Shiee Chimanbhai Patel institute of management & Reseaich Page
Futures and Options on Futures
History 1he 1 sL exchanges were organlzed ln Chlcago because Lhe MldwesL was a ma[or producer of agrlculLural producLs and Lhus Chlcago was a ma[or cenLer for Lradlng agrlculLural producLs and many processlng planLs and warehouses for agrlculLural producLs were locaLed Lhere 1he Ch|cago 8oard of 1rade (C8C1) was Lhe 1 sL organlzed exchange for graln 1he Ch|cago Mercant||e Lxchange (CML) sLarLed ln 1874 as Lhe Chlcago roduce Lxchange Lhen renamed lLself Lhe Chlcago 8uLLer and Lgg 8oard because LhaL was whaL was llsLed on Lhe exchange As Lhe number of commodlLles Lraded lncreasedlncludlng hldes onlons and poLaLoeslL was lnevlLable Lhe exchange would adopL lLs presenL more general name ln 1919 C8C1 and CML are ln Lhe process of merglngLhe comblned exchanges wlll be named Lhe CML Group luLures for frozen pork bellles began Lradlng ln 1961 Lhe 1 sL year fuLures on sLored meaL was Lraded Llve caLLle was added ln 1964 whlch was Lhe 1 sL
fuLures conLracL for llve anlmals ln 1972 Lhe CML lnLroduced flnanclal fuLures LhaL conslsLed of 8 currency fuLures 1he 1 sL cashseLLled fuLures conLracLCML Lurodollarwas lnLroduced ln 1981 1he esLabllshmenL of cash seLLlemenL raLher Lhan physlcal dellvery allowed Lhe fuLures markeL Lo expand lnLo producLs LhaL elLher can'L be dellvered or would be dlfflculL Lo dellver physlcally such as fuLures based on sLock lndexes such as Lhe S 300 sLock lndex LhaL was lnLroduced ln 1982 Cfferlng cashseLLled fuLures ls slmply ellmlnaLlng Lhe unnecessary componenL of physlcal dellvery for mosL Lraders whlle provldlng Lhe 2 lmporLanL quallLles of fuLures Lhe ablllLy Lo hedge porLfollos and Lo proflL from speculaLlon 1oday lLs dlverslLy of producLs lncludes agrlculLural commodlLles forelgn exchange producLs lnLeresL raLe producLs equlLy producLs largely based on ma[or lndexes a|ternat|ve |nvestment products whlch lncludes energy weaLher economlc derlvaLlves and houslng lndex producLs and 1kAkkS (1ota| keturn Asset Contracts) whlch are based on commodlLles euro currency and gold for lnsLance Shiee Chimanbhai Patel institute of management & Reseaich Page
#egulation 1he fuLures markeL ls regulaLed ln Lhe unlLed SLaLes by Lhe Secur|t|es and Lxchange Comm|ss|on (SLC) Lhe Commod|ty Iutures 1rad|ng Comm|ss|on (CI1C) Lhe Nat|ona| Iutures Assoc|at|on (NIA) and by Lhe exchanges Lhemselves 1he Cl1C creaLed by Lhe Commod|ty Iutures 1rad|ng Comm|ss|on Act of 1974 ls a federal agency LhaL regulaLes all fuLures Lradlng ln Lhe unlLed SLaLes and oversees Lhe nlA 1he exchanges musL obLaln approval for any regulaLory changes and for Lhe lnLroducLlon of any new fuLures or opLlons on fuLures All fuLures exchanges musL have Lradlng rules conLracLs and dlsclpllnary procedures approved by Lhe Cl1C 1he nlA a selfregulaLory agency creaLed by Sect|on 17 of Lhe Commod|ty Lxchange Act of 1981 regulaLes Lhe acLlvlLles of lLs members whlch lncludes any brokers Lradlng fuLures and Lhelr agenLs nlAs responslblllLles lnclude screenlng LesLlng and reglsLerlng persons applylng Lo conducL buslness ln Lhe fuLures lndusLry nlA and Lhe exchanges have responslblllLy for audlLlng and enforclng compllance wlLh lndusLry rules such as flnanclal requlremenLs segregaLlon of cusLomers funds accounLlng procedures sales acLlvlLles and floor Lradlng pracLlces Iutures Contract A fuLures conLracL's speclflcaLlon deLalls (also called contract specs) lnclude Lhe Lype quallLy and quanLlLy of Lhe underlylng asseL or commodlLy monLhs Lraded dally llmlLs mlnlmum Llck lncremenLs Lradlng hours and oLher deLalls unlque Lo each producL All conLracL specs can be found onllne aL Lhe exchange Lradlng Lhe conLracL 1he underlylng asseLs of fuLures conLracLs are agrlculLural commodlLles meLals and mlnerals energy such as oll and coal currencles and whaL are called flnanclal fuLures flxedlncome securlLles and sLock markeL lndexes llnanclal fuLures are by far Lhe largesL markeL for fuLures
