The language of futures markets and options

6 Pages·0.097 MB·English

by  John Cottingham, Robert Cropp and Randy Fortenbery.

A2913
The language of
futures markets and options
John Cottingham, Robert Cropp and Randy Fortenbery
Farm product prices have experi- How did futures The Chicago Mercantile Exchange
enced increased volatility in recent also began as a cash exchange, and
and options
years as the federal government has has gained prominence by develop-
reduced income and price supports. develop? ing futures contracts for live cattle,
The Federal Agriculture Improvement Organized trading in commodity live hogs and frozen pork bellies.
and Reform Act of 1996, or the 1996 futures in the United States dates The growing Mid-America
Farm Bill, will reduce or eliminate back more than 100 years. This type Commodities Exchange, also
price and income support programs of trading also exists in several located in Chicago, offers contracts
by 2002. other countries. Buying and selling similar to those on the CBT and
To reduce the risks from fluctuating on these markets developed to help CME but with smaller trading units.
prices, more farmers and agribusi- protect producers and agribusiness Futures and options trading on
ness firms are considering alterna- firms from future price fluctuations. cheddar cheese and nonfat dry milk
began in June 1993 on the New York
tives such as futures markets and There are 12 commodity exchanges
Coffee, Sugar, & Cocoa Exchange.
options. in the United States where traders
Both the CSCE and the CME now
Farmers face two types of risk: buy and sell futures contracts for
offer Grade Araw milk and butter
physical (crop failure) and market products ranging from agricultural
contracts.
(price changes). Production risks commodities to metals to petroleum
from weather, pests and disease are products to interest rate and cur- The volume (number of contracts)
an accepted part of farming, and rency contracts. and value of futures trading has
grown continually for the last
many farmers insure against them. Four exchanges trade products that
decade. Increased price stability and
But tighter profit margins and price are especially relevant to Midwestern
government price supports would
fluctuations in recent years have agriculture. These are:
reduce futures trading volume
increased the amount of market risk.
1) the Chicago Board of Trade
because farmers would have less
Because insurance companies don(cid:213)t
(CBT);
need to reduce market risk.
cover market risk, both farmers and
2) the Chicago Mercantile However, the government(cid:213)s current
the financial institutions that
Exchange (CME); market-oriented policies have
provide their loans are seeking mar-
reduced price protection and public
keting strategies to reduce it. Three 3) the Mid-America Commodities
dollars for farm programs, upping
tools they can use are: Exchange (MACE); and
farmers(cid:213) risk and generating interest
1) cash forward contracts; 4) the New York Coffee, Sugar, &
in these forward pricing alternatives.
Cocoa Exchange (CSCE).
2) hedging on the futures market;
and The oldest and largest of these
exchanges is the Chicago Board of
3) options.
Trade. Cash commodities trading
This publication discusses how
began on the CBT in 1848, and
futures and options developed,
futures trading began in 1865. This
their language and their value to
exchange is especially important in
traders.
trading wheat, corn, oats and soy-
beans.
T H E L A N G U A G E O F F U T U R E S M A R K E T S & O P T I O N S ________________
Language of the matures. Contracts standardize open contracts. In the case of
everything about the specified BFPcontracts, the delivery
futures markets
commodity, delivery month and month occurs when the contract
This section explains some of the place except for price, which is is cash settled. The contracts
important terms and vocabulary determined through trading. require delivery during desig-
used in the futures markets. However, the Basic Formula nated periods and usually at
Cash, or spot, market:Amarket Price (BFP) futures contracts, specified locations.
where commodities are deliv- offered for fluid milk by the Grain delivery months are influ-
ered and paid for immediately. CSCE, are cash settled and do enced mostly by planting,
Its purpose is to fulfill the imme- not have a delivery commitment growing, harvest and storage
diate needs of buyers and sellers. because delivery points vary. conditions. However, designated
Trades made on the exchange
Cash forward sale,or forward delivery months change along
floor determine prices. Trading
contract:Acontract where a com- with changing trade patterns.
involves open outcry in a pit on
modity is sold on the cash market Below are some examples of
the exchange(cid:213)s trading floor
but actual delivery is scheduled current delivery months for
during prescribed hours.
for a future date. Most forward selected commodities.
contracts are offered by food Standard contract quantities:The
processors and purchasers of farm standard quantity specified in Commodity Delivery months
commodities because they need a each futures contract. For Cattle—Live Feb., Apr., June,
reliable product supply and want example, the standard contract (CME) Aug., Oct., Dec.
to protect their input cost. Such a quantity for corn on the CBT is
Corn Mar., May, July,
contract can also act as a market 5,000 bushels. For cattle on the (CBT) Sept., Dec.
price risk management service to CME, it is 40,000 pounds. For the
producers. BFPcontracts, the quantity is BFPcash The current calendar
settle milk month, the next two
100,000 pounds of raw milk.
