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TRADE TYPES
Hedging
Hedging programs are used by individuals and companies who want protection against adverse price moves which would affect the cash commodities in which they deal.The Short Hedge
In a short hedging program, futures are sold. This strategy is used by traders who either own the underlying commodity or are in some way subject to losses if its price declines.
The Long Hedge
Suppose the miller knows in July that in September he will buy 10,000 bushels of wheat from a grain elevator operator for grinding into flour He worries that wheat prices will rise in the meantime because he has already guaranteed a price at which to sell flour to a baker in October. Because he does not have the wheat now, he is considered to be "short the actuals" or "short the cash market." Therefore, to hedge this risk in the futures market, he can buy two wheat futures contracts (each represents 5.000 bushels). In September the cash price of wheat rises, the value of his futures contracts will rise too. The profit on the futures "leg" of his hedge will be earned by selling the futures at a higher price than he paid when he initiated the position, and will offset the extra money he must pay the grain elevator operator for the wheat.
The Relationship Between the Hedger and the Speculator
Unlike the hedger, the speculator usually has no contact with the underlying commodity; he has no natural long or short position as in the case of the hedger. He is in the market to make profits by buying low and selling high. Speculators are very important to a market. They make it more liquid and often take the opposite side of hedgers' trades. In this way. they act as a type of insurance underwriter by bearing the risk which hedgers seek to avoid.Spreads
Much of the non-hedging activity in the futures markets involves spread trades (also called straddles). These strategies generally carry less risk than outright long or short positions; hence, they usually have lower margin requirements. Spreads involve the simultaneous buying and selling of futures contracts with different characteristics.Compared to speculators, traders who put on spreads tend to make limited profits; they also suffer milder losses and likely enjoy a better night's sleep.
TAKING DELIEVERY
You may wonder what happens if a trader forgets to close out a long position. If he bought live hog futures, will someone deliver 40,000 pounds worth of squealing porkers to his back door the morning after his contract expires?
Sorry, but no.
Brokerage firms watch their open accounts and know who has long or short positions in contracts nearing maturity. Prior to delivery day, they inform customers who have open long positions that they must either close out the position or prepare to take delivery and pay the full value of the underlying contract. By the same token traders with short positions are informed that they must close out their trades or prepare to deliver the underlying commodity. In this case, they must have the required quantity and quality of the deliverable commodity on hand.
On the few occasions that a buyer accepts delivery against his futures contract, he is usually not given the underlying commodity itself (except in the case of financials), but rather a receipt entitling him to fetch the hogs, wheat, or corn from warehouses or distribution points.
Food processors or manufacturers who use futures to hedge rarely take delivery because the deliverable grade on the contract may not be exactly what they need. Hence, they will close out their futures position before delivery and buy in the cash market instead.
Sometimes merchants and dealers accept delivery because they can find buyers for many grades and types of the underlying commodity.
FUTURES OPTIONS
Options on futures began trading in 1983. Today, puts and calls on agricultural, metal, and financial (foreign currency, interest-rate and stock index) futures are traded by open outcry in designated pits. These options pits are usually located near those where the underlying futures trade. Many of the features that apply to stock options apply to futures options.
An option's price, its premium, tracks the price of its underlying futures contract which, in turn, tracks the price of the underlying cash. Therefore, the March T-bond option premium tracks the March T-bond futures price. The December S&P 500 index option follows the December S&P 500 index futures. The May soybean option tracks the May soybean futures contract. Because option prices track futures prices, speculators can use them to take advantage of price changes in the underlying commodity, and hedgers can protect their cash positions with them. Speculators can take outright positions in options. Options can also be used in hedging strategies with futures and cash positions.
Futures options have some unique features and a set of jargon all their own.
Puts, Calls, Strikes, etc.
Futures offer the trader two basic choices - buying or selling a contract. Options offer four choices - buying or writing (selling) a call or put. Whereas the futures buyer and seller both assume obligations, the option writer sells certain rights to the option buyer.A call grants the buyer the right to buy the underlying futures contract at a fixed price the strike price. A put grants the buyer the right to sell the underlying futures contract at a particular strike price. The call and put writers grant the buyers these rights in return for premium payments which they receive up front.
The buyer of a call is bullish on the underlying futures; the buyer of a put is bearish. The call writer (the term used for the seller of options) feels the underlying futures' price will stay the same or fall; the put writer thinks it will stay the same or rise.
Both puts and calls have finite lives and expire prior to the underlying futures contract.
The price of the option, its premium, represents a small percentage of the underlying value of the futures contract. In a moment, we look at what determines premium values. For now, keep in mind that an option's premium moves along with the price of the underlying futures. This movement is the source of profits and losses for option traders.
Who wins? Who loses?
The buyer of an option can profit greatly if his view is correct and the market continues to rise or fall in the direction he expected. If he is wrong, he cannot lose any more money than the premium he paid up front to the option writer. ,P> Most buyers never exercise their option positions, but liquidate them instead. First of all, they may not want to be in the futures market, since they risk losing a few points before reversing their futures position or putting on a spread. Second, It is often more profitable to reverse an option that still has some time before expiration.Option Prices
An option's price, its premium, depends on three things: (1) the relationship and distance between the futures price and the strike price; (2) the time to maturity of the option; and (3) the volatility of the underlying futures contract.The Put
Puts are more or less the mirror image of calls. The put buyer expects the price to go down. Therefore, he pays a premium in the hope that the futures price will drop. If it does, he has two choices: (1) He can close out his long put position at a profit since it will be more valuable; or (2) he can exercise and obtain a profitable short position in the futures contract since the strike price will be higher than the prevailing futures price.REGULATION
Through the control offered by the exchanges, and government regulation, trading in the commodities markets does offer some limited protection from manipulation. The use of prudent orders does also offer some protection from loss.
The Short Futures Position
This simply means taking a short position in the hope that the futures price will go down. There is nothing to borrow and return when you take a short position since delivery, if it ever takes place, doesn't become an issue until some time in the future.Limit and Stop-Loss Orders
"Limit orders" are common in the futures markets. In such cases, the customer instructs the broker to buy or sell only if the price of the contract he is holding, or wishes to hold, reaches a certain point. Limit orders are usually considered good only during a specific trading session, but they may also be marked "G.T.C." good till canceled.Maximum Daily Price Moves
Sometimes futures prices in certain markets will move sharply in one direction or the other following very important news extremely bad weather in a growing area or a political upheaval, for instance. To provide for more orderly markets, the exchanges have definite daily trading limits on most contracts.Most futures exchanges use formulas to increase a contract's daily trading limit if that limit has been reached for a specific number of consecutive trading days. Also. in some markets, trading limits are removed prior to expiration of the nearby futures contract. For other contracts, including stock index and foreign currency futures, no trading limits exist.
The Commodity Exchange Act
Trading in futures is regulated by the Commodity Futures Trading Commission, an independent agency of the United States government. The CFTC administers and enforces the Commodity Exchange Act.
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