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Introduction To Futures

A futures contract is a commitment to deliver or
receive a standardized quantity and quality of a commodity (or financial
instrument) at a specified future date. The price associated with
this trade is the trade entry level.

The essence of a futures market is in its name: Trading involves a commodity or financial instrument (you can have futures on stocks for example) for a future delivery date, as opposed to the present time. Thus, if a grain farmer wished to make a current sale, he would sell his crop in the local cash market.However, if he wanted to lock in a price for an anticipated future sale (e.g. the marketing of a still unharvested crop), he would have two options: He could find an interested buyer and negotiate a contract specifying the price and other details (quantity, quality, delivery time, location, etc). Alternatively, he could sell futures. Some of the major advantages of selling futures are:

• The futures contract is standardized
  - this means the farmer doesn’t have to find a specific buyer.
• The transaction can be executed nearly instantaneously
  with a one-line phonecall order (e.g. “Sell 2 March grain
  at the market”).
• The cost of the trade (commissions) is minimal
  compared with the cost of an individualized forward contract (ie.
  if the farmer were to sell to one specific buyer in the future
  via a “contract”).
• The farmer can offset his sale at any time between
  the original transaction date and the final trading day of the
  contract (the reason why he’d want to do this will be discussed
  shortly).
• The futures contract is guaranteed by the exchange.

Until the early 1970’s, futures markets were restricted to commodities
such as wheat, sugar and copper. Three additional market sectors
have been added to the futures area since then: currencies,
interest rate instruments, and stock exchanges.
The same basic principles apply to these non-commodity futures markets.
Trading quotes (futures contract prices) represent prices for a
future expiration date, as opposed to current market prices. These
new financial markets have witnessed spectacular growth since their
introduction and account for approximately two thirds of all trading
volume. In this sense, futures appear to be a far more appropriate
designation than commodities, although the term “commodities”
is still often used when referring to futures (they are considered
synonymous).

Delivery

Shorts who maintain their positions after the last trading day are obligated to deliver the actual commodity (or financial
instrument) against the contract. Similarly,
longs who maintain their position after the last trading day must accept delivery.
In the commodity markets, the number of open long contracts is always equal to the
number of open short contracts (see the Volume & Open Interest section). Most
traders have no intention of making or accepting delivery, and hence will offset
their positions before the last trading day. (Longs offset their position by entering
a sell order, shorts by entering a buy order).

Only a very small fraction of open contracts actually result in delivery. Since
the early 1980s, there has been a strong settlement toward using a cash settlement
(ie. outstanding long and short positions are offset at the prevailing price level
at expiration) instead of a delivery procedure. Most financial contracts and some
commodity-type markets use cash settlement.

Volume & Open Interest

Volume is simply the total number of contracts traded
on a given day. Volume figures are available for each traded month in
a market, but most traders focus on the total volume of all traded
months.

Open interest is the total number of outstanding long
contracts, or equivalently, the total number of outstanding short contracts.
In futures markets, the two are always equivalent. When a new contract
begins trading (normally about 9 – 18 months before its expiration date),
its open interest is equal to zero. If a buy order and sell
order are matched, then the open interest increases to 1. Basically,
open interest increases when a new buyer purchases from a new seller,
and decreases when an existing long sells to an existing short. The
open interest will remain unchanged if a new buyer purchases from an
existing long or a new seller sells to an existing short.

Volume and open interest are very useful as indicators
of a market’s liquidity. Not all listed futures markets are actively
traded. Some are virtually dead, while others are borderline cases in
terms of trading activity. Illiquid markets should be avoided,
because the lack of an adequate order flow will mean that the trader
will often have to accept very poor trade execution prices if he wants
to get in or out of a position.

Generally speaking, markets with open interest levels below 5,000 contracts, or average daily volume levels below 1,000 contracts, should be avoided, or at least approached very cautiously. New markets will usually exhibit volume and open interest levels below these figures during their initial months (and sometimes even years!) of trading, so watch out for these. By monitoring the volume and open interest figures, a trader can determine when the market’s level of liquidity is sufficient to warrant participation.

