BUSINESS ADMINISTRATION FACULTY TETOVO MA studies

Portfolio and Securities Management

Subject: Some information about Futures Contracts

Worked by: Berat Jusufi 106426

Tetovo, january 2012

Contents

The Basics of Futures What is a Futures Contract? What are the Mechanics of a Futures Trade? Futures as an Investment Understanding a Futures Price How Futures and Options Markets Work Margin: The Power of Leverage Why Trade Futures and Options? Offsetting Contracts Common Types of Orders Who Uses Future Contracts?

The Basics of Futures

Futures contracts are financial assets just like stocks and bonds, but with some important differences. These differences are what make futures such an appealing investment for traders. Many tend to think that futures are too complicated to understand and consequently, miss many opportunities by not trading them. However, there is a simple but true formula that applies to futures trading as surely as it does to trading in stocks, bonds and real estate. Money is made if one buy low and sell high. With futures, one can sell before he buys, so the simple rule can also read: sell high and buy back low. What is a Futures Contract?

In the simplest terms, a futures contract is an agreement in which a buyer and a seller agree to consummate a transaction at a predetermined time in the future at a price agreed upon today. Consider the case of the farmer who estimates that it will cost $1.50 per bushel to grow corn and also that the crop will be 100,000 bushels during the summer. The farmer can enter into a contract with a buyer to sell the anticipated 100,000 bushels of corn at a price that represents a profit before the crop is even planted. So the contract stipulates that the farmer will sell 100,000 bushels to the buyer for $2.00 per bushel on September 1 which is 5 months later, regardless of the price of corn at that time in the cash market. The cash market, also known as the spot market is the price at which corn is being sold on that day for immediate delivery. If the farmer does grow 100,000 bushels and the price of the corn does turn out to be $1.50 a bushel, then the farmer will have a profit of $50,000 (100,000 bushels X $0.50) With a futures contract, the underlying merchandise is known. For example, you can buy a futures contract on gold, lumber, pork bellies, swiss francs, and many other items. The underlying item or commodity is described specifically in the contract specifications which are determined by the futures exchange on which it trades. The full price of the commodity must be paid only upon contract expiration at which point the trader takes delivery, if one bought futures, or makes delivery, if he sold futures, of the underlying commodity. Finally, transactions in futures can only be done on futures exchanges. These exchanges are located primarily in Chicago and New York. What are the Mechanics of a Futures Trade?

With a futures contract, the underlying merchandise is known. For example, an investor can buy a futures contract on gold, lumber, pork bellies, swiss francs, and many other items. The underlying item or commodity is described specifically in the contract specifications which are determined by the futures exchange on which it trades. The price of a futures transaction is

agreed upon initially between the buyer and seller, and remains fixed over the holding period, or length of the contract. Each participant in a futures contract is required to open a futures account for depositing margin. Margin is money deposited by both the buyer and the seller to assure the integrity of the contract. Finally, the full price of the commodity must be paid only upon contract expiration at which point the trader takes delivery, if the trader bought futures, or make delivery, if he sold futures, of the underlying commodity. Transactions in futures can only be done on futures exchanges. Futures as an Investment

When a trader buys a futures, he locks in a purchase price for the underlying commodity. Similarly, when he sells a futures, he locks in a selling price of the underlying commodity. How, then, does one make money trading futures? Well, futures prices move around all of the time, that is, they are volatile. Prices of agricultural commodities, for example, may rise in response to unfavorable weather conditions, increased demand by importers, or spread of plant diseases, and fall in response to abundant supplies or a shift in consumer preference. If prices go up after a trader buys a futures contract, then he earns profit since the futures contract has increased in value. For example, if you buy one gold futures at $340 per ounce and two weeks later, the price of gold futures is trading at $350 per ounce, then your futures contract is now worth $10 per ounce more than when you bought it. One futures contract represents 100 ounces of gold, so the total profit on your gold futures position is $1,000. However, gold prices could have fallen instead, in which case the trader would have suffered a loss. The challenge is to anticipate price movements correctly and make the appropriate trade. If a trader expects prices to rise, he will buy futures or, he can buy call options, and if he expects prices to decline, he will sell futures or, he can buy put options. If his expectations turn out to be correct, then he will make money. If not, he will lose money. Realistically, it is virtually impossible to be right all of the time. In fact, many traders are wrong more often than right. Managing risk is the key here.

Margin: The Power of Leverage

Futures contracts are highly leveraged instruments. This is what makes them an appealing investment, and also a risky one. Leverage means that the traders need only commit a little money to control a lot of product. Since a futures contract is based on deferred delivery, no money is exchanged at the time a trader buy or sell the futures contract. Therefore, not a lot of money is needed to buy or sell a futures contract. The margin that traders have to deposit when they buy or sell a futures contract, represents a performance bond - a guarantee that they can handle the risk of the futures position.

