Part 1: Trading futures - principles and practice
1 The history and evolution of futures exchanges
Forward contracts are not traded on a formalised exchange, but are customised on an individual needs basis and are privately negotiated. (p. 4)
2 How futures work
If, for example, Broker A had purchased a 5,000-bushel wheat contract from Broker B, and at later date Broker B had bought a 6,000-bushel wheat contract from Broker A, the two contracts could be offset at the settlement date if Broker B simply sold 1,000-bushel wheat contract to Broker A.
The hassles really kicked in, though, if Broker B had also sold a 1,000-bushel contract to Broker C, who had sold a 1000-bushel contract to Broker A. In this case, each broker bet position was offset, but all three had to meet in order to settle their obligations to one another. This was referred to as a ‘ring settlement’.
‘Transfer settlements’, in which brokers transferred their mutual obligations to other brokers in order to balance out their forward contract obligations, were also common. (p. 12)
3 Who trades futures and why
All futures contracts are based on an underlying physical instrument - a physical commodity such as wheat or gold, or a financial instrument such as an equity index, a currency or an interest rate. A future contract is an agreement between two parties to buy or sell a standardised quantity and quality of the underlying asset at a specified future date but at a price agreed on today.
The buyer of a futures contract is referred to as being ‘long’, which reflects their view that prices will increase. The seller of a futures contract is referred to as being ‘short’. (p. 16)
Figure 2.1 the offsetting process
BUY or SELL a futures contract to open a position > SELL back or BUY back the future contract prior to delivery date to close the position (p. 18)
Central counter party or clearing house
Over the counter (OTC) or bilateral: There is a chance that either party could face a credit or cash default that prevents them from meeting their obligations. An example of OTC market is the spot forex or FX market. (p. 22)
The clearing house charges two types of margin:
Initial margin when a trade is opened (also called a performance bond): security deposit required by the clearing house to ensure that traders have sufficient funds to meet any potential loss from a trade.
Variation or mark-to-market margin on open positions
If at any time your account dips below a specified maintenance level, you will be required to deposit more money to keep your account up to the initial margin requirement level. This us often referred to as a ‘margin call’. (p. 23)
Variation or maintenance margin, this is an amount of the initial margin that must be maintained for each position before a margin call will be issued and you will have to replenish your account with extra cash or close out the position.
Bid = buy
Ask = sell
Minimum price moves are called ‘ticks’. (p. 28)
Once a futures contract has increased or decreased in price by its daily limit, no more trading can take place until the next trading session, this is termed ‘lock-limit’
The daily price limits are eliminated during the contract expiry month (also called the delivery or spot month) (p. 29)
Unlike shares, which have an indefinite life so long as the company remains solvent and listed on the exchange, l futures contracts are terminal.
Short hedge
Figure 3.1 results of short hedge when price declines
Sell six soybean futures (30,000 bushels) at $9.50 per bushel: $285,000
Buy back six soybean futures at $8.50 per bushel: $255,000
Gain on futures position: $30,000
Deliver 30,000 bushels of soybeans at prevailing cash price of $8.50: $250,000
Total return = ($250,000 cash received - $30,000 profit from futures hedge): $285,000
Figure 3.2 results of short hedge when price increases
Sell six soybean futures (30,000 bushels) at $9.50 per bushel: $285,000
Buy back six soybean futures at $10.50 per bushel: $315,000
Loss on futures position: $30,000
Deliver 30,000 bushels of soybeans at prevailing cash price of $10.50: $315,000
Total return = ($315,000 cash received - $30,000 loss from futures hedge): $285,000
Long hedge
Figure 3.3 results of long hedge when price rises
Buy three gold futures contracts (300 troy ounces) at $1208.70: $362,610
Sell three gold futures contracts at $1397.00 per troy: ounce: $419,100
Gain on futures position: $56,490
Buy 300 troy ounces of gold at prevailing cash price of $1,397.00: $419,100
Total cost of 300 troy ounces of gold = ($419,100 - $56,490): $362,610 (or $1208.70 per troy ounce)
Figure 3.4 results of long hedge when price falls
Buy three gold futures contracts (300 troy ounces) at $1208.70: $362,610
Sell three gold futures contracts at $1020.40 per troy ounce: $306,120
Loss on futures position: $56,490
Buy 300 troy ounces of gold at prevailing cash price of $1,020.40: $306,120
Total cost of 300 troy ounces of gold = ($306,120 - $56,490): $362,610 (or $1208.70 per troy ounce)
Trading firms that are contracted to add liquidity to the markets by continually providing bid-and-offer prices are referred to as market makers. (p. 53)
Position traders tend to be ‘trend followers’... Position traders use ‘trailing stops’ to protect their profits (p. 54)
Spreading (p. 60)
Inter-delivery spread or calendar spread: between the price of the same commodity on the same exchange in different delivery months. They are inter-market spread, as they occur in the same market.
Inter-commodity spread: between different but related future contracts (e.g. buying March feeder cattle and selling March live cattle).
Inter-market spread: between the price of the same commodity trading on different exchanges.
Basis spread: between the cash price and the futures price of the same commodity in the same deliberations period.
