Introduction to

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Introduction to Futures and Options Contracts
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www.dairy.nu
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Outline

• Futures Contracts
• Basic Concepts
• Characteristics of Market Participants
• Futures Exchanges
• Open-Outcry vs Electronic Trading
• The Trading Process
• Margins
• Options on Futures
• Terminology
• Option Volatility

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What is a Futures Contract?
An obligation to buy, sell, or cash-settle a
commodity that meets set grades and standards on
some future date. Futures contracts are
standardized based on Commodity What is being
traded including grade and quality
specifications Contract month When the contract
will expire open contracts must be
delivered or cash- settled Quantity The
size of one contract pounds, bushels,
barrels, etc.
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Examples of Futures Contracts
Corn
Commodity Number 2 yellow corn Contract
month Nov, Dec, Jan, Mar, May, Jul, Sep
Quantity 5,000 bushels
Milk
Commodity Class III fluid milk Contract
month All months available Quantity 200,000
pounds
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What About Price?
The price of a futures contract is determined
through a competitive auction.
BUY!!
SELL!!
vs.
Someone who wants to buy the commodity will bid
Someone who wants to sell the commodity will offer
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Who trades commodities?

• Hedgers
• Produce or use the commodity traded
• Utilize futures contracts to manage price risk
• Speculators
• Trade solely for profit
• Add liquidity to the market

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Buyers and Sellers

• Buyers and sellers meet two different ways
• In person, on an exchange trading floor
• The open outcry system still accounts for the
  majority of domestic futures volume
• Electronically
• Increasingly popular, especially in foreign
  countries

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Futures Exchanges
Futures exchanges are organized gatherings of
buyers and sellers. Futures exchanges are located
throughout the United States and the world. A
few examples
Chicago Mercantile Exchange Chicago Board of
Trade Tokyo Grain Exchange London International
Financial Futures and Options Exchange
Chicago Mercantile Exchange
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Futures Exchanges
Each commodity has its own trading pit on the
exchange floor where buyers and sellers meet.
Traders on the floor of the Chicago Mercantile
Exchange
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Futures Exchanges
Traders in the pits use voice or hand signals to
bid, offer, and trade commodity contracts
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Electronic Trading
Below is an example of an electronic trading
platform screen.
Many CME contracts are traded both in trading
pits and on the GLOBEX platform (right).
GLOBEX terminal
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Electronic Trading

• Similar to open-outcry trading, except
• Bids and offers are posted electronically
• An order-matching system executes trades
• Electronic trading dominates in Europe and is
  rapidly gaining popularity in the U.S.
• Eurex Fully electronic
• CME Electronic (GLOBEX) and open outcry
• CBOT Electronic (a/c/e) and open outcry

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Most CME contracts are still traded by open-outcry
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Where Do I Begin?

• Establish a hedging account with a broker.
• Brokers place buy and sell orders for their
  customers.
• A fee, or commission, is charged for this
  service.
• Your broker may also
• Help you open your account
• Provide advice on appropriate trading strategies
• Answer your questions about futures trading

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How Do I Trade a Futures Contract?

• Call your broker and place an order
• The broker routes your order to the trading pit
  via the brokerage firms central order desk
• A floor broker executes the trade
• Your broker calls you back to confirm your order
  has been filled

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Margins
You have taken a position in the futures market.
Now what? Initial margin funds must be posted for
each contract bought or sold. Since futures
contracts are simply an agreement to buy or sell
something at a future date, no cash changes hands
when the position is opened. Instead, a
good-faith deposit must be made to guarantee
performance.
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Class III/IV Margins

• Initial margin deposit made when position is
  entered, 800/contract for hedgers
• Maintenance margin minimum balance that must
  remain in the account, 800/contract
• Exchanges set minimum margins for each commodity
  based on historical volatility and expected
  market conditions
• Margin funds may be withdrawn when the hedge is
  exited

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Margins
Margin accounts are marked to market each day
to reflect changes in position value.
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Margin Example
On March 7, a dairy producer sold one Class III
contract at 12.20 and an end-user purchased an
identical contract
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The Clearing House

• For each matched trade, the exchanges Clearing
  House
• Is substituted as the buyer to the seller
• Is substituted as the seller to the buyer
• Eliminates counter-party credit risk (the
  clearing house guarantees performance)
• Futures positions can be offset by executing an
  equal but opposite transaction with anyone, not
  necessarily the original party

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The Clearing House

• The Clearing House is made up of brokerage firms
  that are clearing members.
• In the case of a customer default, financial
  liability rests with
• The customers margin money/equity
• The customers clearing member firm
• All clearing member firms
• The exchange
• No clearing firm has ever defaulted on its
  financial obligations.

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Options on Futures

• Options are the right, but not the obligation, to
  buy or sell a futures contract at a specified
  price.
• Call Option The right to buy futures at a
  predetermined price
• Put Option The right to sell futures at a
  predetermined price
• For every option buyer, there must be a seller.

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Options on Futures

• Option buyers
• Receive price insurance
• Protect against rising or falling prices
• Must pay a premium
• Risk limited to the premium paid (plus
  commissions and fees)
• Option Sellers
• Collect the premium
• Are obligated to take the opposite side of a
  futures trade if the buyer chooses
• Risk unlimited (unless position is covered with
  futures, another option, or the cash commodity)

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Option Example
July Class III Milk 12.50 put
Commodity
Put/Call
Month
Strike Price
Buyer Has the right to sell one July Class III
contract at 12.50 Seller Has the obligation to
buy one July Class III contract at 12.50 if the
owner of the put chooses to exercise it
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Options Terminology
Intrinsic value The value of the option if it
were exercised today Time value The remainder of
the option premium Date April 10 August
futures price 13.20
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Options Terminology
At-the-money option Option strike price is
identical to the price of the futures
contract In-the-money option An option with
intrinsic value Out-of-the-money option An
option with no intrinsic value (only time
value) In-the-money call Futures price is
currently above option strike price In-the-money
put Futures price is currently below option
strike price
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Margins on Options

• Buyers
• Pay entire option premium up front
• No margin calls
• Sellers
• Margin will vary
• Based on risk characteristics of the option
• Never exceeds the futures margin

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Option Valuation

• The 4 primary factors that impact the price of an
  option
• Option strike price
• In-the-money vs. Out-of-the-money
• 2. Current underlying price
• 3. Time until option expiration
• 4. Volatility of the underlying

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What is Volatility?
The degree to which prices fluctuate over
time The price of the underlying, not the price
of the option itself! Measured as the standard
deviation of daily price changes
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Types of Volatility
Historical Based on daily data from past trading
days Implied Use quoted option price to back
out volatility (markets estimate of future
volatility) Future volatility is the key to
option value! The more volatile the underlying
commodity is expected to be, the more an option
is worth. Historical volatility is a guide to
what future volatility may be.