The breakdown of volume and open interest figures by contract
month can be very useful in determining whether a specific month is
sufficiently liquid. For example, a speculater wishing to enter a long
position may prefer the futures contract with an expiration date nine
months forward, as opposed to more nearby contracts, because he believes
the forward position is relatively underpriced. The most important reservation
about trading the more distant contract would be whether its level of
trading activity was sufficient to avoid problems related to illiquidity
(poor execution prices). In this case, the breakdown of volume and open
interest figures by contract month can help the speculator decide whether
its reasonable to enter a position in the more forward contract or if
its better to restrict trading to the nearby positions.

Contract Specifications

Futures are traded for a wide variety of markets on a
number of exchanges both in the United States and abroad. Although we’ll
not provide a full list of available futures markets and their exchanges,
an example market will be provided:

Market	Exchange	Trading Hours	Contract Size	Months Traded	Price Quoted in
Wheat	CBT	9:30am – 1:15pm	5,000 bushels	H,K,N,U,Z	Cents / Bushel

(…continued)

Minimum Fluctuation	Value of min. Fluct	Max. Daily Limit	First Notice Day	Last Trading Day
1/4 cent	$12.50	20 cents(limitless spot during delivery period)	Last business day of month preceding contract month	Eighth last day of contract month

1. Exchange

The exchange is where the market is being traded. In this case we have
wheat being traded on the Chicago Board of Trade (CBT).
Among the other US futures exchanges are the Chicago Mercantile Exchange
(CME), New York Futures Exchange (NYFE) and the Financial Instruments
Exchange (FINEX) to name but a few. Foreign exchanges include the Deutsche
Terminboerse (DTB), International Petroleum Exchange of London (IPE),
Marche a Terme International de France (MATIF).

2. Trading Hours

As indicated, trading hours are listed in terms of the local times
for the given exchange (All US exchanges are currently located in either
the Eastern or Central time zones).

3. Contract Size

The specification of a uniform quantity per contract is one of the
key ways in which a futures contract is standardized. By multiplying
the contract size by the price, you can determine the dollar value of
the contract. For example, if wheat is trading at $3.00/bushel (bu.),
the contract value equals $15,000. Although there are a few important
exceptions, roughly speaking, higher per-contract dollar values will
imply a greater reward / risk level. (The concept of a contract has
no meaning in the interest rate markets).

4. Months Traded

Symbol	Month	Symbol	Month	Symbol	Month
F	January	K	May	U	September
G	February	M	June	V	October
H	March	N	July	X	November
J	April	Q	August	Z	December

The code for the monthly symbols is shown in the table above. Each
market is traded for specific months. For example, corn is traded for
March, May, July, September and December. The last trading day for a
contract will occur on a specified date in the contract month or, in
some cases, the month preceding the contract month. For most markets,
futures are listed for contract months at least one year forward from
the current date. However, trading is usually heavily concentrated in
the nearest one or two contracts.
5. Price Quoted In

Indicates the relevant unit of measure for the given market.

6 . Minimum Fluctuation

This column indicates the minimum increments in which
prices can trade. For example, the minimum fluctuation for wheat is
1/4 c/bu.. This means you can enter an order to buy December wheat at
$3.01 1/2 or $3.01 3/4, but not $3.01 5/8 per bushel.

7. Value of Minimum Fluctuation

This figure is obtained by multiplying the minimum fluctuation
by the contract size. For example, for wheat, 1/4 c/bu. x 5,000 = $12,50.

