Opportunity: Trading Futures Options On Futures

Opportunity
AND
Risk
An Educational Guide to
Trading
Futures
and
Options on
Futures
National Futures Association is a congressionally authorized self-regulatory organization
of the United States futures industry. Its mission is to provide innovative regulatory
programs and services that protect investors and ensure market integrity.
NFA has prepared this book as part of its continuing public education efforts to pro-
Opportunity
vide information to potential investors. The booklet provides a necessary overview of AND
Risk
the opportunities and risks in trading futures and options on futures by presenting impor-
tant information that investors need to know before they invest.
PUBLISHER
National Futures Association
200 West Madison Street, Suite 1600 An Educational Guide to
Chicago, Illinois 60606-3447
800-621-3570 • www.nfa.futures.org Trading Futures
DESIGN and
Lenz Design • Chicago, Illinois • www.lenzdesign.com
ILLUSTRATION Options on Futures

Philip Nicholson • Varberg, Sweden • www.illustrations.se
© 2006 National Futures Association All Rights Reserved.
No part of this book may be reproduced, stored, or transmitted by any means,

including electronic, mechanical, photocopying, recording, or otherwise,
without written permission from National Futures Association. The publica-
tion is designed to provide accurate and authoritative information in regard
to the subject matter covered. While great care was taken in the preparation
of this book, National Futures Association disclaims any legal responsibility
for any errors or omissions and disclaims any liability for losses or damages
incurred through the use of the information in the book. If legal advice,
financial advice, or other expert assistance is required, the services of a
competent professional person should be sought.
Opportunity AND Risk
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 How to Participate in Futures Trading . . . . . . . . . . . . . . . . . . . . . . 38
Trade Your Own Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
How the Markets are Regulated . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Have Someone Manage Your Account . . . . . . . . . . . . . . . . . . . . . . . .42
Conducting Business with a Registered Firm . . . . . . . . . . . . . . . . . . 12 Use a Commodity Trading Advisor . . . . . . . . . . . . . . . . . . . . . . . . . .44
Participate in a Commodity Pool . . . . . . . . . . . . . . . . . . . . . . . . . . .46
Introduction to Futures Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Establishing an Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50
Futures Contracts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
How Prices are Quoted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Introduction to Options on Futures . . . . . . . . . . . . . . . . . . . . . . . . .52
The Market Participants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 The Arithmetic of Option Premiums . . . . . . . . . . . . . . . . . . . . . . . . .54
Hedgers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54
Speculators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55
The Process of Price Discovery. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Understanding Options Transaction Fees . . . . . . . . . . . . . . . . . . . . .56
Minimum Price Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58
Daily Price Limits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Calculating the Break-Even Price . . . . . . . . . . . . . . . . . . . . . . .58
Position Limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Factors Affecting the Choice of an Option . . . . . . . . . . . . . . . .62
Daily Close . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 After You Buy an Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64
The Arithmetic of Futures Trading . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Offset the Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64
Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Continue to Hold the Option . . . . . . . . . . . . . . . . . . . . . . . . . . .66
Margins. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Exercise the Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .66
Basic Trading Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Who Writes Options and Why . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68
Buying (Going Long) to Profit from an Expected Price Increase . . . . 30
Selling (Going Short) to Profit from an Expected Price Decrease . . . . 32 If a Dispute Should Arise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72
Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Stop Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Glossary of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .75
Additional Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93
4 5
Introduction Opportunity and Risk: An Educational Guide
mortgage bankers bonds dealers

Introduction
For nearly a century and Just as the types of instru-
ments traded on futures
a half, futures markets have
exchanges have evolved, so has
fulfilled an important eco- the method of trading those
nomic function—provid- instruments. Until the 1990s,
ing an efficient and effec- futures trading was conducted individual
tive mechanism for the
primarily on the floor of the investors
exchanges.Traders crowded into
management of price risks. trading “pits” or “rings”, shouting grain
and signaling bids and offers to
Beginning with agricultural
each other. This type of trading,
merchants
futures contracts traded on known as open-outcry, resulted
the Chicago Board of Trade in competitive, organized price
in 1865, the U.S. futures discovery. lending institutions farmers
markets now list an ever- In the 1990s, exchanges intro- Who Trades?
duced electronic trading on cer-
expanding number of
tain contracts during off- as well as grain merchants, lend- hedgers seek to avoid. Most
instruments, including met- exchange hours. Since then, elec- ing institutions and individual speculators have no intention of
als, energy, financial instru- tronic trading has expanded to speculators. By buying or selling making or taking delivery of
include side-by-side open outcry futures contracts—contracts the commodity. They seek
ments, foreign currencies,
and electronic trading, as well as that establish a price level now instead to profit from a change
stock indexes, prediction contracts that are exclusively for items to be delivered later— in the price. That is, they buy
markets and event futures. traded electronically. Futures individuals and businesses seek when they anticipate rising
Additionally, the industry trading has truly become a 24 to achieve what amounts to prices and sell when they antic-
hours a day, seven days a week insurance against adverse price ipate declining prices. The
introduced trading in financial marketplace. changes.This is called hedging. interaction of hedgers and
options on futures con- Participants in today’s futures speculators helps to provide
Other futures market partici-
tracts in 1982. markets include mortgage bankers active, liquid and competitive
pants are speculative investors
as well as farmers, bond dealers markets.
who accept the price risks that
6 7
Introduction Opportunity and Risk: An Educational Guide
Speculative participation in The pages which follow are

futures trading has become Speculation in futures intended to help provide you We have also included a
increasingly widespread with with the kinds of information Glossary at the back of this
contracts, however, is
the availability of alternative you should obtain—and the Guide for easy reference. In fact,
methods of participation. clearly not appropriate for questions you should seek we suggest that you become
Whereas many futures traders everyone. Just as it is possi- answers to—before making any familiar with some of the terms
continue to prefer to make their ble to realize substantial decisions to trade futures included in the Glossary before
own trading decisions—such as and/or options on futures. continuing.
profits in a short period of
what to buy and sell and when
Topics covered include: It is not the purpose of this
to buy and sell—others choose time, it is also possible to
Guide to suggest that you
to utilize the services of a pro- incur substantial losses in ■ The regulatory should—or should not—partici-
fessional trading advisor, or to a short period of time. structure of the pate in futures and/or options
avoid day-to-day trading respon- futures industry on futures trading.That is a deci-
sibilities by establishing a fully The possibility of large profits
sion you should make only after
managed trading account or or losses in relation to the initial ■ How to conduct a consultation with your broker
participating in a commodity commitment of capital stems background check or financial advisor and in light
pool which is similar in concept principally from the fact that of a futures firm of your own financial situation
to a mutual fund. futures trading is a highly lever-
and objectives.
aged form of speculation. Only a ■ How futures
For those individuals who
relatively small amount of Finally, this Guide focuses
fully understand and can afford contracts are traded
money is required to control primarily on exchange-traded
the risks which are involved, the
assets having a much greater futures and options on futures
allocation of some portion of ■ The costs of trading
value. As we will discuss and contracts. For information
their capital to futures trading
illustrate, the leverage of futures regarding off-exchange foreign
can provide a means of achiev- ■ How gains and
trading can work for you when currency (forex) futures and
ing greater diversification and a losses are realized
prices move in the direction options, consult the NFA
potentially higher overall rate of
you anticipate or against you brochure “Trading in the Off-
return on their investments. ■ How options on
when prices move in the oppo- Exchange Foreign Currency
There are also a number of ways futures are traded
site direction. Market: What Investors Need to
in which futures can be used in
Know.” The brochure is avail-
combination with stocks, bonds ■ How to resolve
able free of charge on NFA’s
and other investments. futures-related
Web site (www.nfa.futures.org).
disputes
8 9
How the Markets are Regulated Opportunity and Risk: An Educational Guide
CFTC
How the Markets
are Regulated NFA Exchanges
The U.S. futures industry ment powers of the CFTC are

similar to those of other major
has experienced unprece-
federal regulatory agencies, The CFTC provides government oversight for the entire futures industry.
dented growth in trading including the power to seek All U.S. futures Exchanges operate as a self-regulatory organizations,
volume over the past sever- criminal prosecution by the governing their floor brokers, traders and member firms. And NFA
regulates every firm or individual who conducts futures
al years, reflecting the high Department of Justice where
trading business with public customers.
circumstances warrant such
level of trust and confi- action. Regulatory Relationships
dence that customers have National Futures Association
in the marketplace. This (NFA). The same legislation that fail to comply with financial ble, subject to CFTC oversight,
authorized the creation of “reg- and record-keeping requirements for monitoring the business
confidence is due in part to
istered futures associations,” giv- can, if circumstances warrant, be conduct and financial responsi-
a strong, effective regulato- permanently barred from engag- bility o f t h e i r m e m b e r
ing the futures industry the
ry structure that safeguards opportunity to create a nation- ing in any futures-related busi- f i r m s . Violations of exchange
wide self-regulatory organiza- ness with the public. rules can result in substantial
market integrity and pro-
tion. NFA is the industrywide, fines, suspension or revocation
U.S. futures exchanges and
tects investors. This regula- of trading privileges, and loss of
self-regulatory organization for clearing organizations. Futures
tory structure has three the U.S. futures industry. NFA’s Commission Merchants (FCMs)
exchange or clearing corpora-
mission is to develop rules, pro- tion membership.
main components. which are members of an
grams and services that safe- exchange are subject to not Although the various regula-
The Commodity Futures guard market integrity, protect only CFTC and NFA regulation tory organizations in the futures
Trading Commission (CFTC). In investors and help its Members but also to regulation by the industry have their own specif-
1974 Congress established the meet their regulatory responsi- exchanges and clearing organi- ic areas of authority, together
CFTC, a federal regulatory bilities. Firms and individuals zations of which they are mem- they form a regulatory partner-
agency with jurisdiction over that violate NFA rules of profes- bers. Exchange and clearing ship that oversees all industry
futures trading. The enforce- sional ethics and conduct or corporation staffs are responsi- participants.
10 11
Conducting
Business with a
Registered Firm
Membership in NFA is
mandatory, assuring that
everyone conducting busi-
ness with the public on the
U.S. futures exchanges—
more than 4,000 firms and
55,000 associates—must
adhere to the same high
standards of professional
conduct. You can quickly
verify whether a particular tion concerning all current and A BASIC background check will tell
firm or person is currently former CFTC registrants, includ- everything you need to know about the standing
registered with the CFTC ing name, business address and of your financial firm or advisor (www.nfa.futures.org)
registration histor y in the
and is an NFA Member Sometimes the firm will have Members if the case went to
futures industry. BASIC also
through NFA’s Background contains information concern- no disciplinary history, but one hearing and an award was
Affiliation Status Infor- ing disciplinary actions taken by or more of the principals or issued after January 1, 1990.
NFA, the CFTC and all the U.S. salespeople may have been dis- You will also find summary
mation Center (BASIC), ciplined while working at data concerning the number of
futures exchanges. If you are
found on NFA’s Web site researching a firm, you should other firms. cases filed by investors against
(www.nfa.futures.org). also conduct a background registered firms and individu-
In addition, BASIC gives you
check of all the individuals list- als with the CFTC reparations
details concerning NFA arbitra-
BASIC contains current and ed as principals of the firm, as program.
tion matters involving disputes
historical registration informa- well as the firm’s salespeople. between investors and NFA
12 13
Introduction to Futures Trading Opportunity and Risk: An Educational Guide
Introduction to Since delivery on futures Cash settlement futures con-

