organization modity from the seller of a futures contract to each commodity. The only variable is price. Guaranteed Introducing Broker and See Limit Move. Commission Merchant, an Introducing Broker, (i.e., grain elevator, bank, etc.) buy and sell which operates or solicits funds for a com- the buyer of a futures contract. Each futures Equity The value of a futures trading Independent Introducing Broker. a Commodity Trading Advisor or a Commodity the actual commodities. See also Forward modity pool. A CPO is generally required to exchange has specific procedures for account if all open positions were offset at Futures Industry Association Mediation A voluntary process in Pool Operator and who is registered with the (Cash) Contract and Spot. be registered with delivery of a cash commodity. Some futures the current market price. (FIA) The national trade association for Inverted Market See which the parties to a futures-related dispute Commodity Futures Trading Commission. the CFTC. contracts, such as stock index contracts, are Futures Commission Merchants. Backwardation. work with a neutral third party to find a Cash Settlement A method of set- cash settled. Exchange See Contract Market. mutually acceptable solution. At-the-Money Option An option tling certain futures or options contracts Commodity Trading Advisor Grantor A person who sells an option Last Trading Day The last day on which whose strike price is equal—or approximate- whereby the market participants settle in (CTA) A person who, for compensation Delivery Month See Contract Exchange for Physicals and assumes the obligation to sell (in the trading may occur in a given futures or option. Minimum Price Fluctuation ly equal—to the current market price of the cash (rather than delivery of the commodity). or profit, directly or indirectly advises others Month. (EFP) A transaction generally used by case of a call) or buy (in the case of a put) See Tick. underlying futures contract. as to the value of or the advisability of buy- two hedgers who want to exchange futures the underlying futures contract at the exer- Leverage The ability to control large Charting The use of graphs and charts ing or selling futures contracts or commodity Derivative A financial instrument, for cash positions. Also referred to as cise price. Also referred to as an Option dollar amounts of a commodity with a com- Naked Option See Uncovered Backwardation A futures market in the technical analysis of futures markets to options. Providing advice indirectly includes traded on or off an exchange, the price of Against Actuals or Versus Cash. Seller or Writer. paratively small amount of capital. Option. in which the relationship between two deliv- plot price movements, volume, open interest exercising trading authority over a customer’s which is directly dependent upon the value of ery months of the same commodity is abnor- or other statistical indicators of price account. A CTA is generally required to be one or more underlying securities, equity Exercise The action taken by the hold- Guaranteed Introducing Limit See Position Limit, Price Limit and National Futures mal. The opposite of Contango. See also movement. See also Technical Analysis. registered with the CFTC. indices, debt instruments, commodities, other er of a call option if he wishes to purchase Broker A firm or individual that solicits Variable Limit. Association (NFA) Authorized by Inverted Market. derivative instruments, or any agreed upon the underlying futures contract or by the and accepts commodity futures orders from Congress in 1974 and designated by the CFTC Churning Excessive trading that results Confirmation Statement A pricing index or arrangement. Derivatives holder of a put option if he wishes to sell the customers but does not accept money, securi- Liquidate To take a second futures or in 1982 as a “registered futures association,” NFA is the industry wide self-regulatory Basis The difference between the cur- in the broker deriving a profit from commis- statement sent by a Futures Commission involve the trading of rights or underlying futures contract. ties or property from the customer. A options position opposite the initial or open- GLOSSARY 26 GLOSSARY rent cash price of a commodity and the sions while disregarding the best interests of Merchant to a customer when a futures or obligations based on the underlying product Guaranteed Introducing Broker has a written ing position. To sell (or purchase) futures organization of the futures industry. 