Futures market: Amarket where (CSCE) months and each
futures contracts are traded. Contract grade: The standard Feb., Apr., Jun., Aug.,
Clearing corporation:An grade of a commodity specified Oct., Dec.
in a futures contract. The U.S.
exchange associated entity
Department of Agriculture
responsible for settling futures Hedge/hedging: The purchase or
(USDA) sets the standards for
and options transactions. sale of futures and/or options
assigning grades such as USDA
contracts to protect against unfa-
Futures commission merchant
choice steers or USDANo. 2
vorable price movements in
(FCM):Individuals, associations,
corn. The BFPcontract is for
physical markets.
partnerships and corporations
Grade Amilk with 3.5 percent
engaged in soliciting or in Hedger: Atrader who tries to
milkfat.
accepting orders for futures and transfer price risk by simultane-
The contract may allow more
options. ously trading equal but opposite
than one grade to be delivered
contracts in the cash and futures
Futures contract: The instrument
with a premium for higher
markets.
that is actually traded on the
grades or discount price for
futures market. The contract for Speculator:Atrader with interest
lower grades when the product
most commodities involves a in profiting from price changes
is actually delivered. Each com-
commitment to either accept or rather than actually owning the
modity exchange establishes the
deliver a specified quantity and commodity.
grade that will settle a futures
quality of a product at a speci- contract. Basis:The difference between a
fied time and place. Certain commodity(cid:213)s cash price and the
Delivery month: The month in
futures contracts no longer name price of a futures contract calling
which the futures contract
a delivery point. The actual for future delivery of the
expires and the physical com-
product does not change hands product. For example, on July 18
modity must be delivered on
until the contract comes due, or the cash price of No. 2 yellow
2
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corn in Central Illinois was $2.85 Weakened basis:The cash price Limit order: Order to buy or sell a
per bushel. On the same day, the decreases relative to the futures contract at a stated price or
December corn futures contract price, or the cash price increases better.
on the CBT opened at $2.96 per less than the futures price does.
Market order: Order to buy or sell
bushel. It is very common in the
Strengthened basis: The cash a contract at the ten-best avail-
grain trade to express basis as:
price increases relative to the able price.
CASH (MINUS) FUTURE
futures price, or the cash price
Stop order: An order to buy or sell
($2.85 - $2.96 = -$0.11). Thus, in a
decreases less than the futures
contracts at the market once a
normal market for grain, the
price does.
certain price level is reached.
basis would be negative,
Inverted market: The market situ- Often referred to as a (cid:210)stop loss(cid:211)
meaning the cash price is less
ation in which futures contracts order.
than the futures price. The basis
for nearer months are selling for
for cheese and nonfat dry milk is Open position:Acontract that has
more than distant delivery
also negative, but the basis for been neither delivered upon nor
month contracts. In a normal
BFPcash settle milk is positive. offset.
market for commodities that
An understanding of basis is Offset, or cover:To close out or
require storage, contracts for
essential for both speculators offset a previous position by
distant delivery months sell for
who want to profit from price making an opposite transaction
more than contracts for nearer
fluctuations and hedgers who of an equal contract before the
months. However, extraordinary
simply want to transfer price original contract matures.
demand for delivery in nearby
risk. The basis for stable com- months can cause the unusual, In (cid:210)short coverage,(cid:211) a seller
modities measures storage, inter- inverted situation. (short) of a futures contract
est, insurance and transportation covers a position by purchasing
Arbitrage: The simultaneous pur-
costs. Government programs, a new, identical contract before
chase and sale of cash commodi-
export markets and growing the original matures. In (cid:210)long
ties or futures in the same or dif-
conditions also affect the basis. liquidation,(cid:211) a purchaser (long)
ferent markets to profit from
Historically, basis has been easier of a futures contract covers by
price differences. Aspeculator
to forecast than price. Experienced selling a contract before the orig-
referred to as a spreader will
hedgers know what the local inal matures.