Futures Trading contracts is the exception
rather than the rule, why do
tracts are precisely that, con-
tracts which are settled in cash
Futures Contracts most contracts even have a rather than by delivery at the
delivery provision? There are time the contract expires. Stock
A futures contract is a futures contracts very few actual-
two reasons. One is that it offers index futures contracts, for
ly result in delivery. Not many
legally binding agreement buyers and sellers the opportu- example, are settled in cash on
speculators have the desire to
to buy or sell a commodity nity to take or make delivery of the basis of the index number
take or make delivery of 5,000
the physical commodity if they used for the final settlement.
or financial instrument at a bushels of wheat or 112,000
so choose. More importantly, There is no provision for deliv-
later date. Futures contracts pounds of sugar. Rather, the vast
however, the fact that buyers ery of the shares of stock that
majority of speculators in futures
are standardized according and sellers can take or make make up the various indexes.
markets choose to realize their
delivery helps to assure that That would be impractical.
to the quality, quantity and gains or losses by buying or sell-
futures prices will accurately With a cash settlement contract,
delivery time and location ing offsetting futures contracts
reflect the cash market value of convergence is automatic.
prior to the delivery date.
for each commodity. The the commodity at the time the
Futures prices are established
Selling a contract that was contract expires—i.e., that
only variable is price. through competitive bidding
previously purchased liquidates futures and cash prices will
and are immediately and contin-
There are two types of a futures position in exactly the eventually converge. It is con-
uously relayed around the world
futures contracts, those that same way, for example, that sell- vergence that makes hedging an
by wire and satellite. A farmer
provide for physical delivery of ing 100 shares of IBM stock liq- effective way to obtain protec-
in Nebraska, a merchant in
a particular commodity or item uidates an earlier purchase of tion against an adverse price
Amsterdam,an importer inTokyo
and those which call for a cash 100 shares of IBM stock. movement in the cash market.
and a speculator in Ohio have
settlement. The month during Similarly, a futures contract that
simultaneous access to the latest
which delivery or settlement is was initially sold can be liquidat-
market-derived price quotations.
to occur is specified. For exam- ed by an offsetting purchase. In
And, should they choose, they
ple, a July futures contract is either case, the resulting gain or
can establish a price level for
one providing for delivery or loss is the difference between
future delivery—or for specula-
settlement in July. the buying price and the selling
tive purposes—simply by having
price less transaction costs
It should be noted that even their broker buy or sell the
(commissions and fees).
in the case of delivery-type appropriate contracts.
14 15
FUTURES
Monetary
units per Lifetime Open Crude Oil
The
$80
Future
AGRICULTURAL
Corn
Exchange quantity
CBT ¢ / bushel
High Low
302 ¾ 217 ¼
Date
Jul 06
Open
238 ¼
High Low
243 238 ¼
Settle
240
Change
+ 2
Interest
576,182
Market
Soybeans CBT ¢ / bushel 736 485 Jul 06 606 612 604 ¾ 606 + 1½ 225,894 70
Soybean Meal
Soybean Oil
Wheat
CBT
CBT
CBT ¢
$ / ton
¢ / lb
/ bushel
227.00 158.70
26.57 19.61
418 ¼ 268 ¾
Jul 06
Jul 06
Jul 06
180.00 181.50 178.20 178.80
25.10 25.35 25.01 25.28
384 ¾ 389 ½ 383 ½ 384 ½
-- .70
+ .20
-- ¼
93,312
162,452
240,326 60
Participants
Winter Wheat KC ¢ / bushel 474 ½ 342 Jul 06 468 ½ 472 ½ 465 465 ¼ -- 2 ¾ 83,750
Oats ¢ 270 ½ 133 ¼ Jul 06 189 190 ¼ 187 ½ 189 8,505
Rough Rice
CBT
CBT
/ bushel
$ / CWT 9.210 6.900 Jul 06 8.460 8.560 8.450 8.545
-- ¼
+ .085 5,695 50 $
Should you at some time In either case, the person
In newspaper financial sections decide to trade in futures who takes the opposite side of
your trade may be or may repre-
contracts, either for specu- sent someone who is a commer-
How Prices are Quoted lation or in connection cial hedger or perhaps someone
with a risk management who is a public speculator. Or,
Futures prices are usual- rencies; and in points and per-
quite possibly, the other party
ly quoted the same way centages of a point for financial strategy, your orders to buy may be an independent trader.
instruments. Cash settled index or sell will be communicat-
prices are quoted in the In becoming acquainted with
contract prices are quoted in
ed from the brokerage futures markets, you should
underlying cash market. terms of an index number, usual-
have at least a general under-
ly stated to two decimal points. office you use to the appro- standing of who these various
That is, in dollars, cents, and Be certain you understand the priate trading pit or elec- market participants are, what
sometimes fractions of a cent, price quotation system for the
tronic trading platform for they are doing and why.
per bushel, pound or ounce; particular futures contract you
also in dollars, cents and incre- are considering. execution. If you are a Hedgers
ments of a cent for foreign cur-
buyer, your order will seek The details of hedging can be
a seller at the lowest avail- somewhat complex but the
On financial services websites able price. If you are a sell-
principle is simple. Hedgers are
individuals and firms that make
er, your order will seek a purchases and sales in the
SOYBEANS Delayed Futures -09:20 - Monday, 8 May buyer at the highest avail- futures market for the purpose
( Go to Daily ) ( Profile ) (Click on Contract for Chart)
Contract Last Change Open High Low Prev. Stl. Time of establishing a known price
May ‘06 (SK06) 594-4 +3-6 597-0 601-4 593-0 590-6 05/05/06
able price. Market fluctua-
level—weeks or months in
Jul ‘06 (SN06) 606-4 +2-6 609-4 614-4 605-0 603-6 05/05/06 tion is a process of finding
Aug ‘06 (SQ06) 612-0 +3-0 615-0 619-0 611-0 609-0 05/05/06 advance—for something they
Sep ‘06 (SU06) 615-4 +2-2 620-0 622-0 614-0 613-2 05/05/06 fair prices for both buyers later intend to buy or sell in the
Nov ‘06 (SX06) 625-2 +3-0 627-4 631-0 623-4 622-2 05/05/06
Jan ‘07 (SF07) 632-2 +3-0 636-0 636-0 632-0 629-2 05/05/06 and sellers. cash market (such as at a grain
Mar ‘07 (SH07) 639-0 +4-0 641-0 644-0 636-0 635-0 05/05/06
16 May ‘07 (SK07) 640-0 +3-0 641-0 643-0 638-0 637-0 05/05/06 17
Jul ‘07 (SN07) 643-0 +3-0 645-0 647-0 643-0 640-0 05/05/06
elevator or in the bond market). provided insurance against an Whatever the hedging strategy, The arithmetic of specula-
In this way they attempt to pro- increase in the price of gold. It the common denominator is tion in futures contracts—
tect themselves against the locked in a net cost, that hedgers willingly give up including the opportunities it
risk of an unfavorable price the opportunity to benefit from offers and the risks it involves—
regardless of what hap-
change in the interim. favorable price changes in order will be discussed in detail later
pened to the cash market
Consider this example: to achieve protection against on. For now, just know that
price of gold. Had the price of unfavorable price changes. speculators are individuals and
A jewelry manufacturer will gold declined instead of risen, he firms who seek to profit from
need to buy additional gold from would have incurred a loss on his anticipated increases or
his supplier in six months. Between futures position, but this would decreases in futures prices. In so
now and then, however, he fears the have been offset by the lower cost of doing, they help provide the
price of gold may increase. That acquiring gold in the cash market. risk capital needed to facilitate
could be a problem because he has hedging.
The number and variety of
already published his catalog for Someone who expects a
hedging possibilities are practi-
the year ahead. cally limitless. A cattle feeder futures price to increase would
can hedge against a decline in purchase futures contracts in the
To lock in the price level at
livestock prices and a meat hope of later being able to sell
which gold is presently being quot- them at a higher price. This
packer or supermarket
ed for delivery in six months, he is known as “going long.”
chain can hedge against an
buys a futures contract at a price of Conversely, someone who
increase in livestock
$550 an ounce. prices. Borrowers can expects a futures price to decline
Speculators would sell futures contracts in
If, six months later, the cash hedge against higher
Were you to speculate in the hope of later being able to
market price of gold has risen, he interest rates, and
futures contracts, the person buy back identical and offsetting
lenders against lower
will have to pay his supplier that taking the opposite side of your contracts at a lower price. The
interest rates. In addi-
increased amount to acquire gold. trade on any given occasion practice of selling futures con-
tion, investors can
However, the extra cost may be off- could be a hedger or it might tracts in anticipation of lower
h e d ge a g a i n s t
set by a corresponding profit when well be a speculator—someone prices is known as “going short.”
a decline in
whose opinion about the proba- One of the unique features of
the futures contract bought at $550 stock prices.
ble direction of prices may dif- futures trading is that one can ini-
is sold for $570. In effect, the hedge
fer from your own. tiate a transaction with a sale as
well as with a purchase.
18 19
Reasons for Reasons for

BUYING SELLING
futures contracts futures contracts in response to changing expecta- contracts you plan to trade.
tions. As the term indicates, You’ll also need to know how a
HEDGERS To lock in a price To lock in a price futures markets “discover”—or price change of any given
and thereby and thereby reflect—cash market prices. amount will affect the value of
obtain protection obtain protection They do not set them. the contract.
against rising against declining
cash prices cash prices Competitive price discovery
is a major economic function—
Daily Price Limits
SPECULATORS To profit from To profit from and, indeed, a major economic Exchanges establish daily
rising futures prices declining future prices benefit—of futures trading. In price limits for trading in some
summary, futures prices are an futures contracts. The limits are
ever changing barometer of sup- stated in terms of the previous
ply and demand and, in a dynam- day’s closing price plus and
The Process of Price Discovery ic market, the only certainty is minus so many cents or dollars
that prices will change. per trading unit. Once a futures
Futures prices increase ments are reassessed, and the price has increased by its daily
price of a particular futures con- Minimum limit, there can be no trading at
and decrease largely because
tract may be bid upward or Price Changes any higher price until the next
of the myriad factors that downward. The process of trading session. Conversely,
Exchanges establish the min-
influence buyers’and sellers’ reassessment—of price discov- once a futures price has
imum amount that the price can
judgments about what a par- ery—is continuous. declined by its daily limit, there
fluctuate upward or downward.
Thus, in January, the price of can be no trading at any lower
ticular commodity will be This is known as the “tick.” For
a July futures contract would price until the next session.
example, each tick for grain is
worth at a given time in the reflect the consensus of buyers’ Thus, if the daily limit for a
.0025¢ per bushel. On a 5,000
future (anywhere from less and sellers’ opinions at that time particular grain is currently 10¢
bushel futures contract, that’s
as to what the value of a com- a bushel and the previous day’s
than a month to more than $12.50. On a gold futures con-
modity or item will be when the settlement was $3.00, there can-
two years). tract, the tick is 10¢ per ounce,
contract expires in July. On any not be trading during the cur-
so one tick on a 100 ounce con-
given day, with the arrival of new rent day at any price below 2.90
As new supply and demand tract is $10.You’ll want to famil-
or more accurate information, or above 3.10. The price is
developments occur and as new iarize yourself with the mini-
the price of the July futures con- allowed to increase or decrease
and more current information mum price fluctuation—the
tract might increase or decrease by the limit amount each day.
becomes available, these judg- tick size—for whatever futures
20 21
tion at will. In this event, possible Daily