Lxamp|e of contract deta||s for 2 butter futures and 1 opt|on on butter futures
Source Ch|cago Mercant||e 8ank Shiee Chimanbhai Patel institute of management & Reseaich Page
CML 8U11Lk IU1UkLS 1rade unlL 40000 pounds of Crade AA buLLer SeLLle MeLhod hyslcally dellvered olnL descrlpLlon 1 point $.0001 per pound $4.00 ConLracL Six months oI March, May, July, September, October, and December. LlsLlng CurrenL llsLlng roducL Code ClearingDB TickerDB 1radlng venue floors Pours 9:30 a.m. to 1:10 p.m. LTD (12:10 p.m. II the LTD is on a day that the market closes early, then the time is 11:10 a.m.) llsLed All llsLed monLhs llmlLs $0.05/lb, 500 pts, $2000 Expandable price limits, see Rule 1202.D Mlnlmum flucLuaLlons Regular 0.00025$10.00
Shiee Chimanbhai Patel institute of management & Reseaich Page
CML 8U11Lk C1ICNS
1rade unlL One Butter Futures Contract olnL uescrlpLlons 1 point $.0001 per pound $4.00 ConLracL Mar, May, Jul, Sep, Oct, Dec and Flex Options. LlsLlng Current Listings SLrlke rlce lnLerval Cents per pound at $0.02 intervals (i.e., 1.20, 1.22, 1.24) roducL Code ClearingDB TickerDB 1radlng venue Floor Pours 9:30 a.m.-1:12 p.m. LTD (12:10 p.m.) LlsLed All listed series SLrlke All listed intervals Mlnlmum llucLuaLlon Regular 0.00025$10.00
Cab 0.000125$5.00
Shiee Chimanbhai Patel institute of management & Reseaich Page
CML CashSett|ed 8utter Iutures 1rade unlL 20000 Llmes Lhe uSuA monLhly welghLed average prlce per pound ln Lhe uS for Crade AA 8uLLer SeLLle MeLhod Cash SeLLled olnL uescrlpLlons 1 polnL00023 per pound $300 ConLracL 12 consecuLlve calendar monLhs LlsLlng CurrenL LlsLlngs roducL Code ClearlngC8 1lckerC8 1radlng venue CML Clobex Pours 930 am110 pm (1210 pm L1u) LlmlLs $03 per pound expanded Lo $10 per pound afLer one day llmlL move no llmlLs durlng lasL 3 days of Lhe explrlng conLracL monLh Mlnlmum llucLuaLlon 8egular 000023$300
Shiee Chimanbhai Patel institute of management & Reseaich Page
ll u 1nlNk 1nl5 u414 l5 u5luL u M4Y lNcLuu l15 uP1O u Cpt|on Markets CpLlon and fuLure conLracLs are boLh derlvaLlve securlLles whlch play a large and lncreaslngly lmporLanL role ln flnanclal markeLs 1hese are securlLles whose prlces are deLermlned by or derlve from" Lhe prlces of oLher securlLles 1hese asseLs are also called conLlgenL clalms because Lhelr payoffs are conLlgenL on Lhe prlces of oLher securlLles 1radlng of sLandardlsed opLlons conLracLs on a naLlonal exchange sLarLed ln 1973 when Lhe Chlcago 8oard CpLlon Lxchange (C8CL) began llsLlng call opLlons 1hese conLracLs were almosL lmmedlaLely a greaL success crowdlng ouL Lhe prevlously exlsLlng overLhecounLer Lradlng ln sLock opLlons CpLlon conLracLs are Lraded now on several exchanges 1hey are wrlLLen ln commen sLocks sLock lndexes forelgn exchange agrlculLure commodlLles preclous meLals and lnLeresL raLe fuLures 1he Cpt|on Contract A call opLlon glves lLs holder Lhe rlghL Lo purchase an asseL for a speclfled prlce called Lhe exerclse or sLrlke prlce on or before some speclfled explraLlon daLe 1he holder of Lhe call ls noL requlred Lo exerclse Lhe opLlon 1he holder wlll choose Lo exerclse only lf Lhe markeL value of Lhe asseL Lo be purchased Lo be exceeds Lhe exerclse prlce
CpLlon And fuLure ConLracLs are boLh derlvaLlve securlLles Shiee Chimanbhai Patel institute of management & Reseaich Page
