Futures and Options: An Overview



Futures and Options: An Overview

A futures contract is defined as a contract for future delivery traded on organized futures exchanges such as the Chicago Board of Trade, Kansas City Board of Trade, New York Board of Trade, etc. The futures contract involves a commitment to accept delivery (buyer) or make delivery (seller) of a specified quantity and quality of a particular commodity (corn, gold, wheat, milk, etc.) at a specified time and location. No actual commodity is ever physically exchanged until the contract matures. Futures contracts for a specified commodity (e.g., corn) involving a specified contract month (e.g., July 2006) are standardized with regard to quantity, quality and location of physical exchange but not price. Prices are determined by trades made by open outcry within a pit on the trading floor of the exchange within a prescribed time period, however, some futures contracts are now traded electronically.

Let us give consideration to corn futures contracts traded on the Chicago Board of Trade. Each contract includes 5,000 bushels (quantity) of No.2 yellow corn (quality), which upon maturity of the contract (March, May, July, September, December) will be physically traded in Chicago or a predetermined location on the Illinois or upper Mississippi Rivers (location) unless an additional trade is carried out. The price associated with the physical trade is that arrived at earlier between traders in the pit on the floor of the exchange.

Today, through my broker I could buy (go long) one contract of Chicago Board of Trade July 06 corn at about 200 cents per bushel and if I never took any additional action I would expect to receive 5,000 bushels of No. 2 yellow corn in a Chicago (or River location) grain warehouse in late July for which I would be required to pay 200 cents/bushel. Conversely, a trader who sold (short) a contract would be obligated to have in store 5,000 bushels of corn in a Chicago or River elevator warehouse for delivery if the trader took no further action.

Interestingly, there is very little product (e.g. corn) that is actually physically traded between buyers and sellers of futures contracts. This results because futures contracts can be offset. Offsetting involves buying back after selling the future, or selling the future after buying the future to cancel a previously established futures position. So, if you bought one contract of July corn today (April 18) and sold one contract of July corn before contract maturity in the third week of July, you would have offset and would have no further obligations regarding the traded contracts. It is estimated that 98 % of all futures trades are offset.

Initial margin is the monies required, per contract, before a potential trader can be involved in buying and selling futures contracts for a particular commodity. It is usually no more than 5 % of the contract’s value. Maintenance margin is the level of margin funds that precipitates a margin call if the account balance falls below the specified maintenance margin level. The maintenance level is often about 65 % of the initial margin. Margin calls result when an account is incurring a loss. When this occurs, monies must be sent to the brokerage firm by the trader since his/her account balance has fallen below the specified maintenance margin level. Daily the clearinghouse at the exchange identifies gainers and losers and determines who will receive a margin call. It is through the clearinghouse that futures contracts are made, offset, or fulfilled through delivery of the commodity and through which financial settlement is made.

Three groups trade futures—they are speculators, hedgers and floor traders. A speculator is a trader who typically has no involvement in the cash market and is attempting to earn profits based on anticipated price movements. A speculator will go long a futures contract if a price increase is anticipated, short a futures contract if a price decline is anticipated, or can straddle/spread two futures contracts if a widening/narrowing between the two contracts is anticipated. A bear believes prices will decline while a bull believes prices will increase. A hedger is one who has involvement or will have involvement in a cash market and wishes to transfer risk associated with cash price fluctuations to someone else through a process identified as hedging. A floor trader operates on the exchange and makes trades for his/her own account and brokerage firms. The Commodity Futures Trading Commission is a government agency that regulates and oversees the futures markets.

The following terms are used in reporting futures prices in daily papers, internet, etc.

Open is price for the first contract traded during a day. High designates highest price of the day for a contract. Low designates the lowest price for a day. The close is the last traded price for the day. Change is the change in closing price from the previous day.

Seasons high and low as of a date are the highest and lowest transactions price during contracts lifetime. Volume is number of futures contracts traded per day. Open interest is the total number of futures contracts of a given commodity not yet offset by opposite futures transactions or fulfilled by delivery of actual commodity.

A chartist or technician refers to those traders who use technical analysis and attempt to predict price from past price patterns or market characteristics. In contrast, a fundamentalist focuses on demand and supply in an attempt to forecast price movements.