For some contracts, daily
alternative strategies should be Close
discussed with a broker.
price limits are eliminated
At the end of a day’s trad-
during the month in which Position Limits
ing, the exchange’s clearing
the contract expires.Because Although the average trader
is unlikely to ever approach organization matches each
prices can become particu-
them, exchanges and the CFTC clearing firm’s purchases
larly volatile during the expi- establish limits on the maxi-
made that day with corre- For example, if a speculator were to
ration month (also called the mum speculative position that
have a $300 profit as a result of the
“delivery” or “spot” month), any one person can have at one sponding sales and tallies
day’s price changes, that amount
time in any one futures con- each clearing firm’s gains or
persons lacking experience would be immediately credited to
tract. The purpose is to prevent
in futures trading may wish losses based on that ses- his brokerage account and, unless
one buyer or seller from being
to liquidate their positions able to exert undue influence sion’s price changes—a required for other purposes, could
prior to that time.At the very on the price in either the estab- massive undertaking consid- be withdrawn. On the other hand, if
lishment or liquidation of posi- ering that several million the day’s price changes had resulted
least, they should trade cau-
tions. Position limits are stated in a $300 loss, his account would be
tiously and with an under- in number of contracts or total futures contracts are bought
immediately debited for that
standing of the risks which units of the commodity. and sold on an average day.
amount.
may be involved. The easiest way to obtain the Each firm, in turn, calculates
The process just described is
types of information just dis- the gains and losses for known as a daily cash settlement
Daily price limits set by the cussed is to ask your broker or
each of its customers having and is an important feature
exchanges are subject to change. other advisor to provide you
futures contracts. of futures trading. As will be
They can, for example, be with a copy of the contract spec-
seen when we discuss margin
increased or decreased on suc- ifications for the specific futures
Gains and losses on futures requirements (see page 26), it is
cessive days. Because of daily contracts you are thinking about
contracts are not only calculat- also the reason a customer who
price limits, there may be occa- trading. You can also obtain the
ed on a daily basis, they are incurs a loss on a futures posi-
sions when it is not possible to information from the exchange
credited and deducted by the tion may be called on to deposit
liquidate an existing futures posi- where the contract is traded.
clearing firm on a daily basis. additional funds to his account.
22 23
Leverage can Each tick is $

work to realize a $50 gain
The Arithmetic swift profit June S&P
500 E-mini $1,000
of Futures or 25%
stock index
Trading
Leverage 1,420
% profit
+2%
To say that gains and losses in Initial $4,000
futures trading are the result of 1,400 Investment
Leverage can as -2%
price changes is an accurate easily deliver
explanation but by no means a
1,380
great losses
complete explanation. Perhaps
-$1,000
more so than in any other form of
speculation or investment, gains
and losses in futures trading are
highly leveraged. An understand-
leverage Each tick is
a $50 loss
or 25%
loss
ing of leverage—and of how it

can work to your advantage or
disadvantage—is crucial to an
Small movements in % create big changes in $
understanding of futures trading. $200,000.The smaller the margin For example, assume that in antic- $1,000 profit (20 x $50) and a
The leverage of futures trading in relation to the value of the ipation of rising stock prices you buy decrease from 1400 to 1380 would
stems from the fact that only a rel- futures contract, the greater the
one June S&P 500 E-mini stock index be a $1,000 loss on your $4,000 mar-
atively small amount of money leverage will be.
futures contract at a time when the gin deposit. That’s a 25 percent gain
(known as initial margin) is If you speculate in futures con- June index is trading at 1400. And or loss as the result of less than a 2
required to buy or sell a futures tracts and the price moves in the
assume your initial margin require- percent change in the stock index.
contract. On a particular day, a direction you anticipated, high
margin deposit of only $1,000 ment is $4,000. Since the value of the Said another way, while buy-
leverage can produce large profits
might enable you to buy or sell in relation to your initial margin. futures contract is 50 times the index, ing (or selling) a futures contract
a futures contract covering Conversely, if prices move in the each one point change in the index provides exactly the same dollars
$25,000 worth of soybeans. Or opposite direction, high leverage represents a $50 gain or loss. and cents profit potential as
for $20,000, you might be able can produce large losses in rela- owning (or selling short) the
Thus, an increase in the index
to purchase a futures contract tion to your initial margin. actual commodities or items cov-
from 1400 to 1420 would produce a ered by the contract, low margin
covering common stocks worth Leverage is a two-edged sword.
24 25
requirements sharply increase Margins futures trading. It is much like

the percentage profit or loss money held in an escrow
As is apparent from the pre-
potential. account.
ceding discussion, the arith-
Futures trading, therefore, metic of leverage is the arith- Minimum margin require-
requires not only the necessary metic of margins. An under- ments for a particular futures
financial resources but also the standing of margins—and of the contract at a particular time are
necessary emotional tempera- several different kinds of mar- set by the exchange on which
ment. For example, it can be gin—is essential to an under- the contract is traded. They are
one thing to have the value of standing of futures trading. typically about five percent of
your portfolio of common stocks the current value of the futures
If your previous investment
decline from $200,000 to contract.
experience has mainly involved
$190,000 (a five percent loss) but
common stocks, you know that Exchanges continuously moni-
quite another, at least emotionally,
the term margin—as used in tor market conditions and risks
to deposit $20,000 as margin and
connection with securities— and, as necessary, raise or reduce
end up losing half of it as the result
has to do with the cash down their margin requirements.
of only a five percent decline.
payment and money borrowed Individual brokerage firms may
from a broker to purchase require higher margin amounts
stocks. But used in connection from their customers than the
with futures trading, margin has exchange-set minimums.
an altogether different meaning There are two margin-related
It is essential for anyone considering trading in futures con- and serves an altogether differ- terms you should know: Initial
tracts—whether it’s sugar or stock indexes, pork bellies or ent purpose. margin and maintenance margin.
petroleum—to clearly understand the concept of leverage as Rather than providing a Initial margin (sometimes
down payment, the margin called original margin) is the sum
well as the amount of gain or loss that will result from any required to buy or sell a futures of money that the customer must
given change in the futures price of the particular futures con- contract is solely a deposit of deposit with the brokerage firm
tract you would be trading. If you cannot afford the risk, or good faith money that can be for each futures contract to be
drawn on by your brokerage bought or sold. On any day that
even if you are uncomfortable with the risk, the only sound
firm to cover losses that you profits accrue on your open posi-
advice is don’t trade. Futures trading is not for everyone. may incur in the course of tions, the profits will be added to
26 27
Before trading in futures

Initial Margin Needed contracts, be sure you
$2,000 Assume, for example, that the ini- understand the brokerage
Margin tial margin needed to buy or sell a par- firm’s Margin Agreement
Maintenance Margin Call ticular futures contract is $2,000 and and know how and when
Requirement
$1,500 $600 that the maintenance margin require- the firm expects margin
ment is $1,500. Should losses on open calls to be met. Some firms
positions reduce the funds remaining
If Your Account Drops to may require only that you
in your trading account to $1,400 (an
$1,400 amount less than the maintenance
mail a personal check.
requirement), you will receive a mar- Others may insist you wire
gin call for the $600 needed to restore transfer funds from your
margin your account to $2,000. bank or provide same-day

or next-day delivery of a
certified or cashier’s check.
If margin calls are not met
the balance in your margin ment—your broker will require in the prescribed time and
account. On any day losses that you deposit additional funds form, the firm can protect
accrue, the losses will be deduct- to bring the account back to the itself by liquidating your
ed from the balance in your mar- level of the initial margin. You
open positions at the avail-
gin account. may also be asked for additional
margin if the exchange or your able market price (possibly
If and when the funds remain-
brokerage firm raises its margin resulting in a loss for which
ing available in your margin
requirements. Requests for addi- you would be liable).
account are reduced by losses to
tional margin are known as
below a certain level—known as
margin calls.
the maintenance margin require-
28 29
Basic For example, assume it’s now

Trading January, the July soybean futures
Strategies contract is presently quoted at $6.00
a bushel, and over the coming
Even if you should months you expect the price to
decide to participate in increase. You decide to deposit the
futures trading in a way required initial margin of $1,000
and buy one July soybean futures
that doesn’t involve having
contract. Further assume that by
to make day-to-day trading April the July soybean futures price
decisions (such as a man- has risen to $6.40, and you decide
aged account or commodi- Buying (Going Long) to take your profit by selling. Since
ty pool), it is nonetheless to Profit from an each contract is for 5,000 bushels,
Expected Price your 40-cent a bushel profit would
useful to understand the Increase be 5,000 bushels x 40¢ or $2,000
dollars and cents of how Someone expecting the less transaction costs.
futures trading gains and price of a particular commodity
losses are realized. If you or item to increase over a given Price Per Value of 5,000
period of time can seek to prof- Bushel Bushel Contract
intend to trade your own it by buying futures contracts. If
account, such an under- correct in forecasting the direc- January Buy 1 July soybean $6.00 $30,000
standing is essential. tion and timing of the price futures contract
change, the futures contract can
April Sell 1 July soybean $6.40 $32,000
Dozens of different strategies later be sold for the higher
futures contract
and variations of strategies are price, thereby yielding a profit.*
employed by futures traders in If the price declines rather than GAIN $ .40 $ 2,000
pursuit of speculative profits. increases, the trade will result in
Here is a brief description and a loss. Because of leverage, the
illustration of several basic gain or loss may be greater than *For simplicity, examples do not take into account commissions
strategies. and other transaction costs. These costs are important, however,
the initial margin deposit.
and you should be sure you fully understand them.
30 31
Price Per Value of 5,000

Bushel Bushel Contract For example, assume that in original selling price. On the 40,000
January your research or other pound contract, that’s a gain of 5¢ x
January Buy 1 July soybean $6.00 $30,000 available information indicates a 40,000 lbs. or $2,000 less transac-
futures contract probable decrease in cattle prices tion costs.
April Sell 1 July soybean $5.60 $28,000 over the next several months. In the
futures contract hope of profiting, you deposit an ini-
tial margin of $700 and sell one
LOSS $ .40 $ 2,000
April live cattle futures contract at a
price of, say, 85¢ a pound. Each
Suppose, however, that rather cover the projected losses contract is for 40,000 pounds,
than rising to $6.40, the July soy- marked to the settlement price. meaning each 1¢ a pound change in
bean futures price had declined to price will increase or decrease the
$5.60 and that, in order to avoid the
Selling (Going Short)
value of the futures contract by
to Profit from an
possibility of further loss, you elect $400. If, by March, the price has
Expected Price
to sell the contract at that price. On Decrease declined to 80¢ a pound, an offset-
5,000 bushels your 40-cent a bushel ting futures contract can be pur-
The only way going short to
loss would thus come to $2,000 plus profit from an expected price chased at 5¢ a pound below the
transaction costs. decrease differs from going long
Note that the loss in this to profit from an expected price
example exceeded your $1,000 increase is the sequence of the Price Per Value of 40,000
initial deposit. Your broker trades. Instead of first buying a Pound Pound Contract
would then call upon you, as futures contract, you first sell a
needed, for additional funds to futures contract. If, as expected, January Sell 1 April live cattle 85¢ $34,000
cover the loss. Had you not off- the price declines,a profit can be futures contract
set the position and the soybean realized by later purchasing an
offsetting futures contract at the March Buy 1 April live cattle 80¢ $32,000
contract was open in your
lower price. The gain per unit futures contract
account, your broker would ask
you to deposit more margin will be the amount by which the
GAIN 5¢ $ 2,000
funds into your account to purchase price is below the ear-
lier selling price.
32 33
Price Per Value of 40,000