A futures margin deposit is not the same as margin on stock purchases. Both margins secure one's purchases or sales, but they differ in many ways. Stock market margins are a form of down payment for the purchases of an asset. A futures margin is more of a performance pledge, ensuring that obligations will be honored. Since a futures deposit is not an extension of credit (like a stock margin is), one may earn interest rather than pay it. Moreover, while a stock margin is typically 50% of the value of the purchased assets, a futures margin generally ranges from 510% of the contract value. There are two kinds of margin: initial margin and maintenance margin. Initial margin is that minimum amount of cash that must reside in the trader's trading account the first day that he establishes a futures position, whether long or short, and ranges from 2% to 20% of the market value of the futures position, although it can be less. Maintenance margin is that minimum amount of cash that must reside in the trading account the second day and every subsequent day so long as the trader continues to carry the futures position. Maintenance margin is usually less than initial margin, so the amount of cash one needs to carry a position is less than that required to establish the position. Margin requirements are met by the cash or equity in the trader's account and that equity is eroded if his futures position starts to lose money. (Equity increases if his position becomes profitable.) If total equity in his account falls below the maintenance margin level, then he will be required to close open positions or to deposit additional funds in his trading account to bring the equity level back up to the initial margin level. This request for additional funds is referred to as amargin call. Any profits over the initial margin requirement may be withdrawn or used as margin for other futures contracts. The determination of the account equity is done by the clearing house at the end of every trading day using futures settlement prices. That is, the trader's position is marked-to-market daily. Any request for additional margin must be deposited into the account by the following morning, or else the futures positions may be closed. Lack of control of leverage is the single leading cause of financial death among beginning futures traders because most tend to "bite off more than they can chew". Since with a little money, one can control a lot of product, net profit or loss can quickly become significant relevant to one's initial margin. This can, in turn, make him very rich or very poor in a short space of time. It is important, therefore, to control leverage. For example, in Spring of 1994, June live cattle futures plunged $11 per hundredweight (cwt) over 32 trading days as the number and weight of cattle on feed increased. A trader who sold one June cattle futures contract at $74 per cwt having initial margin of $700 earned close to $4,400 as prices fell to $63 per cwt ($11 gain per cwt x 400 cwt) for a return of 628% on the initial investment in little more than a month. On the other side, a trader who had purchased cattle futures over this time period would have lost around $4,400 per contract.

hy Trade Futures and Options?

Some of the features that make futures and options appealing investments include leverage, diversification, opportunity, liquidity and price availability. y Leverage [Back to the top] Futures and options have a unique feature that make them a more attractive instrument from a trading perspective than stocks and bonds, and that is high leverage. Leverage is a measure of the worth or value of an investment relative to the money required to buy (or sell) the investment. For example, if a trader needs to pay the full value of an asset when he buys it, then there is no leverage. On the other hand, if the trader only needs to put up a small fraction of the value of an asset in order to buy it, then leverage is high. Futures are highly leveraged assets since only a little money, referred to as margin, is needed to control a lot of futures value. Typically, a futures contract can be bought or sold with a margin of 2% to 20% of the value of the contract. As mentioned before, with futures, the money or margin required to buy or sell a contract is not a cost but just a "goodwill" performance bond - you get this money back when you close your futures position, plus any gain or minus any loss on the futures position itself. y Diversification [Back to the top] Futures contracts are also appealing because they can provide diversification to a portfolio of traditional financial assets such as stocks and bonds. Many investors are already aware of the benefits of diversification within their equity portfolios - the more company stocks you hold, the less volatile is the value of your overall portfolio since as some stocks go down, others go up. On average, the portfolio earns a return very similar to the entire market. In the same way, an investment in futures can provide diversification benefits in terms of reducing the overall risk of one's investment portfolio and increasing total profits. y Opportunity [Back to the top] Futures and options are available on a wide range of instruments including agricultural commodities like wheat and soybeans, precious metals like gold and silver, foreign currencies like the Deutschemark and Canadian dollar, interest rates like U.S. long-term bonds and Treasury bills, soft commodities like coffee and sugar, index products on equities and currencies, and energy products like crude oil and natural gas, to name a few. With all of these markets, one is bound to discover a trading opportunity or two at almost any time. y Liquidity [Back to the top] Investors require market liquidity. A market is said to be liquid if transactions can be executed quickly and easily. There are many futures markets that are liquid, sometimes even more liquid than the cash market for the underlying instruments themselves. For instance, the futures market in U.S. Treasury bonds is regarded as being much more liquid than the cash market. In some cases, the futures market is so liquid that futures prices become the industry benchmark. For example, gold, crude oil and cotton futures prices form the basis for pricing other related products in the industry. On the other hand, some futures markets are thin, meaning not very liquid. A trader should know the liquidity of the market that he is trading or wants to trade, and adjust his trading style appropriately. Volume and open interest provide a good indication of market liquidity, the higher are they, the more liquid is the market.