$tock options give the option holder the right, but not the obligation, to buy or sell particular stocks Ior a particular price, called the strike price, within a speciIied time. Options (also called contingent claims) are derivatives, so called because their value derives Irom other securities (called the underlying security, or just underlying or underlier), which in the case oI stock options are particular stocks. They are used extensively Ior hedging because options allow an investor to protect a position Ior a small cost, and speculators like them because their proIit potential is much greater than the underlying securities. Besides common stock, there are also options Ior stock indexes, Ioreign exchange, agricultural commodities, precious metals, and interest rate Iutures. Although options were originally traded in the over-the-counter (OTC) market, where the terms oI the contract were customized or negotiated, option trading really took oII when the Iirst option exchange, the Chicago Board Options Exchange (CBOE) was organized in 1973 to trade standardized contracts, which greatly increased the market and liquidity oI options. Options trading began on April 26, 1973, with 1.1 million contracts traded that year. Trading volumes have increased substantially since then: O 1981: 100 million O 2004: 1 billion O 2006: 2 billion everage is the Fundamental Advantage of Options everage is the Iundamental advantage oI options. A small investment can beneIit Irom the price movements oI securities that would either cost much more to own outright, or would require a much greater risk. For instance, to buy 100 shares oI a $50 stock would require a $5,000 investment, but to buy 1 call contract Ior 100 shares oI that same stock at $5 per share would require a $500 investment. It is because oI leverage that options are excellent Iinancial instruments Ior hedging a long or short position, or Ior pure speculation. OI course, options have a downside; otherwise, why would anyone bother buying the underlying security. Although the risk is limited to the premium Ior the option holder, the disadvantage oI buying options is that they can expire completely worthless, and oIten will. II the stock price does not move suIIiciently in the right direction beIore the expiration date, then the investor loses the entire investment. Example-The Profit Advantage of Options, and the #isk On October 6, 2006, an April 2007 call to buy MicrosoIt stock Ior the price oI $30 (October 6, 2006 stock price: $27.87) was selling Ior .80 per share. Thus, 1 call contract to buy 100 shares oI MicrosoIt stock would cost $8.00. To buy 100 shares oI MicrosoIt stock would cost $2,787.00! Since MicrosoIt is coming out with OIIice 2007 and Windows Vista, let's say the price rises to $40 per share by April, 2007. The call contract would allow the holder to buy 100 shares oI MicrosoIt stock Ior $30, which could then be sold Ior $40 in the market. That's a proIit oI $10 per share, or $1,000 per call contract, which equals 12,500 ($1,000/$8), over the original investment oI $8 Ior the call contract, in the span oI about 6 months. It would be virtually impossible to even approach getting the same return on investment buying the stock itselI! An investor who bought the stock instead oI the call would have a proIit oI only 144 ($40/$27.87) in the same time period. OI course, iI MicrosoIt's stock price didn't increase Shiee Chimanbhai Patel institute of management & Reseaich Page 8