Pound Pound Contract As an illustration, assume it’s Assume time and events prove
now November, that the March you right and that, by February, the
January Sell 1 April live cattle 85¢ $34,000 CBOT mini Wheat futures price is March futures price has risen to
futures contract presently $3.50 a bushel and the $3.60 and May futures price is
March Buy 1 April live cattle 90¢ $36,000 May CBOT mini Wheat futures price $3.75, a difference of 15¢. By liqui-
futures contract is presently $3.55 a bushel, a differ- dating both contracts at this time,
ence of 5¢. Your analysis of market you can realize a net gain of 10¢ a
LOSS 5¢ $ 2,000
conditions indicates that, over the bushel. Since each contract is 1,000
next few months, the price differ- bushels, the total gain is $100.
Assume you were wrong. Instead Spreads ence between the two contracts will
of decreasing, the April live cattle While most speculative widen to become greater than 5¢. To
futures price increases to 90¢ a futures transactions involve a profit if you are right, you could sell
pound by the time in March when simple purchase of futures the March futures contract (the
you eventually liquidate your short contracts to profit from an lower priced contract) and buy the
futures position through an offset- expected price increase—or
May futures contract (the higher
an equally simple sale to profit
ting purchase. The outcome would priced contract).
from an expected price
be as shown above.
decrease—numerous other
In this example, the loss of Spread
possible strategies exist.
5¢ a pound on the future trans- Spreads are one example. November Sell March Buy March
action resulted in a total loss of Mini Wheat Mini Wheat
A spread, at least in its sim-
the $2,000 plus transaction @ 3.50 bu. @ 3.55 bu. 5¢
plest form, involves buying one
costs.
futures contract and selling
February Buy March Sell March
another futures contract. The
Mini Wheat Mini Wheat
purpose is to profit from an
@ 3.60 bu. @ 3.75 bu. 15¢
expected change in the relation-
ship between the purchase $.10 LOSS $.20 GAIN
price of one and the selling
price of the other. Net gain = 10¢ per bushel
Gain on 1,000 bushel contract = $100
34 35
Had the spread (the price dif- to experience losses on both of For example, were you to pur- be possible to execute your
ference) narrowed by 10¢ a the futures contracts involved chase a crude oil futures contract at order at any price. In addition,
bushel rather than widened by (that is, on both legs of the $61 a barrel and wished to limit although it happens infrequent-
10¢ a bushel, the transactions spread). ly, it is possible that markets
your loss to $1 a barrel, you might
just illustrated would have may be lock limit for more than
Virtually unlimited numbers place a stop order to sell an offset-
resulted in a loss of $100. one day, resulting in substantial
and types of spread possibilities ting contract if the price should fall losses to futures traders who
Because of the potential of exist, as do many other, even
to $60 a barrel. If and when the may find it impossible to liqui-
one leg of the spread to hedge more complex futures trading
market reaches whatever price you date losing futures positions.
against price loss in the other strategies. These, however, are
leg and because gains and loss- beyond the scope of an intro- specify, a stop order becomes an Subject to the kinds of limita-
es occur only as the result of a ductory booklet and should be order to execute the desired trade. tions just discussed, stop orders
change in the price differ- considered only by someone There can be no guarantee, can nonetheless provide a use-
ence—rather than as a result of who fully understands the however, that it will be possible ful tool for the futures trader
a change in the overall level of risk/reward arithmetic involved. under all market conditions to who seeks to limit his losses.
futures prices—spreads are execute the order at the price In addition to providing a
often considered more conser- specified. In an active, volatile way to limit losses, stop orders
vative and less risky than hav- market, the market price may be can also be employed to protect
ing an outright long or short declining (or rising) so rapidly profits.
futures position. In general, that there is no opportunity to
this may be the case. liquidate your position at the For instance, if you have bought
It should be recognized,
Stop Orders stop price you have designated.It crude oil futures at $61 a barrel and
though, that the loss from a A stop order is an order is important to understand each the price is now at $64 a barrel, you
spread can be as great as—or placed with your broker to buy exchange’s rules and regulations might wish to place a stop order to
even greater than—that which or sell a particular futures con- as to the type of orders permitted sell if and when the price declines to
might be incurred in having an tract if and when the price and the nuances of each. $63. This (again subject to the
outright futures position. An reaches a specified level. Stop In the event that prices have described limitations of stop orders)
adverse widening or narrowing orders are often used by futures risen or fallen in a market that could protect $2 of your existing $3
of the spread during a particular traders in an effort to limit the utilizes a maximum daily limit,
amount they might lose if the
profit while still allowing your posi-
time period may exceed the and there is presently no trading
change in the overall level of futures price moves against tion to benefit from any continued
in the contract (known as a
futures prices, and it is possible their position. increase in price.
“lock limit” market), it may not
36 37
How to Participate in Futures Trading Opportunity and Risk: An Educational Guide
Futures Commission
How to Participate Merchants (FCMs)

are brokerage firms doing
business with the public.
in Futures Trading Commodity

Introducing
Brokers (IBs)
act as independent salespeople,
Pool Operators soliciting customer accounts
(CPOs) which are traded through FCMs.
Now that you have an Choosing a method of partic- manage combined funds,
ipating in the futures markets is much like a mutual fund. Commodity Trading
overview of what futures
largely a matter of deciding how Advisors (CTAs)
markets are, why they exist directly and extensively you, offer trading advice to
individuals, organizations
and how they work, the personally, want to be involved and commodity pools.
next step is to consider var- in making trading decisions and

managing your account. Many
ious ways in which you futures traders prefer to do their Categories and Makeup of NFA Members
may be able to participate own research and analysis and
in futures trading.There are make their own decisions about
There’s no formula for decid- quently required. Some recog-
what and when to buy and sell.
a number of alternatives ing. Your decision should, how- nize and accept the fact that
That is, they manage their own
ever, take into account such futures trading all but inevitably
and the only best alterna- futures trades in much the same
things as your knowledge of and involves having some losing
tive—if you decide to par- way they would manage their
any previous experience in trades. Others lack the neces-
own stock portfolios. Others
ticipate at all—is whichev- futures trading, how much time sary disposition or discipline to
choose to rely on or at least con-
and attention you are able to acknowledge that they were
er one is best for you. In sider the recommendations of a
devote to trading, the amount of wrong on this particular occa-
addition to describing sev- brokerage firm or account exec-
capital you can afford to com- sion and liquidate the position.
utive. Some purchase independ-
eral possibilities, the pages mit to futures, and, perhaps
ent trading advice. Others Many experienced traders
most importantly, your individ-
that follow suggest ques- would rather have someone else suggest that, of all the things
ual temperament and tolerance
tions you should ask and be responsible for trading their you need to know before trad-
for risk. Some individuals thrive
account and therefore give trading in futures contracts, one of
information you should on being directly involved in the
the most important is to know
ing authority to their broker or
obtain before making a fast pace of futures trading.
a trading advisor. Still others yourself. This can help you
Others are unable, reluctant, or
decision. purchase an interest in a com- make the right decision about
lack the time to make the imme-
modity trading pool. whether to participate at all
diate decisions that are fre-
and, if so, in what way.
38 39
An individual trading account

Trade Your
can be opened either directly
It bears repeating, that Own Account with an FCM or through an IB.
you should never partici- Whichever course you choose,
pate in futures trading This involves opening the account itself will be carried
your individual trading by an FCM, as will your money.
unless the capital you
IBs do not accept or handle cus-
would commit is risk capi- account and—with or
tomer funds but most offer a
tal. That is, capital you can without the recommenda- variety of trading-related servic-
afford to lose. It should be tions of the brokerage es. FCMs are required to main-
tain the funds and property of
capital over and above that firm—making your own
their customers in segregated
needed for necessities, trading decisions. You futures business with the public accounts, separate from the
emergencies, savings and will also be responsible must be registered with the firm’s own money, if used for
achieving your long-term CFTC as Futures Commission trading futures or options on
for assuring that adequate
Merchants (FCMs) or Introducing futures on an exchange.
investment objectives. You funds are on deposit with Brokers (IBs) and must be
should also understand In addition to the particular
the brokerage firm for Members of NFA.
services a firm provides, you
that, because of the lever-
margin purposes, or that Different firms offer different should also discuss the com-
age involved in futures, the services. Some, for example, missions and trading costs that
such funds are promptly
profit and loss fluctuations have extensive research depart- will be involved. And, as men-
provided as needed. ments and can provide current tioned, clearly understand how
may be wider than in most
information and analysis con- the firm requires that any mar-
types of investment activity Practically all of the major
cerning market developments gin calls be met. Remember,
brokerage firms you are familiar
and you may be required to as well as specific trading sug- you should always conduct
with, and many you may not be
cover deficiencies due to familiar with, have departments
gestions. Others tailor their a background check on the
losses over and above what services to clients who prefer to firm using NFA’s BASIC
or even separate divisions to
make market judgments and system on NFA’s Web site
you had expected to com- serve clients who want to allo-
arrive at trading decisions on (www.nfa.futures.org) or
cate some portion of their invest-
mit to futures. their own. Still others offer vari- contact NFA’s Information
ment capital to futures trading.
ous combinations of these and Center toll-free at 800-621-3570.
All brokerage firms conducting
other services.
40 41
Have Someone is acceptable. Others tailor their

Manage Your trading to a client’s objectives.
In either case, obtain enough
Account information and ask enough
questions to assure yourself that
A managed account is also Although an account manag-
your money will be managed in
er is likely to be managing the
your individual account.The a way that’s consistent with
accounts of other persons at the
major difference is that you your goals.
same time, there is no sharing of
give someone else—an gains or losses of other cus-
account manager—written tomers. Trading gains or losses
in your account will result sole-
Discuss fees. In addition
power of attorney to make ly from trades which were made to commissions on trades
and execute decisions about for your account. made for your account,
what and when to trade. He Many FCMs and IBs accept it is not uncommon for
or she will have discre- managed accounts. In most a c c o u n t m a n a ge r s t o
instances, the amount of money
tionary authority to buy or charge a management fee,
needed to open a managed Finally, take note of whether
sell for your account or will account is larger than the amount and/or there may be some the account management agree-
contact you for approval to required to establish an account arrangement for the man- ment includes a provision to
you intend to trade yourself. ager to participate in the automatically liquidate posi-
make trades he or she sug-
Different firms and account man- tions and close out the account
gests. You, of course, remain net profits that his manage-
agers, however, have different if and when losses exceed a cer-
fully responsible for any loss- requirements and the range can ment produces. These tain amount.And, of course, you
es which may be incurred be quite wide. Be certain to read charges are required to be should know and agree on what
and understand all of the litera- fully disclosed in advance. will be done with profits, and
and, as necessary, for meet- ture and agreements you receive what, if any, restrictions apply to
Make sure you know about
ing margin calls, including from the broker. withdrawals from the account.
every charge to be made to
making up any deficiencies Some account managers
have their own trading
your account and what
that exceed your margin
approaches and accept only each charge is for.
deposits. clients to whom that approach
42 43
Use a Commodity CFTC Regulations require same questions you would ask
Trading Advisor that CTAs provide their cus- of any account manager you are
considering.
tomers, in advance, with
As the term implies, a Internet or through the Most CTAs must be regis-
what is called a Disclosure
tered as such with the CFTC,
Commodity Trading Advisor mail. Some provide a fre- Document. Read it carefully and registered CTAs that
(CTA) is an individual (or quently updated hot-line or and ask the CTA to explain accept authority to manage
firm) that, for a fee, provides Web site you can access for any points you don’t under- customer accounts must also
advice on commodity trad- current information and be Members of NFA.
stand. If your money is
ing, including specific trad- trading advice. important to you, so is the You can verify whether an
advisor is registered and an
ing recommendations such information contained in
Even though you may trade NFA Member by conducting a
as when to establish a par- on the basis of an advisor’s rec- the Disclosure Document! background check using NFA’s
ticular long or short posi- ommendations, you will need to BASIC system on NFA’s Web
open your own account with, site (www.nfa.futures.org) or
tion and when to liquidate
and send your margin payments The prospectus-like docu- by calling NFA toll-free at
that position. Generally, to directly to, an FCM. CTAs cannot ment contains information 800-621-3570.
help you choose trading accept or handle their cus- about the advisor, his experi-
tomers’ funds unless they are ence and his current (and any
strategies that match your
also registered as FCMs. previous) performance records.
trading objectives, advisors If you use an advisor to manage
Some CTAs offer managed
offer analysis and judg- accounts, with the advisor des- your account, he must first
ments as to the prospective ignated in writing to make and obtain a signed acknowledg-
execute trading decisions on a ment from you that you have
rewards and risks of the received and understood the
discretionary basis.The account
trades they suggest. Trading itself, however, must still be Disclosure Document. As in any
recommendations may be with an FCM and in your name. method of participating in
futures trading, discuss and
communicated by phone,
understand the advisor’s fee
electronically via the arrangements. And if he will be
managing your account, ask the
44 45
Participate in a risks incurred by with a Disclosure Document