8. Maximum Daily Limit

Exchanges normally specify a maximum amount by which the
contract price can change on a given day. For example, if the December
wheat contract closed at $3.10 the previous day, and the daily price
limit is 20c/bu., wheat cannot trade above $3.30 or below $2.90. Some
markets employ formulas for increasing the daily limit of a specified
number of consecutive limit days.
This has quite a profound effect upon us as traders: In
cases in which free markets would normally seek an equilibrium price
outside the range boundaries implied by the limit, the max-limited futures
market will simply move to the limit and virtually cease to trade. For
example, if after the market close the U.S. Department of Agriculture
(USDA) releases a very bullish wheat crop production estimate, which
hypothetically would result in an immediate 30c/bu. price rise in an
unrestricted market, prices will be locked limit up (20c/bu.)
the next day. This means that the market will open and stay at the limit,
with virtually no trading taking place. The reason for the absence of
trading activity is that the limit rule restriction maintains an artificially
low price, leading to a large surplus of buy-orders at that price but
few if any sell orders.
In the case of a very sever surprise event (e.g. sudden
major crop damage), a market could move several limits in succession.
If this occurs, traders on the wrong side of a trade might not able
to liquidate their positions until the market trades freely! The
new trader should be aware of and practice caution to this possibility.
However there’s no need for overly frightened, since such events of
extreme volatility rarely come as a complete surprise. In most cases,
markets vulnerable to such volatile price action can be identified early.
Some examples of such markets would include commodities in which the
USDA is scheduled to release a major report, coffee or frozen concentrated
orange juice during their respective freeze seasons, and markets that
have exhibited recent extreme trading volatility.

9. First Notice Day

This is the first day on which a long can receive a delivery notice. First notice day presents no problem for traders holding short positions, since they are not obligated to issue a notice until after the last trading day. Furthermore, in some markets, first notice day occurs after last trading day, presenting no problem to the long either, since all remaining longs at that point presumably wish to take delivery. However, in markets in which first notice day precedes last trading day, longs who do not wish to take delivery should be sure to offset their positions in time to avoid receiving a delivery notice (Brokerage firms routinely supply their representitives with a list of these important dates). Although longs can pass on an undesired delivery notice by liquidating their position, this action will incur extra transaction costs and should be avoided.

10. Last Trading Day

This is the last day on which the positions can be offset
before delivery becomes obligatory for shorts and the acceptance of
delivery obligatory for longs. As indicated previously, the vast majority
of traders will liquidate their positions before this day.

Options vs. Other Instruments

Option trading provides many advantages over other plain stock trading. Leverage,
limited risk, insurance, profiting in bear markets, each-way betting or market going
nowhere are only a few. But let’s look at a couple in more detail.

Leverage

One thing to note before we go on is that the buyer of an options contract pays
an amount, known as the premium, to the option seller. An option seller is also
known as the writer of the option. The option premium is simply the amount paid
for the option.

When you buy an option contract from an option seller, you aren’t actually buying anything – no asset is actually transferred until the buyer chooses to exercise the optiono. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset – Microsoft Shares as an example.

Options give the buyer the right to buy a number of shares of the underlying instrument
from the option seller. The amount of shares (or futures contracts) to buy is determined
by;

The number of option contracts, multiplied by the contract multiplier (also called
contract size) is different for most classes of options and is determined by each
exchange. In the US, the contract size for options on shares is 100.

This means that every 1 option contract gives buyer the right to buy 100 shares
from the option seller.

So, if you buy 10 IBM option contracts, it means that you have the right to buy
1,000 IBM shares at expiration if the price is right (10 x 100).

Note: In other countries such as Australia, the contract multiplier for stock options
is 1,000, which means the every option contract you buy entitles you to 1,000 underlying
share contracts. So pay attention to the contract specs before you begin option
trading.

This also means that the price of the option is also multiplied by the contract
multiplier. For example, say in the above you purchased 10 options contracts that
were quoted in the marketplace for 15c, then you would actually pay the seller $150.

This is a crucial concept to understand. If you go out and buy 5 IBM share options
for 15c that have a Strike Price of $25, then you will;

Pay the option seller $75

If you decide to exercise your right and buy the shares, you will have to buy 500
(5 x 100) (100 being the contract size) shares at the exercise price of $25, which
will cost you $12,500.