monitor price changes among
basis will be at a given time of markets and attempt to profit Most futures traders are trying
the year. The risk-transfer possi- from the different prices. to either profit or transfer risk
bilities in a hedge require this rather than actually deliver or
Long: When the initial trade is the
initial assessment of the basis. receive the commodities.
purchaseof a futures contract, the
Basis risk: The risk that the final Therefore, traders settle fewer
buyer is (cid:210)long(cid:211) in the market.
basis will differ from the initial than one percent of all futures
The buyer haspurchaseda com-
estimated basis. The net outcome contracts by delivery; they cover
mitment to receive delivery of a
of a hedge (the difference them instead.
commodity.
between the result and the objec- Round turn: Acompleted futures
Short: When the initial trade is the
tive) is equal to the change in the transaction involving both a pur-
saleof a futures contract, the
basis. Hedging transfers market chase and a liquidating sale, or a
seller is said to be (cid:210)short(cid:211) in the
risk to basis risk. Since the basis sale followed by a covering pur-
market. The seller has solda
changes less than market prices, chase.
commitment to make delivery of
basis risk is less than market
a commodity. Broker:An agent who executes a
risk. This is how futures con-
futures contract or option order
tracts can help insure a farmer Good ‘til canceled order (GTC):
for the customer and charges a
against market fluctuations. Order to buy or sell contracts at
commission for the services.
a particular price that remains
valid until it is canceled or
expires.
3
T H E L A N G U A G E O F F U T U R E S M A R K E T S & O P T I O N S ________________
Commission: The broker(cid:213)s fee for Maintenance margin:An addi- Change:Change in settlement
executing a trade. In the com- tional margin the broker calls for price from the previous trading
modities market, commissions as the futures market price day.
are (cid:210)round-turn,(cid:211) entitling the moves in a direction that jeopar-
High:The peak price of the day
broker to buy and sell the cus- dizes the broker(cid:213)s position.
for one or more transactions.
tomer(cid:213)s contract. The customer Falling prices for a long (pur-
Open:The price for the first con-
pays the commission only once. chasing) position or rising prices
tract traded that day.
Brokerage firms can provide for a short (selling) position jeop-
information on current commis- ardize the broker(cid:213)s position. The Open interest:The total number
sions. trader must pay additional of the contracts on one side of
margin to restore the initial level the market which have not been
Initial margin: The amount of
of performance assurance. offset. If buyers and sellers hold
money buyers and sellers
Maintenance margins normally 1,000 contracts for a particular
deposit with the broker to ensure
run 60—85 percent of the original delivery month, the open inter-
performance on contract com-
margin. If the customer refuses est is 500 because half of the con-
mitments. This is like the earnest
or defaults, the broker will close tracts are on the long side, and
money in a real estate deal; it is
out the position at a loss to the half are on the short side. Since
intended to offset any losses
customer. contracts are all in standard
incurred if a contract is liqui-
volume units, the number of
dated. The margins are returned to the
long contracts must equal the
trader when the contract either
Margins normally range from
number of short contracts.
matures or is covered by an
2—20 percent of the contract(cid:213)s
opposite transaction. When the Lifetime high and low: The highest
value and are set by each futures
futures price movement favors and lowest transaction prices
exchange. They are based mostly
the trader, the broker returns the recorded from the first day the
on historic price fluctuations,
margin deposit plus the profits if contract was traded to the
and they are adequate whenever
the trader requests it. If the present.
the deposit can cover the proba-
ble price change. For example, if trader loses money with price Low: The lowest price of the day
corn is selling for $2.60, history movements, the broker deducts for one or more transactions.
it from the margin. The trader
shows that it will likely fall to Settlement price: The weighted
has to pay the loss if his/her
$2.30 or rise to $2.90. Thus, it average of contract prices nor-
contract does not recover before
would be unrealistic to require a mally measured during the last
settlement.