Commodity Pool an individual that contains information
trader. The pool about the pool operator, the
still trades in pool’s principals and any out-
Another alter native
futures contracts side persons who will be pro-
method of participating in which are highly leveraged and viding trading advice or making
futures trading is through a in markets which can be highly trading decisions. It must also
volatile. And like an individual disclose the previous perform-
commodity pool, which is
trader, the pool can suffer sub- ance records, if any, of all per-
similar in concept to a stantial losses.A major considera- sons who will be operating or
common stock mutual tion, therefore, is who will be advising the pool (or, if none,
fund. It is the only method managing the pool in terms of a statement to that effect).
directing its trading. Disclosure Documents contain
of participation in which important information and
While a pool must execute
you will not have your own all of its trades through a bro-
should be carefully read before
individual trading account. if you were to establish you invest your money. Ano-
kerage firm which is registered
ther requirement is that the
Instead, your money will be your own trading account. with the CFTC as an FCM, it may
Disclosure Document advise
or may not have any other affili-
combined with that of Another is that your risk of you of the risks involved.
ation with the brokerage firm.
other pool participants loss is generally limited to Some brokerage firms, to serve In the case of a new pool,
and, in effect, traded as a your investment in the those customers who prefer to there is frequently a provision
participate in commodity trad- that the pool will not begin trad-
single account.You share in pool, because most pools
ing through a pool, either oper- ing until (and unless) a certain
the profits or losses of the are formed as limited part- ate or have a relationship with amount of money is raised.
pool in proportion to your nerships. And you won’t be one or more commodity trading Normally, a time deadline is set
pools. Other pools operate inde- and the CPO is required to state
investment in the pool. subject to margin calls.
pendently. in the Disclosure Document
One potential advantage is what that deadline is (or, if there
Bear in mind, however, that In most instances, a
greater diversification of the risks which a pool incurs in Commodity Pool Operator
is none, that the time period for
risks than you might obtain any given futures transaction raising funds is indefinite). Be
(CPO) cannot accept your
are no different than the risks sure you understand the terms,
money until it has provided you
46 47
including how your money will Determine whether you will

be invested in the meantime,
what interest you will earn (if
be responsible for any losses in
excess of your investment in the costs
any), and how and when your
investment will be returned in
the event the pool does not
commence trading.
pool. If so, this must be indicated
prominently at the beginning of
the pool’s Disclosure Document.
fees
restrictions
Ask about fees and other costs, including what, if any,
initial charges will be made against your investment for
organizational or administrative expenses. Such informa-
disclosures
tion should be noted in the Disclosure Document. You With a few exceptions,
should also determine from the Disclosure Document how CPOs must be registered
the pool’s operator and advisor are compensated. with the CFTC and be
Members of NFA. You can
Understand, too, the procedure for redeeming your shares
verify that these require-
in the pool, any restrictions that may exist, and provisions ments have been met by
for liquidating and dissolving the pool if more than a certain conducting a background
percentage of the capital were to be lost. search on NFA’s BASIC
system at NFA’s Web site
Ask about the pool operator’s general trading philosophy, (www.nfa.futures.org) or by
what types of contracts will be traded, whether they will be contacting NFA toll-free at
800-621-3570.
day-traded, etc.
48 49
Establishing obligations as well as the rights

an Account and obligations of the firm with
which you are dealing before
you enter into any futures trans-
At the time you apply to
action. If you have questions
establish a futures trading about exactly what any provi-
account, you can expect to sions of the Agreement mean,
don’t hesitate to ask. A good
be asked for certain infor-
and continuing relationship can
mation beyond simply your exist only if both parties have,
name, address and phone from the outset, a clear under-
number. The requested standing of the relationship.
information will generally Nor should you be hesitant

to ask, in advance, what services
include (but not necessari- you will be getting for the trad-
ly be limited to) your ing commissions the firm
income, net worth, what charges.As indicated earlier, not
all firms offer identical services,
previous investment or
and not all clients have identical
At a minimum, the person or Just as you wouldn’t consider
futures trading experience needs. If it is important to you,
firm who will handle your buying a car or a house without
you have had, and any for example, you might inquire
account is required to provide carefully reading and under-
about the firm’s research capa-
other information needed you with risk disclosure docu- standing the terms of the con-
bility and whatever reports it
in order to advise you of ments or statements specified tract, neither should you estab-
makes available to clients. Other
by the CFTC and obtain written lish a trading account without
the risks involved in trad- subjects of inquiry could be
acknowledgment that you have first reading and understanding
how transaction and statement
ing futures contracts. You received and understood them. the Account Agreement and all
information will be provided,
will also be required to pro- other documents supplied by
Opening a futures account is a and how your orders will be
your broker. It is in your interest
vide proof of identity to serious decision and should obvi- handled and executed.
and the firm’s interest that you
ously be approached as such.
comply with federal law. clearly know your rights and
50 51
Introduction to Options on Futures Opportunity and Risk: An Educational Guide
Introduction to
Options on Futures
Although futures contracts during the life of the option. A Options on futures contracts
put option conveys to the option can offer a wide range of invest- However, options trading
have been traded on U.S.
buyer the right to sell a particu- ment opportunities.
exchanges since 1865, is a speculative investment
lar futures contract at a stated
options on futures contracts price at any time during the life and should be treated as
were not introduced until of the option. such. Even though the pur-
1982. There are two styles chase of options on futures
contracts limits your poten-
of options—American and
tial losses to the amount of
European. For the purposes
the investment,it is nonethe-
of this discussion, we will
less possible to lose your
focus on American-style
entire investment in a short
options.
period of time. And for
An option on a futures con- investors who sell rather
tract gives the option buyer the than buy options, there may
right—but not the obligation—
be no limit at all to the size
to buy or sell a particular futures
contract at a stated price at any of potential losses.
time prior to a specified date.
There are two types of options:
calls and puts.
A call option conveys to the
option buyer the right to pur-
chase a particular futures con-
tract at a stated price at any time
52
An option that currently has consensus opinion as to the

The Arithmetic
intrinsic value is said to be “in- likelihood of the option’s
of Option the-money” (by the amount of increasing in value prior to its
Premiums its intrinsic value). An option expiration.
that does not currently have
The three principal factors
intrinsic value is said to be
An option premium is There are two, known as intrin- that affect an option’s time
either “at-the-money” or “out-of-
sic value and time value. The value are:
the price paid by the buyer the-money.”
premium is the sum of these.
of the option and received
Intrinsic Time For example, at a time when a Time
by the seller of the option. Premium = + Value
Value Value U.S. Treasury bond futures contract
At the time you purchase a is trading at 120-00, a call option
particular option, its premi- Intrinsic Value with a strike price of 123-00 would
um cost may be $1,000. A be “out-of-the-money” by $3,000.
Intrinsic value is the amount Time to Expiration
month or so later, the same of money that could currently
option may be worth only be realized by exercising the
option at its strike price and liq-
Time Value
Options also have time value.
1 Time remaining until expiration.
Time value declines as the
$800 or $700 or $600. Or it uidating the acquired futures In fact, if a given option has no option approaches expiration.
could be worth $1,200 or position at the present price of intrinsic value—currently “out- At expiration, it will no longer
the futures contract of-the-money”—its premium have any time value. (This is
$1,300 or $1,400.
will consist entirely of time why an option is said to be a
Since an option is something For example, at a time when a value. wasting asset.)
that most people buy with the
intention of eventually liqui-
U.S. Treasury bond futures contract
is trading at a price of 120-00, a
Time value is the amount
option buyers are presently will-
2 Relationship between the
option strike price and the cur-
dating (hopefully at a higher call option conveying the right to ing to pay (and option sellers rent price of the underlying
price), it’s important to have at are willing to accept)—over and futures contract. The further an
purchase the futures contract at a
least a basic understanding of above any intrinsic value the option is removed from being
below-the-market strike price of
the major factors which influ- option may have—for the spe- worthwhile to exercise—the
115-00 would have an intrinsic further “out-of-the-money” it
ence the premium for a particu- cific rights that a given option
lar option at a particular time. value of $5,000. is—the less time value it is like-
conveys. It reflects, in effect, a
ly to have.
54 55
3 Volatility. The more volatile a

market is, the more likely it is
Understanding option investment, you should
be aware that:
You should fully understand
what a firm’s commission
that a price change may eventu- Options charges will be and how
■ Commission can be
ally make the option worth- Transaction Fees charged on a per-trade
they’re calculated. If the
while to exercise. Thus, the charges seem high—either on
or a round-turn basis,
option’s time value and premi- Before you decide to buy a dollar basis or as a percent-
covering both the pur-
um are generally higher in age of the option premium—
and/or sell (write) options, chase and sale.
volatile markets. you might want to seek com-
you should understand the ■ Commission charges can parison quotes from one or
differ significantly from
two other firms. If a firm seeks
+ other costs involved in the

transaction—commissions
and fees. ■
one brokerage firm to
another.
Some firms charge com-
to justify an unusually high
commission charge on the
basis of its services or per-
– Commission is the amount of

money, per option purchased or
sold, that is paid to the brokerage
missions per option
transaction and others
charge a percentage of
the option premium,
formance record, you might
want to ask for a detailed
explanation or documentation
in writing. In addition to com-
firm for its services, including the usually subject to a cer-
missions, some firms will
execution of the order on the tain minimum charge.
include a separate charge for
trading floor of the exchange. ■ Commission charges
exchange and NFA fees.
The commission charge increas- based on a percentage of
es the cost of purchasing an the premium can be sub-
option and reduces the sum of stantial, particularly if
= money received from selling an

option. In both cases, the premi-
um and the commission should
be stated separately.
■
the option is one that
has a high premium.
Commission charges
can have a major impact
on your chances of mak-
Each firm is free to set its
ing a profit.A high com-
own commission charges, but mission charge reduces
the charges must be fully dis- your potential profit
closed in a manner that is not and increases your
misleading. In considering an potential loss.
56 57
Leverage have expired worthless, and the

investor would have lost 100
Just as in futures trading,
percent of his investment plus
leverage plays an important role
any commissions and fees.
in trading options on futures.
The premium paid for an option Example: It’s January and
Calculating the Option
is only a small percentage of the
Break-Even Price
the 1,000 barrel April crude oil Strike Price $63.00
value of the assets covered by futures contract is currently trading
the underlying futures contract. Before purchasing any
at around $62.50 a barrel. Premium + .95
Therefore, even a small change option, it’s essential to deter-
Expecting a potentially significant Commission
in the futures contract price can mine precisely what the under-
lying futures price must be in
increase in the futures price over the & Transaction + .05
result in a much larger percent-
order for the option to be prof- next several months, you decide to Costs
age profit—or a much large per-
centage loss—in relation to the itable at expiration (or whenev- buy an April crude oil call option
Break-Even $64.00
premium. Consider the follow- er you choose to offset it). The with a strike price of $63. Assume Price
ing example: calculation isn’t difficult.All you the premium for the option is 95¢ a
need to know to figure a given barrel and that the commission and
An investor pays $200 for a
option’s break-even price is the
100-ounce gold call option with a other transaction costs are $50,
following:
strike price of $500 an ounce at a which amounts to 5¢ a barrel.
time when the gold futures price is ■ The option’s strike price; Before investing, you need to
$500 an ounce. If, at expiration, the know how much the April crude oil
■ The premium cost; and
futures price has risen to $503 (an futures price must increase by expi-
increase of less than one percent), ■ Commission and other
ration in order for the option to
the option value will increase by transaction costs.
break even or yield a net profit
$300 (a gain of 150 percent on your after expenses. The answer is that
original investment of $200). Use the following formula to
the futures price must increase to
determine the break-even price
But always remember that $64.00 for you to break even and
for a call option if you are the
leverage is a two-edged sword. In to above $64.00 for you to realize
purchaser:
the above example, unless the any profit.
futures price at expiration had Option Commission & Break
been above the option’s $500 Strike + Option + Transaction = Even
Price Premium Costs Price
strike price, the option would
58 59
The option will exactly break Example: The price of gold is