above $30 per share by the expiration date in April, 2007, then the call contract would expire completely worthless, while the stock holder would still have the stock, and could receive dividends on it. In Iact, according to the Options Clearing Corporation), about 30 oI all options expire worthless every month. The Option Contract Option Contract O &nderlying Security O Call or Put O American or European Style O Strike Price O Expiration Date O umber oI Shares (or other Multiplier usually 100) The elements oI a standardized option contract speciIies whether it is a put or call, its style as to when the option can be exercised, the underlying security, the number oI shares oI the underlying security Ior each contract, which is almost always 100 shares Ior equity options, the strike price, and the expiration date. Calls and puts are the 2 types of options. A call gives the holder the right, but not the obligation, to buy a speciIic security Ior a set price, called the strike or exercise price. A put gives the holder the right, but not the obligation, to sell a particular security Ior the strike price. Depending on the price oI the underlying security, option strike prices are set at $2.50, $5 or $10 intervals, and most options are created and traded with price increments a little above and a little below the current market price oI the underlying security. II the price oI the underlying security moves substantially beIore expiration dates, then new options are created with strike prices closer to the new market price oI the underlying security. The older contracts are then exercised, closed out, or leIt to expire. There are 3 styles oI options that diIIer as to when the option can be exercised. American options allow the holder to exercise the option at any time beIore expiration, whereas European options allow the holder to exercise only Ior a short time beIore the expiration date. All equity options are American-style options, but most Ioreign currency options and CBOE stock index options are European-style options. ote that, although European-style options can only be exercised during a brieI time right beIore expiration, the options can be sold beIore then. Most options that require a cash settlement instead oI the delivery oI securities are European-style options, because it makes no sense to exercise an option Ior cash when it can simply be sold Ior cash. The capped-style option can only be exercised Ior a speciIic time beIore expiration, unless the underlying security reaches the cap price, in which case, the capped-style option is exercised automatically. This cap limits the proIit potential oI the option Ior the holder and the risk Ior the option writer. Shiee Chimanbhai Patel institute of management & Reseaich Page 9
A standardized option contract is always Ior 100 shares oI the underlying security, unless it is adjusted Ior a stock split, or some other event that would aIIect the relationship oI the option to the underlying security. Options always expire on the Saturday Iollowing the 3 rd Friday oI the expiration month, although they must be exercised by the Friday beIore expiration since that is the last trading day. There are at least 2 near-term options which expire in the nearest 2 months, and there are 2 long-term options. When the current month's options expire, then more are created that expire in the month aIter the next. Example: when January options expire, then more options are created that expire in March, so that the 2 near-term options will expire in February and March. The expiration dates oI long-term options are based on speciIic sequences. The exact months oI expiration are based on 3 diIIerent sequential cycles: the 1anuary $equential Cycle, the February $equential Cycle, and the March $equential Cycle. For larger companies and major indexes Ior which there is a signiIicant market demand, there are also EAP$ (ong- Term Equity AnticiPation $ecurities), which are special options that initially have expiration dates several years into the Iuture, and always expire in January. Generally, there are 2 series oI LEAPS that expire in the 2 January's Iollowing the long-term options.