27 futures price of the same commodity. the customers. options position has been initiated. The but do not directly transfer property. They are Exercise Price See Strike Price. agreement with a Futures Commission contracts of the same delivery month statement shows the price and the number of used to hedge risk or exchange a floating Merchant that obligates the FCM to assume purchased (or sold) during an earlier transac- National Introducing Bear Market (Bear/Bearish) Circuit Breaker A system of trad- contracts bought or sold. Sometimes com- rate of return for a fixed rate of return. Expiration Date Generally the last date financial and disciplinary responsibility for tion or make (or take) delivery of the cash Brokers Association (NIBA) A market in which prices are declining. A ing halts and price limits on equities and bined with a Purchase and Sale Statement. on which an option may be exercised. It is not the performance of the Guaranteed commodity represented by the futures mar- NIBA is a non-profit organization for guaran- market participant who believes prices will derivatives markets designed to provide a Designated Self-Regulatory uncommon for an option to expire on a specified Introducing Broker in connection with futures ket. Also referred to as Offset. teed and independent introducing brokers. move lower is called a “bear.” A news item cooling-off period during large, intraday mar- Contango A futures market in which Organization (DSRO) When a date during the month prior to the and options customers. Therefore, unlike an is considered bearish if it is expected to ket declines. prices in succeeding delivery months is pro- Futures Commission Merchant (FCM) is a delivery month for the underlying futures contract. Independent Introducing Broker, a Liquidity (Liquid Market) A Nearby Delivery Month The result in lower prices. gressively higher. The opposite of member of more than one Self-Regulatory Guaranteed Introducing Broker must intro- characteristic of a security or commodity futures contract month closest to expiration. Clear The process by which a clearing- Backwardation. Organization (SRO), the SROs may decide Extrinsic Value See Time Value. duce all accounts to its guarantor FCM but is market with enough units outstanding to Also referred to as the Spot Month. Bid An expression of willingness to buy a house maintains records of all trades and among themselves which of them will be pri- not subject to minimum financial require- allow large transactions without a substan- commodity at a given price; opposite of Offer. settles margin flow on a daily mark-to-market Contract Market A board of trade marily responsible for enforcing minimum First Notice Day The first day on ments. All Introducing Brokers must be reg- tial change in price. Net Asset Value The value of each basis for its clearing members. designated by the CFTC to trade futures or financial and sales practice requirements. which notice of intent to deliver a commodity istered with the CFTC. unit of participation in a commodity pool. Board of Trade See Contract options contracts on a particular commodity. The SRO will be appointed DSRO for that in fulfillment of an expiring futures contract Local A member of an exchange who Basically a calculation of assets minus liabili- Market. Clearinghouse An agency or sepa- Commonly used to mean any exchange on particular FCM. NFA is the DSRO for all non- can be given to the clearinghouse by a seller Hedging The practice of offsetting the trades for his own account or fills orders for ties plus or minus the value of open positions rate corporation of a futures exchange that is which futures are traded. Also referred to as exchange member FCMs. See also Self- and assigned by the clearinghouse to a buyer. price risk inherent in any cash market posi- customers. when marked to the market, divided by the Broker A company or individual that responsible for settling trading accounts, col- an Exchange. Regulatory Organization. Varies from contract to contract. tion by taking an equal but opposite position total number of outstanding units. executes futures and options orders on lecting and maintaining margin monies, in the futures market. A long hedge involves Long One who has bought futures con- behalf of financial and commercial institu- regulating delivery and reporting trade data. Contract Month The month in Disclosure Document The Floor Broker An individual who exe- buying futures contracts to protect against tracts or owns a cash commodity. Net Performance An increase or tions and/or the general public. The clearinghouse becomes the buyer to which delivery is to be made in accordance statement that must be provided to prospec- cutes orders on the trading floor of an possible increasing prices of commodities. A decrease in net asset value exclusive of addi- each seller (and the seller to each buyer) and with the terms of a futures contract. Also tive customers that describes trading strate- exchange for any other person. short hedge involves selling futures contracts Low The lowest price of the day for a tions, withdrawals, and redemptions. Bucketing Directly or indirectly taking assumes responsibility for protecting referred to as Delivery Month. gy, fees, performance, etc. to protect against possible declining particular futures contract. the opposite side of a customer’s