even if the April crude oil futures currently about $500 an ounce, but
price at expiration is $64.00 a during the next few months you
barrel. For each $1 a barrel the think there may be a sharp decline.
price is above $64.00, the option
To profit from the price decrease if
will yield a profit of $1,000.
you are right, you consider buying a Option
If the futures price at expiration is put option with a strike price of Strike Price $495.00
$64.00 or less, there will be a loss. $495 an ounce. The option would
But in no event can the loss exceed Premium – 3.70
give you the right to sell a specific
the $1,000 total of the premium, gold futures contract at $495 an Commission
commission and transaction costs. ounce at any time prior to the expi- & Transaction – .50
Costs
The arithmetic for determin-
ration of the option.
ing the break-even price for pur- Assume the premium for the put Break-Even $490.80
chasing a put option is the same option is $3.70 an ounce ($370 in Price
as for a call option except that
total) and the commission and
instead of adding the premium,
transaction costs are $50 (equal to The option will exactly break even at
commission and transaction
costs to the strike price, you
50¢ an ounce). expiration if the futures price is
subtract them. For the option to break even at $490.80 an ounce. For each $1 an
expiration, the futures price must ounce the futures price is below
Option Commission Break
decline to $490.80 an ounce or $490.80 it will yield a profit of $100.
Strike – Option – & Transaction = Even
Price Premium Costs Price lower. If the futures price at expiration
is above $490.80, there will be a
loss. But in no case can the loss
exceed $420—the sum of the pre-
mium ($370) plus commission and
other transaction costs ($50).
60 61
Factors Affecting the tract or an option on a June become worthwhile to exer- that are out-of-the-money do not
Choice of an Option futures contract. cise. For example, the right to normally respond to changes in
buy a crude oil futures contract the underlying futures price the
If you expect a price Bear in mind that the length of
at $61 a barrel is more valuable same as options that are at-the-
increase, you’ll want to consider an option (such as whether it has
than the right to buy a crude oil money or in-the-money.
the purchase of a call option. If three months to expiration or six
futures contract at $62 a barrel.
you expect a price decline, months) is an important variable Generally speaking,premiums
you’ll want to consider the pur-
chase of a put option. However,
in addition to price expecta-
affecting the cost of the option.
An option with more time com-
mands a higher premium.
length
Conversely, a put option with
a higher exercise price will have
a higher premium cost than a
for out-of-the-money options
do not reflect, on a dollar for
dollar basis, changes in the
tions, there are two other fac- put option with a lower exercise underlying futures price. The
tors that affect the choice of
option:
■ The amount of time
The option strike price
The relationship between the
strike
price. For example, the right to
sell a crude oil futures contract
at $62 a barrel is more valuable
change in option
value is usually less.
Indeed, a change
until the expiration of strike price of an option and the than the right to sell a crude oil in the underlying
■
the option (time value);
and
The option strike price
current price of the underlying
futures contract is, along with
the length of the option, a major
price
futures contract at $61 a barrel.
While the choice of a call
option or put option will be dic-
futures price
could have
little effect,
or even
(intrinsic value). factor affecting the option premi- tated by your price expectations
um. At any given time there may no effect
and your choice of expiration
be trading in options with a at all, on
month by when you look for the
half dozen or more strike the value of
The length of an option expected price change to occur,
prices—some of them below the the option. This
One of the attractive features the choice of strike price is
current price of the underlying could be the case
of options is that they allow somewhat more complex.
futures contract and some of if, for instance,
time for your price expectations That’s because the strike price
them above. the option re-
to be realized. The more time will influence not only the
mains deeply out-
you allow, the greater likelihood A call option with a lower option’s premium cost but also
of-the-money
the option could eventually strike price will have a higher how the value of the option,
after the price
become profitable. This could premium cost than a call option once purchased, is likely to
change or if
influence your decision about with a higher strike price respond to subsequent changes
expiration is
whether to buy, for example, an because the lower strike price in the underlying futures con-
near.
option on a March futures con- will more likely and more quickly tract price. Specifically, options
62 63
After You Example: In anticipation of rising

sugar prices, you bought a call option
Buy an Option on a sugar futures contract. The pre-
mium cost was $950 and the commis-
At any time prior to the In active markets, there are sion and transaction costs were $50.
usually other investors who are Sugar prices have subsequently risen
expiration of an option,
willing to pay for the rights your and the option now commands a pre-
you can: option conveys. How much
mium of $1,250. By liquidating the
they are willing to pay (it may
■ Offset the option; option at this price, your net gain is
be more or less than you paid)
■ Continue to hold the will depend on (1) the current $250. That’s the selling price of
option; or futures price in relation to the $1,250 minus the $950 premium
■ Exercise the option. option’s strike price, (2) the paid for the option minus $50 in com-
length of time still remaining mission and transaction costs.
until expiration of the option
Offset the Option and (3) market volatility. Premium paid for option $ 950
Premium received when option is liquidated $ 1,250
Liquidating an option in the Net profit or loss, after Increase in premium $ 300
same marketplace where it was allowance for commission Less transaction costs $ 50
bought is the most frequent charges and other transaction
method of realizing option prof- costs, will be the difference Net profit $ 250
its. Liquidating an option prior between the premium you paid
to its expiration for whatever to buy the option and the pre- You should be aware, howev- Assuming, though, that
value it may still have is also a mium you receive when you liq- er, that there is no guarantee that there’s still an active market, the
way to reduce your loss (by uidate the option. there will actually be an active price you get when you liqui-
recovering a portion of your market for the option at the time date will depend on the
investment) in case the futures you decide you want to liqui- option’s premium at that time.
price hasn’t performed as you date. If an option is too far Premiums are arrived at through
expected it would, or if the removed from being worthwhile open competition between buy-
price outlook has changed. to exercise or if there is too little ers and sellers according to the
time remaining until expiration, rules of an exchange.
there may not be a market for
the option at any price.
64 65
Continue to Hold
the Option
Exercise
the Option hold
The second alternative you
have after you buy an option is
to hold an option right up to the
You can also exercise the
option at any time prior to the
expiration of the option. It does
exercise
final date for exercising or liqui-
dating it.This means that even if
the price change you’ve antici-
not have to be held until expira-
tion. It is essential to under-
stand, however, that exercising
offset
pated doesn’t occur as soon as an option on a futures contract
you expected—or even if the means that you will acquire But there are both costs Even if you were to exercise
price initially moves in the either a long or short position in and significant risks involved in an option with the intention of
opposite direction—you can the underlying futures con- acquiring a position in the promptly liquidating the futures
continue to hold the option if tract—a long futures position if futures market. For one thing, position acquired through exer-
you still believe the market will you exercise a call and a short the broker will require a margin cise, there’s the risk that the
prove you right. If you are futures position if you exercise deposit to provide protection futures price which existed at
wrong, you will have lost the a put. against possible fluctuations in the moment may no longer be
opportunity to limit your losses the futures price. And if the available by the time you are
through offset. On the other Example: You’ve bought a call futures price moves adversely able to liquidate the futures
hand, the most you can lose by to your position, you could be position. Futures prices can and
option with a strike price of 70¢ a
continuing to hold the option is called upon—perhaps even often do change rapidly.
pound on a 40,000 pound live cattle
the sum of the premium and within hours—to make addi-
futures contract. The futures price For all these reasons, only a
transaction costs. This is why it tional margin deposits. There is
small percentage of option
is sometimes said that option
has risen to 75¢ a pound. Were you no upper limit to the extent of
buyers elect to realize option
buyers have the advantage of to exercise the option, you would these margin calls.
trading profits by exercising an
staying power. You should be acquire a long cattle futures position Secondly, unlike buying an option. Most choose the alter-
aware, however, that options at 70¢ with a “paper gain” of 5¢ a option, which limits potential native of having the broker off-
typically decline in value as they pound ($2,000). And if the futures losses, a futures position has set—i.e., liquidate—the option
approach expiration. (See “Time price were to continue to climb, so potentially unlimited risk. The at its currently quoted premi-
Value” on page 55). further the futures price moves um value.
would your gain.
against your position, the larger
your loss.
66 67
Who Sells
Example: At a time when the
(Writes) March U.S. Treasury Bond futures
Options and Why price is 125-00, an investor expect-
ing stable or lower futures prices
Up to now, we have dis- The attraction of option writ- (meaning stable or higher interest
ing to some investors is the rates) earns a premium of $400 by
cussed only the buying of
opportunity to receive the pre- writing a call option with a strike
options. But it stands to rea- mium that the option buyer
price of 129. If the futures price at
son that when someone pays. An option buyer antici-
expiration is below 129-00, the call
buys an option, someone pates that a change in the
option’s underlying futures
will expire worthless and the option
else sells it. In any given price at some point in time writer will retain the entire $400
transaction, the seller may prior to expiration will make premium. His profit will be that
be someone who previous- the option worthwhile to exer- amount less the transaction costs.
cise. An option writer, on the
ly bought an option and is other hand, anticipates that While option writing can be
now liquidating it. Or the such a price change won’t a profitable activity, it is also an
seller may be an individual occur—in which event the extremely high risk activity. In
option will expire worthless fact, an option writer may have
who is participating in the
and he will retain the entire an unlimited risk. Except for the
type of investment activity amount of the option premium premium received for writing
known as options writing. that was received for writing the option, the writer of an
the option. option stands to lose any
amount the option is in-the-
money at the time of expiration
(unless he has liquidated his
option position in the meantime
by making an offsetting pur-
chase).
68 69
In the previous example, an late a break-even price. For the

investor earned a premium of writer of a call, the break-even
$400 by writing a U.S. Treasury price is the option strike price
Bond call option with a strike plus the net premium received
price of 129. If, by expiration, after transaction costs. For the Option writing as an investment is absolutely inappropri-
the futures price has climbed writer of a put, the break-even
ate for anyone who does not fully understand the nature
above the option strike price by price is the option strike price
more than the $400 premium minus the premium received and the extent of the risks involved and who cannot afford
received, the investor will incur after transaction costs. the possibility of a potentially unlimited loss. It is also possi-
a loss. For instance, if the futures ble in a market where prices are changing rapidly that an
An option writer’s potential
price at expiration has risen to
profit is limited to the amount option writer may have no ability to control the extent of
131-00, the loss will be $1,600.
of the premium less transaction his losses. Option writers should be sure to read and thor-
That’s the $2,000 the option is
costs.The option writer’s poten-
in-the-money less the $400 pre- oughly understand the Risk Disclosure Statement that is
tial losses may be unlimited.And
mium received for writing the provided to them.
an option writer may need to
option (not including transac-
deposit funds necessary to
tion costs).
cover losses as often as daily.
As you can see from this
example, option writers as well
as option buyers need to calcu-
70 71
If a Dispute Should Arise Opportunity and Risk: An Educational Guide
If a Dispute
Shoud Arise The best way
to resolve a
All but a small percentage disagreement is
of transactions involving through direct
regulated futures and discussions by
options on futures contracts the parties
take place without prob- involved.
lems or misunderstandings.
However, in any business in
which millions of contracts
are traded each day, occa-
There are several advantages: If a hearing is required,
sional disagreements are In many circumstances, it it can generally be
inevitable. Obviously, the may be possible to seek resolu- ■ It tends to be faster and scheduled at a time
tion through the exchange less expensive than the and place convenient
best way to resolve a dis- other alternatives.
where the futures contracts for both parties.
agreement is through direct were traded or to file a claim for ■ You have a choice of ■ Unless you wish to do
discussions by the parties reparations with the CFTC. selecting industry or so, you do not have to
Unless you have signed a pre- non-industry related employ an attorney.
involved. Failing this, how-
dispute arbitration agreement, arbitrators.
ever, participants in futures you can also file a claim in ■ You do not necessarily For a plain language expla-
markets have several alter- court. However, most investors have to know what the nation of the arbitration pro-
choose to resolve the disagree- law is to successfully gram and how it works, write
natives (unless some partic-
ment through the arbitration prove your claim. or phone NFA for a copy of
ular method has been program conducted by National
■ In some cases, it may be Arbitration: A Way to Resolve
agreed to in advance). Futures Association.
possible to conduct arbi- Futures-Related Disputes. This
tration entirely through free booklet is also available on
written submissions. NFA’s Web site.
72 73
Glossary Opportunity and Risk: An Educational Guide
In Closing
This booklet ends where it Hopefully, the preceding

pages have helped to provide a
began, with the statement
better understanding of the
that it is not our intention to opportunities and the risks
suggest either that you
should or should not partic-
alike, as well as an understand-
ing of what futures markets are,
Glossary of Terms
how they work, who uses them,
ipate in futures markets. alternative methods of partici-
Low margins, high leverage, pation and, by no means least,
frequently volatile prices, the vital economic function
and the continuing needs of