Futures and Options on Futures Shiee Chimanbhai Patel institute of management & Reseaich Page
Farming is a risky venture. A lot oI money, time, and eIIort is needed to produce Iarm products, with many risks, such as weather or price Iluctuations in the market, which can result in high or low prices in the spot market (aka cash market), which is the market where the buyer pays cash to the seller Ior the immediate delivery oI the commodity. Since the Iarmer can only sell in the spot market when the product is ready Ior delivery, there is no way to know beIorehand what the price will be, and the same is true Ior the buyerboth have price risk. The spot market is a zero-sum tradeiI prices are too high or too low, either the buyer or the seller proIits at the expense oI the other. Thus, iI grain prices rise, Iarmers beneIit, but millers suIIer because they have to pay higher prices Ior their grain. II prices Iall, then Iarmers suIIer, but millers beneIit. Forward contracts became common in the 1800's to protect both the buyer and the seller by agreeing to a set price ahead oI time. A forward contract (sometimes called a cash forward sale) is a contract to supply a commodity at a given date Ior a speciIied price. o money is paid until the date oI delivery. BeIore the organized exchanges, Iorward contracts were signed where Iarmers happened to be selling their goods, such as Iarmer`s markets, public squares, and street curbs. But there were 3 main problems with individual Iorward contracts: 1. there was a risk oI deIault by the other party, especially iI prices were either extremely high or low by the delivery date, which negated the main value oI a Iorward contractprice certainty; 2. the only way to legally terminate a contract was by mutual agreement, which would be unlikely when the market price was signiIicantly diIIerent Irom the delivery price; 3. there was no easy way to resell the contract, because it had customized terms that speciIically suited the seller and buyerhence, Iorward contracts were highly illiquid. Eventually, organized exchanges developed that solved these basic problems. To lower the risk oI deIault, the exchanges required that money be deposited with a 3 rd party to ensure the perIormance oI the contract. The exchanges also standardized the contracts by stipulating the types oI contracts that they would sell, including its terms. Standardized contracts were easier to sell or to oIIset with another contract that eliminated the liability oI the original contract. Standard speciIications include the amount oI the commodity, the grade, and delivery dates. These standard Iorward contracts were called futures, and the exchanges developed listings Ior these contracts that greatly increased their liquidity. More recently, Iutures were created based on assets completely diIIerent Irom agricultural products, such as stock indexes, interest rates, and even the weather, and provided more investment opportunities Ior many more investors. They became great tools to hedge portIolios or to simply proIit Irom speculation. The buyers and sellers oI Iutures can be classiIied as hedgers or speculators. Hedgers use Iutures to minimize risk, like the Iarmers who use Iutures to guarantee a price Ior their product, or a miller who wants a set price Ior grain when it is harvested. Futures can also be used to hedge investment portIolios. Thus, Iutures is a signiIicant means oI price risk transfertransIerring price risk to someone with an opposite risk, or to a speculator who is willing to accept risk to make a proIit. Shiee Chimanbhai Patel institute of management & Reseaich Page
$peculators use Iutures to make a proIit, by buying low and selling high (not necessarily in that order). The speculator has no intention oI making or taking delivery. A speculator is making a bet on the future price of a commodity. II he thinks the price oI the commodity will drop, he takes a short position by selling a Iutures contract. II he thinks that the price oI the commodity will increase, then he takes a long position by buying a Iutures contract. Later, he will close out his position by oIIsetting the contract. II he sold short, he will buy back the contract, and iI he bought long, then he will sell the contract. Short's ProIit/Loss
Long's Loss/ProIit The buying and selling oI Iutures contracts is a zero sum gain, because it is basically a contract between 2 traders. It is not an investment in a company that creates wealth, where every shareholder can winor lose. II the short side proIits, the long side loses an equal amount, and vice versa. The number oI assets on which Iutures are based has greatly increased. In Iact, most Iutures contracts today are Iinancial Iutures, which have nothing to do with Iarming or agricultural products, and Iutures continue to expand in diversity.
Llnks used hLLp//LhlsmaLLercom/money/fuLures/fuLureshLm
Shiee Chimanbhai Patel institute of management & Reseaich Page