In this case, your initial investment of $75 has given you $12,500 exposure in the
underlying security.

Option trading is very attractive for the small investor as it gives him/her the
opportunity to trade a very large exposure whilst only outlaying a small amount
of capital.

Say you bought a $25 call option for $1 while the underlying shares were trading
at $26. If the market rallies to $27 the option must at least be worth $2 because
you can exercise your right at $25. So, even though the shares only went up 3.8%
you DOUBLED your money because you can now sell back the option for $2.

Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks
are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it
is for Microsoft to trade from $25 to $50!

For this reason penny stock trading is becoming very lucrative for online speculators.
They can still trade the stocks outright as well as making massive returns if they
are correct about their view on market direction.

The only drawback with penny stocks is trying to pick which stocks to buy. I’m not
that familiar with trading penny stocks, however, I know of a great site that provides
stock picks for penny stocks every two weeks – <penny stock affiliate link>.
They have a free trial, so you can see for yourself whether penny stock trading
is for you or not.

Penny stocks can be risky though – there’s a reason why they’re so cheap, nobody
wants them! So, be careful to act on the right information.

Limited Risk

One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.

Remember our initial example of Peter buying a Microsoft Call option? Here are the
details of that trade provided with the appropriate jargon;

Underlying: MSFT

Type: Call Option

Position: Long (i.e. bought the contract)

Strike Price: $25

Expiry Date: 25th May

At the time of the trade, Microsoft shares (the Underlying) were trading around
$30. The Call option contract had been valued and was trading at $6.5 – known as
the premium, but more on this under pricing.

So, from the above information we can conclude that after the 25th May, if Microsoft
is trading above $31.50 we can make a profit on this.

Why $31.50? Because we paid $6.50 for the right to have this option in the form
of a premium to the option seller. This means we must consider this in our profit
estimate. Therefore we add the option premium to the strike price to determine our
break even point.

A Profitable Trade

If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise
our right to Call the shares from the option seller. Then we will be assigned Microsoft
shares at the exercise price of $25, which is the same as if we actually bought
Microsoft shares for $25.

Note: If we exercise our right and take delivery of the shares, this means that
we will have to pay the full amount for the shares. So, the number of option contracts
bought multiplied by the contract size multiplied by the exercise price. If you
are planning to hold onto option contracts until expiry and take delivery, make
sure you have the cash!

But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares
in your trading account with a purchase value of $25, yet they are trading at $40.
So, you can sell them at $40 and make $8.50 per share.

Why $8.50? Remember the premium we paid? We have to consider that with our profit
estimate.

Think about what happens as the underlying price continues to rise. You continue
to make more and more money once the stock price has exceeded the strike price.

But what about the downside risk?

A Losing Trade

Let’s imagine at expiration Microsoft shares are trading below our exercise price
of $25 at, say, $20. Will we decide to exercise our right and take delivery of the
shares and pay $25 per share? No way, because they’re only worth $20. So, we will
just do nothing and let the option contract expire worthless.

What have we lost though? We lose the premium that we paid to the seller, which
in this example was $6.5. That’s it. A lot less than if the stock plummeted and
we lost our entire investment.

What about if there is a stock market crash and Microsoft Shares are trading at
$5 at the time of expiration? The same as if the shares are trading at $20 – nothing.
We just let the option contract expire worthless and lose our premium – $6.5.

Limited Risk AND Unlimited Profit Potential

Can you see now how this type of strategy gives you the best of both worlds – both
limiting your risk and at the same time leaving you open to make unlimited profit
if the market rallies?

Not all option strategies have this payoff benefit. Only if you are buying options
can you limit your risk. For option sellers, this is the reverse – they have unlimited
risk with limited profit potential.

So, why would anybody want to sell options? Because options are a decaying asset,
which you can read more about under the Time Decay section.

Insurance

Another reason investors may use options is for portfolio insurance. Option contracts
can give the risk averse investor a method to protect his/her downside risk in the
event of a stock market crash.

Put Options