which futures markets perform.
Trading Futures
In no way, it should be
hedgers to manage the price and
emphasized, should anything
uncertainties inherent in discussed herein be considered Options on Futures
their business create oppor- trading advice or recommenda-
tions. That should be provided
tunities to realize potentially
by your broker or advisor.
substantial profits. But for Similarly, your broker or advisor-
each such opportunity, as well as the exchanges where
futures contracts are traded-are
there is commensurate risk.
your best sources for additional,
Trading futures and options more detailed information
on futures, as stated at the about futures trading.
outset, is not for everyone.
74 75
Actuals Broker
See Cash Commodity. A company or individual that executes futures and options orders on
behalf of financial and commercial institutions and/or the general public.
Aggregation
The policy under which all futures positions owned or controlled by one Bull Market (Bull/Bullish)
trader or a group of traders are combined to determine reportable posi- A market in which prices are rising. A market participant who believes
tions and speculative limits. prices will move higher is called a “bull.”A news item is considered bull-
ish if it is expected to result in higher prices.
Arbitrage
The simultaneous purchase and sale of similar commodities in different Call Option (American Style)
markets to take advantage of a price discrepancy. An option which gives the buyer the right, but not the obligation, to pur-
chase (“go long”) the underlying futures contract at the strike price on or
Arbitration
before the expiration date.
The process of resolving disputes between parties by a person or persons
(arbitrators) chosen or agreed to by them. NFA's arbitration program pro- Carrying Broker
vides a forum for resolving futures-related disputes between NFA A member of a futures exchange, usually a clearinghouse member,
Members or between Members and customers. through which another firm, broker or customer chooses to clear all or
some trades.
Associated Person (AP)
An individual who solicits orders, customers or customer funds on behalf Cash Commodity
of a Futures Commission Merchant, an Introducing Broker, a Commodity The actual physical commodity as distinguished from the futures contract
Trading Advisor or a Commodity Pool Operator and who is registered based on the physical commodity. Also referred to as Actuals.
with the Commodity Futures Trading Commission.
Cash Market
At-the-Money Option A place where people buy and sell the actual commodities (i.e., grain ele-
An option whose strike price is equal—or approximately equal—to the vator, bank, etc.).
current market price of the underlying futures contract. See also Forward (Cash) Contract and Spot.
Basis Cash Settlement
The difference between the current cash price of a commodity and the A method of settling certain futures or options contracts whereby the mar-
futures price of the same commodity. ket participants settle in cash (payment of money rather than delivery of
the commodity).
Bear Market (Bear/Bearish)
A market in which prices are declining. A market participant who Charting
believes prices will move lower is called a “bear.”A news item is con- The use of graphs and charts in the technical analysis of futures markets
sidered bearish if it is expected to result in lower prices. to plot price movements, volume, open interest or other statistical
indicators of price movement.
Bid
See also Technical Analysis.
An expression of willingness to buy a commodity at a given price; the
opposite of Offer. Churning
Excessive trading that results in the broker deriving a profit from commis-
Board of Trade
sions while disregarding the best interests of the customers.
See Contract Market.
76 77
Circuit Breaker Commodity Pool

A system of trading halts and price limits on equities and derivatives An enterprise in which funds contributed by a number of persons are
markets designed to provide a cooling-off period during large, intraday combined for the purpose of trading futures or options contracts. The
market declines or rises. concept is similar to a mutual fund in the securities industry. Also
referred to as a Pool.
Clear
The process by which a clearinghouse maintains records of all trades Commodity Pool Operator (CPO)
and settles margin flow on a daily mark-to-market basis for its clearing An individual or organization which operates and solicits funds for a com-
members. modity pool.A CPO may be required to be registered with the CFTC.
Clearinghouse Commodity Trading Advisor (CTA)
A corporation or separate division of a futures exchange that is responsi- A person who, for compensation or profit, directly or indirectly advises oth-
ble for settling trading accounts, collecting and maintaining margin ers as to the advisability of buying or selling futures or commodity options.
monies, regulating delivery and reporting trade data. The clearinghouse Providing advice includes exercising trading authority over a customer’s
becomes the buyer to each seller (and the seller to each buyer) and account. A CTA may be required to be registered with the CFTC.
assumes responsibility for protecting buyers and sellers from financial
Confirmation Statement
loss by assuring performance on each contract.
A statement sent by a Futures Commission Merchant to a customer when
Clearing Member a futures or options position has been initiated.The statement shows the
A member of an exchange clearinghouse responsible for the financial price and the number of contracts bought or sold. Sometimes combined
commitments of its customers.All trades of a non-clearing member must with a Purchase and Sale Statement.
be registered and eventually settled through a clearing member.
Contract Market
Closing Price A board of trade designated by the CFTC to trade futures or options con-
See Settlement Price. tracts on a particular commodity. Commonly used to mean any exchange
on which futures are traded.Also referred to as an Exchange.
Closing Range
A range of prices at which futures transactions took place during the Contract Month
close of the market. The month in which delivery is to be made in accordance with the terms
of the futures contract.Also referred to as Delivery Month.
Commission
A fee charged by a broker to a customer for executing a transaction. Convergence
The tendency for prices of physical commodities and futures to approach
Commission House
one another, usually during the delivery month.
See Futures Commission Merchant.
Covered Option
Commodity Exchange Act (CEA)
A short call or put option position which is covered by the sale or pur-
The federal act that provides for federal regulation of futures trading.
chase of the underlying futures contract or physical commodity.
Commodity Futures Trading Commission (CFTC)
The federal regulatory agency established in 1974 that administers the
Commodity Exchange Act.The CFTC monitors the futures and options on
futures markets in the United States.
78 79
Cross-Hedging Designated Self-Regulatory Organization (DSRO)

Hedging a cash commodity using a different but related futures contract When a Futures Commission Merchant (FCM) is a member of more than
when there is no futures contract for the cash commodity being hedged one Self-Regulatory Organization (SRO), the SROs may decide among
and the cash and futures market follow similar price trends (e.g., using themselves which of them will be primarily responsible for enforcing
soybean meal futures to hedge fish meal). minimum financial and sales practice requirements. The SRO will be
appointed DSRO for that particular FCM. NFA is the DSRO for all non-
Customer Segregated Funds
exchange member FCMs.
See Segregated Account.
See also Self-Regulatory Organization.
Day Order
Disclosure Document
An order that if not executed expires automatically at the end of the trad-
The statement that some CPOs must provide to customers. It describes
ing session on the day it was entered.
trading strategy, fees, performance, etc.
Day Trader
Discount
A speculator who will normally initiate and offset a position within a sin-
(1) The amount a price would be reduced to purchase a commodity of
gle trading session.
lesser grade; (2) sometimes used to refer to the price differences
Default between futures of different delivery months, as in the phrase “July is
The failure to perform on a futures contract as required by exchange trading at a discount to May,” indicating that the price of the July future
rules, such as a failure to meet a margin call or to make or take delivery. is lower than that of May; (3) applied to cash grain prices that are below
the futures price.
Deferred Delivery Month
The distant delivery months in which futures trading is taking place, as Discretionary Account
distinguished from the nearby futures delivery month. An arrangement by which the owner of the account gives written power
of attorney to someone else, usually the broker or a Commodity Trading
Delivery
Advisor, to buy and sell without prior approval of the account owner.
The transfer of the cash commodity from the seller of a futures contract
Also referred to as a Managed Account.
to the buyer of a futures contract. Each futures exchange has specific pro-
cedures for delivery of a cash commodity. Some futures contracts, such as Electronic Order
stock index contracts, are cash settled. An order placed electronically (without the use of a broker) either via the
Internet or an electronic trading system.
Delivery Month
See Contract Month. Electronic Trading Systems
Systems that allow participating exchanges to list their products for
Derivative
trading electronically. These systems may replace, supplement or run
A financial instrument, traded on or off an exchange, the price of which is
along side of the open outcry trading.
directly dependent upon the value of one or more underlying securities,
equity indices, debt instruments, commodities, other derivative instru- Equity
ments, or any agreed upon pricing index or arrangement. Derivatives 1) The value of a futures trading account if all open positions were
involve the trading of rights or obligations based on the underlying prod- offset at the current market price; 2) an ownership interest in a com-
uct but do not directly transfer that product. They are generally used to pany, such as stock.
hedge risk.
80 81
Exchange Fundamental Analysis

See Contract Market. A method of anticipating future price movement using supply and
demand information.
Exercise
The action taken by the holder of a call option if he wishes to purchase Futures Commission Merchant (FCM)
the underlying futures contract or by the holder of a put option if he An individual or organization which solicits or accepts orders to buy or
wishes to sell the underlying futures contract. sell futures contracts or commodity options and accepts money or other
assets from customers in connection with such orders. An FCM must be
Exercise Price
registered with the CFTC.
See Strike Price.
Futures Contract
Expiration Date
A legally binding agreement to buy or sell a commodity or financial instru-
Generally the last date on which an option may be exercised. It is not
ment at a later date. Futures contracts are normally standardized accord-
uncommon for an option to expire on a specified date during the month
ing to the quality, quantity and delivery time and location for each com-
prior to the delivery month for the underlying futures contracts.
modity, with price as the only variable.
Extrinsic Value
Grantor
See Time Value.
See Writer.
First Notice Day
Guaranteed Introducing Broker
The first day on which notice of intent to deliver a commodity in fulfill-
A Guaranteed Introducing Broker is an IB that has a written agreement
ment of an expiring futures contract can be given to the clearinghouse by
with a Futures Commission Merchant that obligates the FCM to assume
a seller and assigned by the clearinghouse to a buyer.Varies from contract
financial and disciplinary responsibility for the performance of the
to contract. 1) The value of a futures trading account if all open positions
Guaranteed Introducing Broker in connection with futures and options
were offset at the current market price; 2) an ownership interest in a
customers. A Guaranteed Introducing Broker is not subject to minimum
company, such as stock.
financial requirements.
Floor Broker
Hedging
An individual who executes orders on the trading floor of an exchange
The practice of offsetting the price risk inherent in any cash market posi-
for any other person.
tion by taking an opposite position in the futures market. A long hedge
Floor Trader involves buying futures contracts to protect against possible increasing
An individual who is a member of an exchange and trades for his own prices of commodities.A short hedge involves selling futures contracts to
account on the floor of the exchange. protect against possible declining prices of commodities
Forward (Cash) Contract High
A contract which requires a seller to agree to deliver a specified cash The highest price of the day for a particular futures or options on futures
commodity to a buyer sometime in the future, where the parties expect contract.
delivery to occur.All terms of the contract may be customized, in contrast
Holder
to futures contracts whose terms are standardized.
The opposite of a Grantor.
Fully Disclosed See also Option Buyer.
An account carried by a Futures Commission Merchant in the name of an
individual customer; the opposite of an Omnibus Account.
82 83
In-the-Money Option Long

An option that has intrinsic value.A call option is in-the-money if its strike One who has bought futures contracts or options on futures contracts or
price is below the current price of the underlying futures contract.A put owns a cash commodity.
option is in-the-money if its strike price is above the current price of the
Low
underlying futures contract.
The lowest price of the day for a particular futures or options on futures
Independent Introducing Broker contract.
An Independent Introducing Broker is an IB subject to minimum capital
Maintenance Margin
requirements.
A set minimum amount (per outstanding futures contract) that a cus-
Initial Margin tomer must maintain in his margin account to retain the futures position.
The amount a futures market participant must deposit into a margin See also Margin.
account at the time an order is placed to buy or sell a futures contract.
Managed Account
See also Margin.
See Discretionary Account.
Intrinsic Value
Managed Funds Association (MFA)
The amount by which an option is in-the-money.
The trade association for the managed funds industry.
Introducing Broker (IB)
Margin
A firm or individual that solicits and accepts commodity futures orders
An amount of money deposited by both buyers and sellers of futures con-
from customers but does not accept money, securities or property from
tracts and by sellers of options contracts to ensure performance of the
the customer.All Introducing Brokers must be registered with the CFTC.
terms of the contract (the making or taking delivery of the commodity or
Last Trading Day the cancellation of the position by a subsequent offsetting trade). Margin
The last day on which trading may occur in a given futures or option. in commodities is not a down payment, as in securities, but rather a per-
formance bond.
Leverage
See also Initial Margin, Maintenance Margin and Variation Margin.
The ability to control large dollar amounts of a commodity with a com-
paratively small amount of capital. Margin Call
A call from a clearinghouse to a clearing member, or from a broker or firm
Limit
to a customer, to bring margin deposits up to a required minimum level.
See Position Limit, Price Limit, Variable Limit.
Mark-to-Market
Liquidate
To debit or credit on a daily basis a margin account based on the close of
To sell a previously purchased futures or options contract or to buy back
that day’s trading session. In this way, buyers and sellers are protected
a previously sold futures or options position. Also referred to as Offset.
against the possibility of contract default.
Liquidity (Liquid Market)
Market Order
A characteristic of a security or commodity market with enough units out-
An order to buy or sell a futures or options contract at whatever price is
standing and enough buyers and sellers to allow large transactions with-
obtainable when the order reaches the trading floor.
out a substantial change in price.
Maximum Price Fluctuation
Local
See Price Limit.
A member of an exchange who trades for his own account.
84 85
Minimum Price Fluctuation Open Interest