The prices of agricultural commodities for which futures contracts are traded are highly volatile. Therefore, firms that handle or process these commodities are vulnerable to adverse price moves or a price move that unfavorably impacts firm profit. These firms may wish to hedge for purposes of transferring price risk to others. Hedging is the establishment of a position in the futures market that is equal and opposite the position, or intended position, in the cash market with an objective of transferring cash price risk to others. Suppose you are a corn trader and have recently bought corn in the cash market but are concerned that corn price might decline as would the value of your purchased corn. To hedge against this out come, the corn trader would enter the corn futures market and sell the corn future—a transaction opposite to that in the cash market. Since the cash and futures market tend to move together (but not lockstep), a decline in corn price will yield a gain in the futures market. This should offset the corresponding loss incurred in the cash corn market. A hedge that is initiated by selling a futures contract is termed a selling hedge or short hedge and is to protect a long cash position from a price decline. Conversely, a corn trader may have made a forward cash sale without having actual ownership of corn and is accordingly concerned that corn price may increase when purchasing corn to deliver on the forward contract. To initiate the hedge so as to protect against the price increase, the corn trader would purchase a corn futures contract and if price does increase, the trader will enjoy a gain on the futures transactions that would offset loses in the cash market. A hedge that is initiated by buying a futures contract is termed a buying or long hedge and is to protect a trader who has a short cash position.

The basis is important to the hedger. The basis is the difference between the cash price in a particular market and time period and a specific commodity futures contract. For example, the basis for Amarillo corn in February may be 15 cents under the March corn futures contract traded on the Chicago Board of Trade. That is, on average the cash price for corn in Amarillo during February is 15 cents less than the March futures price. So, if the future trades at 210 cents then the Amarillo price would be about 195 cents per bushel. The hedger believes that the risk associated with an adverse basis move is less than the risk associated with an adverse price move. When hedging there is an initiating (opening) basis (B1= C1 – F1) and a lifting (closing) basis (B2 = C2 – F2)—if B2 – B1= +, then the basis has strengthened and a gain is secured on selling hedges but a loss on a buying hedges. If B2 – B1 = -, then the basis has weakened and a gain is secured on a buying hedge but a loss on a selling hedge. Optimal hedge ratio refers to the ratio of the number of futures contracts purchased or sold to the size of the cash position being held. It is supposed to represent the most desirable combination of cash and futures prices.

Options are traded in pits that are adjacent to the underlying futures contract. An option contract gives the option buyer the right, but not the obligation, to buy or sell a particular commodity futures contract (July corn) at a specified price for a specified period of time on or before the option expiration. The seller of the option is obligated to perform to conditions outlined in the options contract at the direction of the buyer. There are two types of options—a call option and a put option.

A call option gives the option buyer the right, but not the obligation to purchase (go long) the underlying futures contract at a particular price (strike price) on or before the expiration date. A put option gives the option buyer the right but not the obligation to sell (go short) the underlying futures contract at a particular price (strike price) on or before the expiration date. An option buyer has the right but not the obligation to assume a futures position. The option seller receives a payment (premium) and is obligated to perform when the buyer exercises his/her right under the provisions of the options contract. The premium is the price of an option—the sum of money that the option buyer pays and the option seller receives for the rights granted by the option. The strike price is the price at which the futures contracts underlying a call or put option can be purchased (if a call) or sold (if a put). An option generally expires (expiration date)

on a specific date during the month preceding the futures contract delivery month. For example, an option on the July corn futures contract expires in June but is referred to as the July option because its exercise would result in a July futures contract position. Exercise is the action taken by the buyer or holder of the call option if the trader wishes to purchase the underlying futures contract or by the buyer or holder of a put option if the trader wishes to sell the underlying futures.

An in-the-money option has intrinsic value. A call option is in-the-money if the strike price is below the current price of the underlying futures contract. A put option is in the money if its strike price is above the current price of the underlying futures contracts. Intrinsic value is the amount by which an option is in-the-money. An option with no intrinsic value is called an out-of-the-money option. A call option is out-of-the-money when its strike price is above the current futures price or a put option whose strike price is below the current price. An option whose strike price is equal or approximately equal to the current market price of the underlying futures contract is termed an at-the-money option.

Time value of an option is the amount of money option buyers are willing to pay for an option in anticipation that, over time, a change in the underlying futures price will cause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. An amount by which an option’s premium exceeds the option’s intrinsic value can be considered time value.

The buyer of an option may exit the option by allowing it to expire, by offsetting the option or exercising the option. Offsetting is the most common method of closing out an option position. This is done by selling a put or call identical to the put or call you originally bought. Offsetting the option before expiration is the only way the trader will recover any remaining time value. An option is exercised when the option is converted to the underlying futures contract. In addition, an option buyer can simply allow the option to expire, i.e., do nothing. The seller of the option hopes that futures prices will move in such a way that the option buyer will not exercise. That is, the option seller wants the premium initially earned and then hopes the option buyer is never seen again.

The short hedger that wishes to use options would buy a put option so if exercised, he/ she would be a seller of the underlying future. Conversely, a long hedger would purchase a call option.

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