trader to deposit a 50 percent five minutes of trading. It is the
margin when the price only Marked-to-the-market: The official price used in determining
varies 10—12 percent. process of updating margin net gains or losses, margin
When a seller instructs a broker accounts each day to reflect price requirements, and the next day(cid:213)s
to sell a contract, the broker movement in the market. price limits.
makes the sale through another Bear:Aperson who believes that Volume: The number of pur-
broker who has a buyer cus- prices will decline. chases or sales of a futures con-
tomer. Neither broker knows the Bull:Aperson who believes that tract made during a specified
name of the other(cid:213)s customer, prices will rise. time period; often the total trans-
and each broker wants to protect actions on a given contract for
Futures market reporting terms:
the customer. This protection one trading day.
Terms used by daily newspapers
requires the brokers to deposit a
and other agencies to report on
margin in cash, and, in turn,
futures market prices.
each broker asks the customer to
deposit this margin.
4
______________________________________________________________________________________________________________________________________________
Language of the Corn (CBT)
options markets 5,000 bu.; cents per bu.
Strike Calls-Settle Puts-Settle
The terms below explain commonly
used terms in the options markets. Price Sep Dec Mar Sep Dec Mar
Option: The right, but not the oblig- 270 26 31 36 17(cid:218)8 53(cid:218)8 5
ation, to buy or sell a futures 280 181(cid:218)2 251(cid:218)4 29 43(cid:218)4 93(cid:218)8 9
contract at a specific price on or
290 133(cid:218)4 21 233(cid:218)4 91(cid:218)4 141(cid:218)8 131(cid:218)4
before an expiration date. :
300 93(cid:218)4 161(cid:218)2 187(cid:218)8 151(cid:218)2 20 19
There are two different types of
options(cid:209)putsand calls. These 310 63(cid:218)4 131(cid:218)2 151(cid:218)2 223(cid:218)4 261(cid:218)2 ....
are separate option contracts; for 320 47(cid:218)8 105(cid:218)8 121(cid:218)2 .... 333(cid:218)4 ....
each put buyer there is a put
Est vol 24,000 17,870 calls 12,741 puts
seller, and for each call buyer
Op Int Mon 237,929 calls 133,766 puts
there is a call seller. Puts and
calls provide a different opportu- Strike prices on the CBT corn premiums for puts (to sell a
nity to take advantage of futures futures contract are set by the futures contract) at higher strike
price moves without having a Board at 10¢ intervals with a prices because they are buying
futures position. probable 50¢ range of price more price insurance to protect
Put option: The right, but not the change, but you can trade above against falling prices. But, for
obligation, to sell (go short on) a or below the range. CME live- calls (to buy a futures contract),
futures contract during a speci- stock futures contracts are set by they pay larger premiums at
fied time period. The put ensures the Exchange at $1/cwt. inter- lower strike prices; they are
protection from falling prices for vals for live cattle with a range buying more price insurance to
people who want to sell. of $5 from low to high. protect against rising prices. The
Est volis the volume of options
Call option: The right, but not the Premium:The price the option
transacted in the previous two
obligation, to buy (go long on) a buyer pays to the option seller
trading sessions. Each unit repre-
futures contract during a speci- for each option contract. It repre-
sents both a buyer and a seller.
fied time period. The call ensures sents the maximum amount the
The Op Intis the number of
protection from rising prices for option holder can lose. The
options that were still open posi-
people who want to buy. premium is determined in the
tions at the end of the previous
option market by the willingness
Collar: An option combination day(cid:213)s trading session.
of buyers to purchase an option
involving the simultaneous pur-
sellers are willing to sell. The Exercise: The option buyer acts on
chase of a put and sale of a call
cost of a premium reflects his right to take futures position.
option.
market volatility, time until The call holder takes a long
Option writer, or grantor: A option expiration (time value), (buy) position on the futures
person who sells an option. and strike price level relative to contract, and the put holder
Option buyer,or holder:Aperson futures contract price level takes a short (sell) position.
who buys an option. The buyer (intrinsic value). Expiration date:The last day that
has the right, but not the obliga- The Wall Street Journal listing of an option may be exercised or
tion, to acquire a futures contract futures options prices for July 18 converted to a futures position.
position. provides an example above.