order into buyers and sellers from financial loss by Floor Trader An individual who is a prices of commodities. Notice Day Any day on which a the broker’s own account or into an account assuring performance on each contract. Convergence The tendency for Discount (1) The amount a price member of an exchange and trades for his Maintenance Margin A set clearinghouse issues notices of intent to in which the broker has an interest, without prices of physical commodities and futures to would be reduced to purchase a commodity own account on the floor of the exchange. High The highest price of the day for a minimum margin (per outstanding futures deliver on futures contracts. open and competitive execution of the order Clearing member A member of an approach one another, usually during the of lesser grade; (2) Sometimes used to refer Also referred to as a Local. particular futures contract. contract) that a customer must maintain in on an exchange. exchange clearinghouse responsible for the delivery month. to the price differences between futures of his margin account to retain the futures posi- Offer An indication of willingness to sell financial commitments of its customers. All different delivery months, as in the phrase Forward (Cash) Contract A Holder The purchaser of either a call or tion. See also Margin. a futures contract at a given price; opposite Bull Market (Bull/Bullish) A trades of a non-clearing member must be Cost of Carry See Carrying Charge. “July is trading at a discount to May,” indi- contract on which a seller agrees to deliver a put option. Option buyers receive the right, of Bid. market in which prices are rising. A market registered and eventually settled through a cating that the price of the July future is specified cash commodity to a buyer some- but not the obligation, to assume a futures Managed Account See participant who believes prices will move clearing member. Covered Option A short call or put lower than that of May; (3) Applied to cash time in the future. All terms of the contract position. The opposite of a Grantor. Also Discretionary Account. Offset See Liquidate. higher is called a “bull.” A news item is con- option position that is covered by the sale or grain prices that are below the futures price. are customized, in contrast to futures con- referred to as the Option Buyer. sidered bullish if it is expected to result in Closing Price See Settlement Price. purchase of the underlying futures contract or tracts whose terms are standardized. Managed Funds Association Omnibus Account An account higher prices. physical commodity. Discretionary account An Forward contracts are not traded on In-the-Money Option An option (MFA) The trade association for the carried by one Futures Commission Merchant Closing Range A range of prices at arrangement by which the owner of the exchanges. having intrinsic value. A call is in-the-money if managed funds industry. (FCM) with another FCM in which the trans- Call Option An option that gives the which futures transactions took place during Cross-Hedging Hedging a cash account gives written power of attorney to its strike price is below the current price of the actions of two or more persons are combined buyer the right, but not the obligation, to pur- the close of the market. commodity using a different but related someone else, usually the broker or a Frontrunning A process whereby a underlying futures contract. A put is Margin An amount of money deposited and carried in the name of the originating chase (“go long”) the underlying futures con- futures contract when there is no futures Commodity Trading Advisor, to buy and sell futures or options position is taken based on in-the-money if its strike price is above the cur- by both buyers and sellers of futures con- FCM rather than of the individual customers; tract at the strike price on or before the Commission A fee charged by a bro- contract for the commodity being hedged and without prior approval of the account owner. non-public information about an impending rent price of the underlying futures contract. tracts and by sellers of option contracts to opposite of Fully Disclosed. expiration date. ker to a customer for executing a transaction. the cash and futures market follow similar Also referred to as a Managed Account. transaction in the same or related futures or ensure performance of the terms of the con- price trends (e.g. using soybean meal futures options contract. tract (the making or taking delivery of the to hedge fish meal). commodity or the cancellation of the position by a subsequent offsetting trade). Margin in Open The period at the beginning of the exchange where the contract is traded. Round Turn A completed futures Time Value The amount of money trading session officially designated by the transaction involving both a purchase and a options buyers are willing to pay for an exchange during which all transactions are Position