‘Buying a spread’ involves buying the higher prices futures contract and selling the lower priced contract with the expectation that the price difference, or spread, will continue to widen. ‘Selling a spread’ involves selling the higher priced futures contract and buying the lower priced contract in the expectation that the price difference between the two will narrow or converge. (p. 61)
Part 2: Natural commodity futures contracts
6 Grains
The most actively traded grains are often referred to as the food and feed grains…
Corn and oats tend to be used primarily as food grains, with some use in the food industry. Rice and wheat are mainly food grains, although wheat is also used as a feed source when other feeds such as corn or oats are in short supply. The soybean complex (soybeans, soybean meal and soybean oil) is considered both a feed and a food grain. The most actively traded grain futures are (p. 129) -
Corn
Wheat
Soybean complex
Because of variations in moisture content and grain size, cereal grains are measured using a volume measurement called a bushel.
Livestock-corn ratio: cost of the grain relative to the price of meat. When this ratio is low, livestock feeders will make adjustments by feeding less corn. (p. 132)
In order to make a profit, soybean processors must be able to purchase soybeans at lower cost than the combined sales income they will receive from soybean meal and soybean oil. This difference is called the gross processing margin, or GPM. If the GPM is high enough, processors will commit to buying soybeans (p. 152)
7 Food and fibre - the 'softs'
The term ‘soft’ was originally applied to any commodity that was not extracted or minded. These days it is used to describe those commodities that are grown on a plant but are not a grain or oilseed. The five major soft commodities are (p. 157) -
Cocoa
Coffee
Cotton: Carryover stock levels and stock-to-use ratios will influence the area planted to cotton, causing price fluctuations to occur. If carryover stock levels from previous years are high and the amount of cotton being used is stable, then demand can be maintained. Farmers may plant less cotton under such a scenario, preferring to plant alternate crops such as corn or soybeans if they offer a better price and return. (p. 169)
Orange juice
Sugar
8 Livestock - the meats
The three main futures contracts associated with the meat industry are (p. 183) -
Live cattle
Feeder cattle
Lean hogs contracts
Access to feed grains, particularly corn, is one of the most important cost considerations in the production of pork. Feed costs account for more than half of all production costs and are the primary determinant of how much pork will be produced. (p. 193)
9 Energy markets
The four main futures contracts covering the energy sector are (p. 199) -
Crude oil: prices can be extremely volatile owing to the highly sensitive nature of price of crude to a wide range of supply-related issues (p. 203);
Reformulated Blendstock for Oxygenate Blending (RBOB) gasoline futures: replaced unleaded gasoline futures in 2006 as gasoline manufacturers began phasing out the use of methyl tertiary-butyl either (MYBE) and producing unleaded gasoline with 10 percent oxygenate content. (p. 205)
Gasoline, or petrol, is the single largest product refined from crude oil, with almost half of each barrel of crude oil produced refined into gasoline. (p. 206)
The demand for gasoline is also influenced by the strength of the US and global economies. If economies are expanding there is a greater trend for transportation of goods and people, and increased affluence and disposable incomes encourage people to travel more, increasing the use of and demand for gasoline.
Heating oil
Natural gas
10 Metals
Metals are used in jewellery and coins and have a wide range of commodity and industrial applications… three of the most liquid and actively traded contracts (p. 221) -
Gold: key driver of the gold price is fear. When the global economy is experiencing periods of economic, political and social instability, investors will seek to hold their wealth in gold as a safe and secure store of value. (p. 225)
Silver
Copper
Part 3: Financial markets futures contracts
11 Interest rates future
three of the most actively traded interest rate futures products -
Eurodollars: time, or term, deposits denominated in US dollars held in banks outside the US, and are not under the jurisdiction of the US Federal Reserve banking system. (p. 246)
US Federal Government issues 30-year Treasury bonds with a face value or par value of $100,000 and a maturity date of up to 30 years. Interest is paid twice each year until the maturity date. At the maturity date the face value ($100,000) is repaid to the holder of the bond. (p. 251)
The relationship between the price of the bond and the interest rate is inverted. If interest rates increase, the price of the bond will decrease. For example, a $100,000 bond issued with a coupon rate of 5 per cent ($5000) will fall in value if interest rates rise to 5.5 per cent, as new bonds issued will now return $5500 per annum. The original owner of the bond paying a 5 per cent coupon rate will have to sell it at a lower price to reflect the current yield or interest rate of 5.5 percent on the new bond issuance. The original bond will fall in value around $99 950 in order for a new purchaser to achieve the same effective return ?$99 950 x 5.5% = $5500). (p. 252)
Like Treasury bonds, Treasury notes are fixed-interest paying debt instruments that are issued by governments for short (2-year) and intermediate (5- and 10-year) periods. (p. 258)
12 Equity index futures
the most actively traded and monitored stock index futures contracts -
Standard and Poor (S&P) 500 index and the E-mini S&P 500: an index of the prices of 500 of the largest actively traded stocks listed on the NYSE, the American Stock Exchange (ASE) and the NASDAQ Exchange in the United States. (p. 267)
Euro Stoxx 50 Index futures contract: based on the Euro Stoxx 50 stock index of 50 major European companies from 12 European countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. (p. 276)
FTSE 100 (‘footsie’): represents the top 100 stocks by market capitalisation in the United Kingdom trading on the London Stock Exchange (p. 279)
Nikkei 225: represents the top 225 companies trading on the Tokyo Stock Exchange in Japan. (p. 282)
ASX Share Price Index (SPI) 200 futures contract: based on the S&P/ASX 200 stock index. It represents the top 200 companies listed on the ASX and covers approximately 87 per cent of the market capitalisation of listed securities on the ASX. (p. 286)
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