In-the-money:An option contract
Strike price,or exercise price: At a strike price of 280 ($2.80) for has a positive value if the buyer
The price at which the option corn, a put option buyer for exercises it because the current
holder (buyer) may buy or sell March would have paid a market price exceeds the strike
the underlying futures contract premium of 9¢ per bushel to the price of a call (to buy) or is
during the life of the option. option seller. Traders pay larger below the strike price of a put (to
5
T H E L A N G U A G E O F F U T U R E S M A R K E T S & O P T I O N S ________________
sell). For example, if a hog pro- The first objective in futures A(cid:210)spreader(cid:211) simultaneously pur-
ducer buys a $48 strike price July trading is to provide protection chases one futures contract and sells
put option for hogs and, in late from price fluctuations.The another for a different delivery
June, the July hog futures are trader tries to transfer price risk. month, in a different commodity, or
trading at $44, the option has This type of trader (a hedger), on a different exchange.
intrinsic value, or is in-the- simultaneously trades equal but
A(cid:210)scalper(cid:211) provides market liquid-
money. opposite transactions in the cash
ity by buying and selling rapidly for
and futures markets, hoping a loss
Out-of-the-money:The current small profits or losses. Ascalper will
in one market will be offset by a
market price is less than the usually buy at a fraction below the
gain in the other. The farmer or
strike price of a call or is greater last transaction price and sell at a
agribusiness firm is trying to reduce
than the strike price of a put. For fraction above.
the risk of fluctuating prices.
example, if a feedlot operator in
A(cid:210)pit trader(cid:211) operates like a
March buys a $2.80 strike price A second objective of futures
scalper, but pit traders take larger
July corn call option, and, in trading is to speculate.The
positions and hold them for a
mid-June, the July corn futures trader, a speculator, tries to profit
longer time and for larger price
are trading for $2.60, the option from changes in the price of futures
changes. They watch brokers and
is out-of-the-money. contracts. The speculator usually
try to anticipate the day(cid:213)s remaining
has no interest in physical owner-
At-the-money: The strike price is trades. This way the pit traders can
ship of the commodity. Speculators
the same as the underlying try to accommodate the trades and
are essential to the futures market
futures contract price. Options make a profit in the transaction.
because they assume the risk of
at-the-money or out-of-the-
Other speculators are outsiders that
price change and provide liquidity,
money are not worth exercising.
trade through brokers.
or the ability to convert the con-
How do traders tracts to cash, by buying and selling Aspeculator counting on rising
use futures and frequently. prices will buy a call or a long posi-
tion on a futures contract. Aspecula-
Any attempt to classify speculators
options?
tor who assumes declining prices
provides only a general overview
Traders use futures contracts and will buy a put or a short position on
because individual speculators
options to do one of two things: to a futures contract. If speculators limit
often have overlapping roles. The
protect themselves from price fluc- trading to options, the most they can
following types of speculators offer
tuations or to make money. lose is the option premiums.
an idea of speculators(cid:213) potential
roles in the futures market.
Authors:John Cottingham is a professor of agricultural economics with the University of Wisconsin—Platteville and a
marketing specialist with the Unviersity of Wisconsin-Extension, Cooperative Extension. Robert Cropp is a professor of agricultural
economics and applied economics with the University of Wisconsin—Madison and a dairy marketing specialist with the University of
Wisconsin—Extension, Cooperative Extension. Randy Fortenbery is an assistant professor of agricultural economics and applied eco-
nomics at the University of Wisconsin—Madison and a marketing specialist with the University of Wisconsin—Extension, Cooperative
Extension.
Editor: Molly Placke
Issued in furtherance of Cooperative Extension work, Acts of May 8 and June 30, 1914, in cooperation with the
U.S. Department of Agriculture, University of Wisconsin—Extension, Cooperative Extension. University of
Wisconsin—Extension provides equal opportunities in employment and programming, including Title IX and
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' 1997 by the Board of Regents of the University of Wisconsin System doing business as the division of
Cooperative Extension of the University of Wisconsin—Extension. Send inquiries about copyright permission to:
Director, Cooperative Extension Publishing, 201 Hiram Smith Hall, 1545 Observatory Dr., Madison, WI 53706.
You can obtain copies of this publication from your Wisconsin county Extension office or from Cooperative Extension Publications,
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A2913 The Language of Futures Markets and Options R-01-98-1.5M-100