Trader A commodity trad- liquidating sale, or a sale followed by a cov- option in anticipation that over time a change considered made “at the open.” er who either buys or sells contracts and ering purchase. in the underlying futures price will cause the holds them for an extended period of time, as option to increase in value. In general, an Open Interest The total number of distinguished from the day trader. Rules (NFA) The standards and option premium is the sum of time value and futures or options contracts of a given com- requirements to which participants that are intrinsic value. Any amount by which an modity that have not yet been offset by an Prearranged Trading Trading required to be Members of National Futures option premium exceeds the option’s intrinsic opposite futures or option transaction nor ful- between brokers in accordance with an Association must subscribe and conform. value can be considered time value. Also filled by delivery of the commodity or option expressed or implied agreement or under- referred to as Extrinsic Value. exercise. Each open transaction has a buyer standing. Prearranged trading is a violation Scalper A trader who trades for small, and a seller, but for calculation of open inter- of the Commodity Exchange Act. short-term profits during the course of a trading Uncovered Option A short call or est, only one side of the contract is counted. session, rarely carrying a position overnight. put option position which is not covered by Premium Refers to (1) the amount a the purchase or sale of the underlying futures Open Outcry A method of public auc- price would be increased to purchase a bet- Segregated Account A special contract or physical commodity. Also tion for making bids and offers in the trading ter quality commodity; (2) a futures delivery account used to hold and separate customers’ referred to as a Naked Option. pits of futures exchanges. month selling at a higher price than another; assets from those of the broker or firm. (3) cash prices that are above the futures Underlying futures contract Open Trade Equity The unreal- price; (4) the price paid by the buyer of an Self-Regulatory The specific futures contract that the option ized gain or loss on open positions. options; or (5) the price received by the sell- Organization (SRO) Self-regula- conveys the right to buy (in case of a call) or er of an option. tory organizations (i.e., the futures exchanges sell (in case of a put). Opening Range The range of prices and National Futures Association) enforce at which buy and sell transactions took place Price Discovery The process of minimum financial and sales practice require- Variable Limit A price system that during the opening of the market. determining the price of a commodity by ments for their members. See also allows for larger than normally allowable trading conducted in open outcry at an Designated Self-Regulatory Organization. price movements under certain conditions. In Option Buyer See Holder. exchange. periods of extreme volatility, some exchanges Settlement Price The last price permit trading at price levels that exceed reg- Option Contract A contract which Price Limit The maximum advance or paid for a futures contract on any trading day. ular daily price limits. gives the buyer the right, but not the obliga- decline, from the previous day’s settlement Settlement prices are used to determine tion, to buy or sell a specified quantity of a price, permitted for a futures contract in one open trade equity, margin calls, and invoice Variation Margin Additional mar- commodity or a futures contract at a specific trading session. Also referred to as prices for deliveries. gin required to be deposited by a clearing price within a specified period of time. The Maximum Price Fluctuation. member firm to the clearinghouse during seller of the option has the obligation to sell Short One who has sold futures con- periods of great market volatility or in the the commodity or futures contract or buy it Purchase and Sale tracts or plans to purchase a cash commodity case of high-risk accounts. from the option buyer at the exercise price if Statement (P&S) A statement sent (e.g., a food processor). the option is exercised. See also Call Option by a Futures Commission Merchant to a cus- Volatility A measurement of the and Put Option. tomer when a futures or options position has Speculator A market participant who change in price over a given time period. been liquidated or offset. The statement tries to profit from buying and selling futures Option Premium The price a buyer shows the number of contracts bought or and options contracts by anticipating future Volume The number of purchases and pays (and a seller receives) for an option. sold, the prices at which the contracts were price movements. Speculators assume sales of futures contracts made during a Premiums are arrived at through open outcry. bought or sold, the gross profit or loss, the market price risk and add liquidity and capital specified period of time, often the total trans-