See Tick. The total number of futures or options contracts of a given commodity
that have not yet been offset by an opposite futures or option transaction
Naked Option
nor fulfilled by delivery of the commodity or option exercise. Each open
See Uncovered Option.
transaction has a buyer and a seller, but for calculation of open interest,
National Futures Association (NFA) only one side of the contract is counted.
Authorized by Congress in 1974 and designated by the CFTC in 1982 as
Open Outcry
a “registered futures association,” NFA is the industrywide self-regulatory
A method of public auction for making bids and offers in the trading pits
organization of the futures industry.
of futures exchanges.
Nearby Delivery Month
Open Trade Equity
The futures contract month closest to expiration. Also referred to as the
The unrealized gain or loss on open positions.
Spot Month.
Opening Range
Net Asset Value
The range of prices at which buy and sell transactions took place during
The value of each unit of participation in a commodity pool. Basically a
the opening of the market.
calculation of assets minus liabilities plus or minus the value of open posi-
tions when marked to the market, divided by the total number of out- Option Buyer
standing units. The purchaser of either a call or put option. Option buyers receive the
right, but not the obligation, to assume a futures position.Also referred to
Net Performance
as a Holder.
An increase or decrease in net asset value exclusive of additions,
withdrawals and redemptions. Option Contract
A contract which gives the buyer the right, but not the obligation, to buy
Offer
or sell a specified quantity of a commodity or a futures contract at a spe-
An indication of willingness to sell a futures contract at a given price; the
cific price within a specified period of time. The seller of the option has
opposite of Bid.
the obligation to sell the commodity or futures contract or to buy it from
Offset the option buyer at the exercise price if the option is exercised.
See Liquidate. See also Call Option and Put Option.
Omnibus Account Option Premium
An account carried by one Futures Commission Merchant (FCM) with The price a buyer pays (and a seller receives) for an option. Premiums are
another FCM in which the transactions of two or more persons are com- arrived at through the market process. There are two components in
bined and carried in the name of the originating FCM rather than of the determining this price—extrinsic (or time) value and intrinsic value.
individual customers; the opposite of Fully Disclosed.
Option Seller
Open See Writer.
The period at the beginning of the trading session officially designated
Out-of-the-Money Option
by the exchange during which all transactions are considered made “at
A call option with a strike price higher or a put option with a strike price
the open.””
lower than the current market value of the underlying asset, (i.e., an
option that does not have any intrinsic value).
86 87
Over-the-Counter Market (OTC) Purchase and Sale Statement (P&S)

A market where products such as stocks, foreign currencies and other A statement sent by a Futures Commission Merchant to a customer when
cash items are bought and sold by telephone, Internet and other electron- a futures or options position has been liquidated or offset.The statement
ic means of communication rather than on a designated futures exchange. shows the number of contracts bought or sold, the prices at which the
contracts were bought or sold, the gross profit or loss, the commission
Pit
charges and the net profit or loss on the transaction. Sometimes com-
The area on the trading floor where trading in futures or options con-
bined with a Confirmation Statement.
tracts is conducted by open outcry. Also referred to as a ring.
Put Option
Pool
An option which gives the buyer the right, but not the obligation, to sell
See Commodity Pool.
the underlying futures contract at a particular price (strike or exercise
Position price) on or before a particular date.
A commitment, either long or short, in the market.
Quotation
Position Limit The actual price or the bid or ask price of either cash commodities or
The maximum number of speculative futures contracts one can hold as futures or options contracts at a particular time.
determined by the CFTC and/or the exchange where the contract is traded.
Range
Position Trader The difference between the high and low price of a commodity during
A trader who either buys or sells contracts and holds them for an extend- a given trading session, week, month, year, etc.
ed period of time, as distinguished from a day trader.
Regulations (CFTC)
Premium The regulations adopted and enforced by the CFTC in order to administer
Refers to (1) the price paid by the buyer of an option; (2) the price the Commodity Exchange Act.
received by the seller of an option; (3) cash prices that are above the
Reparations
futures price; (4) the amount a price would be increased to purchase a
The term is used in conjunction with the CFTC’s customer claims proce-
better quality commodity ; or (5) a futures delivery month selling at a
dure to recover civil damages.
higher price than another.
Reportable Positions
Price Discovery
The number of open contracts specified by the CFTC when a firm or
The determination of the price of a commodity by the market process.
individual must begin reporting total positions by delivery month to the
Price Limit authorized exchange and/or the CFTC.
The maximum advance or decline, from the previous day's settlement
Round Turn
price, permitted for a futures contract in one trading session.Also referred
A completed futures transaction involving both a purchase and a liquidating
to as Maximum Price Fluctuation.
sale, or a sale followed by a covering purchase.
Rules (NFA)
The standards and requirements to which participants who are required to
be Members of National Futures Association must subscribe and conform.
88 89
Scalper Stop Order

A trader who trades for small, short-term profits during the course of a An order that becomes a market order when the futures contract reaches
trading session, rarely carrying a position overnight. a particular price level. A sell stop is placed below the market, a buy stop
is placed above the market.
Segregated Account
A special account used to hold and separate customers’ assets for trading Strike Price
on futures exchanges from those of the broker or firm. The price at which the buyer of a call (put) option may choose to exer-
cise his right to purchase (sell) the underlying futures contract. Also
Self-Regulatory Organization (SRO)
called Exercise Price.
Self-regulatory organizations (i.e., the futures exchanges and National
Futures Association) enforce minimum financial and sales practice Technical Analysis
requirements for their members. An approach to analysis of futures markets which examines patterns of
See also Designated Self-Regulatory Organization. price change, rates of change, and changes in volume of trading, open
interest and other statistical indicators.
Settlement Price
See also Charting.
The last price paid for a futures contract on any trading day. Settlement
prices are used to determine open trade equity, margin calls and invoice Tick
prices for deliveries. The smallest increment of price movement for a futures contract. Also
referred to as Minimum Price Fluctuation.
Short
One who has sold futures contracts or plans to purchase a cash commodity. Time Value
The amount of money options buyers are willing to pay for an option in
Speculator
anticipation that over time a change in the underlying futures price will
A market participant who tries to profit from buying and selling futures
cause the option to increase in value. In general, an option premium is the
and options contracts by anticipating future price movements.
sum of time value and intrinsic value.Any amount by which an option pre-
Speculators assume market price risk and add liquidity and capital to the
mium exceeds the option's intrinsic value can be considered time value.
futures markets.
Also referred to as Extrinsic Value.
Spot
Uncovered Option
Usually refers to a cash market for a physical commodity where the par-
A short call or put option position which is not covered by the purchase
ties generally expect immediate delivery of the actual commodity.
or sale of the underlying futures contract or physical commodity.
Spot Month Also referred to as a Naked Option.
See Nearby Delivery Month.
Underlying Futures Contract
Spreading The specific futures contract that the option conveys the right to buy (in
The buying and selling of two different delivery months or related case of a call) or sell (in the case of a put).
commodities in the expectation that a profit will be made when the
Variable Limit
position is offset.
A price system that allows for larger than normal allowable price move-
ments under certain conditions. In periods of extreme volatility, some
exchanges permit trading at price levels that exceed regular daily
price limits.
90 91
Variation Margin
Additional Resources
Additional margin required to be deposited by a clearing member firm to
the clearinghouse during periods of great market volatility or in the case
of high-risk accounts. Commodity Futures Trading Commission Kansas City Board of Trade (KCBT)
Three Lafayette Centre 4800 Main St., Suite 64112
Volatility 1155 21st Street, NW (816) 753-7500
A measurement of the change in price over a given time period. Washington, DC 20581 www.kcbt.com
(202) 418-5800
Volume www.cftc.gov Minneapolis Grain Exchange (MGE)
The number of purchases and sales of futures contracts made during a 400 S. Fourth St.
specified period of time, often the total transactions for one trading day. CBOE Futures Exchange (CFE) Minneapolis, MN 55415
400 S. LaSalle St. (612) 321-7101
Writer Chicago, IL 60605 www.mgex.com
A person who sells an option and assumes the potential obligation to sell (312) 786-5600
(in the case of a call) or buy (in the case of a put) the underlying futures www.cfe.cboe.com NASDAQ OMX Futures Exchange (NFX)
contract at the exercise price.Also referred to as an Option Grantor. 1900 Market St.
Yield Chicago Climate Futures Exchange (CCFE) Philadelphia, PA 19103
400 S. LaSalle St. (215) 496-5000
A measure of the annual return on an investment.
Chicago, IL 60605 www.nasdaqtrader.com/Micro.aspx?id=PBOToverview
(312) 554-3350
www.chicagoclimatex.com North American Derivatives Exchange (Nadex)
311 S. Wacker Dr., Suite 2675
CME Group Chicago, IL 60606
141 W. Jackson Blvd. (312) 884-0100
Chicago, IL 60604 www.nadex.com
(312) 435-3500
www.cmegroup.com OneChicago
141 W. Jackson Blvd., Suite 2240
ICE Futures U.S. (ICE) Chicago, IL 60604
1 North End Avenue (312) 424-8500
New York, NY 10282 www.onechicago.com
(212) 748-4000
www.theice.com
92 93

Opportunity: Trading Futures Options On Futures

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Opportunity

ILLUSTRATION Options on Futures

© 2006 National Futures Association All Rights Reserved.

No part of this book may be reproduced, stored, or transmitted by any means,

Additional Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .93

mortgage bankers bonds dealers

Speculative participation in The pages which follow are

The U.S. futures industry ment powers of the CFTC are

Introduction to Since delivery on futures Cash settlement futures con-

Reasons for Reasons for

tion at will. In this event, possible Daily

Leverage can Each tick is $

ing of leverage—and of how it

requirements sharply increase Margins futures trading. It is much like

Before trading in futures

margin your account to $2,000. bank or provide same-day

Basic For example, assume it’s now

Price Per Value of 5,000

Price Per Value of 40,000

How to Participate Merchants (FCMs)

in Futures Trading Commodity

next step is to consider var- in making trading decisions and

An individual trading account

Have Someone is acceptable. Others tailor their

Participate in a risks incurred by with a Disclosure Document

including how your money will Determine whether you will

Establishing obligations as well as the rights

information will generally Nor should you be hesitant

An option that currently has consensus opinion as to the

3 Volatility. The more volatile a

+ other costs involved in the

– Commission is the amount of

= money received from selling an

Leverage have expired worthless, and the

The option will exactly break Example: The price of gold is

After You Example: In anticipation of rising

In the previous example, an late a break-even price. For the

This booklet ends where it Hopefully, the preceding

and the continuing needs of

Circuit Breaker Commodity Pool

Cross-Hedging Designated Self-Regulatory Organization (DSRO)

Exchange Fundamental Analysis

In-the-Money Option Long

Minimum Price Fluctuation Open Interest

Over-the-Counter Market (OTC) Purchase and Sale Statement (P&S)

Scalper Stop Order

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