28 GLOSSARY There are two components in determining commission charges, and the net profit or to the futures markets. actions for one trading day. this price—extrinsic (or time) value and loss on the transaction. Sometimes combined intrinsic value. with a Confirmation Statement. Spot Usually refers to a cash market Warehouse Receipt A document price for a physical commodity that is avail- guaranteeing the existence and availability of Option Seller See Grantor. Put Option An option that gives the able for immediate delivery. a given commodity in storage; commonly option buyer the right, but not the obligation, used as the instrument of transfer or owner- Out-of-the-Money Option A to sell the underlying futures contract at a Spot Month See Nearby Delivery ship in both cash and futures transactions. call option with a strike price higher or a put particular price (exercise or strike price) on or Month. option with a strike price lower than the cur- before a particular date. Wire House See Futures Commission rent market value of the underlying asset Spreading The simultaneous buying Merchant. (i.e., an option that does not have any intrin- Pyramiding The use of unrealized and selling of two related markets in the sic value). profits on existing futures positions as mar- expectation that a profit will be made when Writer See Grantor. gin to increase the size of the position, nor- the position if offset. mally in successively smaller increments. Out Trade A trade that cannot be Yield The measure of the annual return MINNEAPOLIS GRAIN EXCHANGE cleared by a clearinghouse because the data Stop Order An order that becomes a on an investment. submitted by the two clearing members Quotation The actual price or the bid or market order when the commodity reaches a involved in the trade differs in some respect. ask price of either cash commodities or futures particular price level. A sell stop is placed Yield Curve A chart in which yield All out trades must be resolved before the or options contracts at a particular time. below the market, a buy stop is placed above level is plotted on the vertical axis, and the Acknowledgements market opens the next day. the market. term to maturity of debt instruments of simi- Range The difference between the high lar creditworthiness is plotted on the horizon- We express our appreciation to those who Overbought A technical opinion that the and low price of a commodity during a given Strike Price The price at which the tal axis. market price has risen too steeply and too fast trading session, week, month, year, etc. buyer of a call (put) option may choose to exer- generously gave their time and effort in reviewing in relation to underlying fundamental factors. cise his right to purchase (sell) the underlying this publication. Registered Commodity futures contract. Also called Exercise Price. Glossary of Futures Terms: An Representative (RCR) See Oversold A technical opinion that the mar- Introduction to the Language of the Minneapolis Grain Exchange ket price has declined too steeply and too fast in Broker, Associated Person. Swap In general, the exchange of one Futures Industry is reprinted with per- relation to underlying fundamental factors. asset or liability for a similar asset or liability mission from the National Futures members and member firm personnel Regulations (CFTC) The regulations for the purpose of lengthening or shortening Association. Par The face value of a security. adopted and enforced by the CFTC in order to maturities, or raising or lowering coupon DePaul University Professor Jin Choi administer the Commodity Exchange Act. rates, to maximize revenue or minimize Pit The area on the trading floor of some financing costs. exchanges where trading in futures or options Reparations The term is used in con- Minneapolis Grain Exchange on futures is conducted by open outcry. junction with the CFTC’s customer claims pro- Technical Analysis An approach marketing and public relations staff cedure to recover civil damages. to analysis of futures markets which exam- Pool See Commodity Pool. ines patterns of price change, rates of Reportable Positions The num- change, and changes in volume of trading, Minneapolis Grain Exchange Position A market commitment, either ber of open contracts specified by the CFTC open interest, and other statistical indicators. clearing department staff long or short, in the market. at which one must begin reporting total posi- See also Charting. tions by delivery month to the authorized National Futures Association (Glossary of Terms) Position Limit The maximum num- exchange and/or the CFTC. Tick The smallest allowable increment of ber of speculative futures contracts one can price movement for a contract. Also referred hold as determined by the CFTC and/or the to as Minimum Price Fluctuation.