y Price Availability [Back to the top] Futures and options prices are readily available from a wide range of sources including the Internet. This makes it very easy for traders to monitor the markets, determine their entry and exit points, and manage their futures positions - all of which provide more reasons to trade futures. Offsetting Contracts

In reality, most trader are looking to profit from movements in futures prices and do not want to actually buy or sell bushels of oats, or bars of gold, or whatever is the underlying commodity of the contract. So, most will not hold a futures contract to its expiration. In practice, only a small percentage of futures contracts traded are actually held to delivery. Instead, one can close or square his futures position by entering an equal but opposite trade - for example, buying if he previously sold or selling if he previously bought. By offsetting a futures contract, the trader cancels any obligation he has to make or take delivery of the underlying commodity. The difference between the price of the futures contract when the trade was initiated and the price when it is offset is the net gain or loss on the trade. Offsetting must be done prior to contract expiration, and these differ depending upon the futures in question. Common Types of Orders

A futures or options order originates with the customer, and is simply a set of instructions for the executing broker. A trader uses a futures order or options order to tell his broker exactly what to buy or sell, when to do it, and at what price. There are many types of orders, each being used during different occasions, but the most common are the market order, the limit order, and the stop order. The examples below use these orders for futures transactions, but the identical orders can be used for option transactions. All orders are assumed to be day orders, meaning that they automatically expire at the end of the trading day if not filled or executed, unlessit is specified that the order is "open" or GTC (Good Till Cancelled). A GTC order remains a working order session after session until it is filled or cancelled by the trader who put in the order. y The Market Order [Back to the top] A market order is the simplest of orders and is used when the greatest priority of the customer is for immediate execution. An order is executed or filled when the futures contracts have all been bought or sold, depending upon the instructions in the order. A market order instructs the executing broker to buy or sell futures contracts immediately at the market price, the best possible price for immediate execution. Market orders are the easiest way to enter or exit a market since the customer receives immediate execution - and must pay or receive whatever price is necessary for immediate execution. For example, a customer who wants to sell 5 March cotton futures immediately would call his broker with a market order to sell 5 March cotton at the market.

There are times when a market order may not result in immediate execution. Some futures contract markets have price limits outside of which no trades can be executed. If prices rise and reach the upper limit, one may be unable to get execution of a market order to buy since sellers may be waiting for prices to go even higher. Similarly, if prices fall to the lower price limit, one may be unable to get execution of a market order to sell since buyers may be waiting for prices to fall even further. In these cases, the trader must wait until the price limits are expanded, which may not happen until the next day, before a market order can be executed. For example, cotton futures may have price limits set at three cents per pound above and below the previous day's settlement price. If prices rally to the upper limit, a market order to buy may go unexecuted and returned as "unable". The market order will have to be re-entered the following day when price limits are expanded. As well, a market order may not result in immediate execution during times when trading is very thin or illiquid. In these cases, there is no available counterparty to your trade and your market order consequently goes unfilled.

y The Limit Order [Back to the top] A limit order is like a market order with one exception, price takes the highest priority. For limit buy orders, the customer includes, along with the type and quantity of futures contracts to purchase, a maximum price to pay for the contracts. A customer will use a limit buy order if they desire to buy the futures contract, but want to pay no more than a specified price - the limit price. This price is always below the prevailing market price, since the customer would have otherwise entered a market order. For example, December gold is trading at $395.75 per ounce. A customer who enters a limit order to buy 5 December contracts at $392.00 is willing to buy gold futures only if they can be acquired for $392.00 per ounce. A limit order to buy is only executed if the market price declines to the limit price. Limit orders are assumed to be day orders, meaning that if prices have not declined to the specified limit by the end of the day, then the order is left unfilled and cancelled. For limit sell orders, the customer includes, along with the type and quantity of futures contracts to sell, a minimum price to sell the contracts. A customer will use a limit sell order if they desire to sell the futures contract, but want to receive at least some specified price - the limit price. This price is always above the prevailing market price, since the customer would have otherwise entered a market order. For example, December gold is trading at $395.75 per ounce. A customer who enters a limit order to sell 5 December contracts at $398.00 is willing to sell gold futures only at a price of $398.00 per ounce or higher. A limit order to sell is only executed if the market price rises to the limit price.

y The Stop Order [Back to the top] A stop order, like a limit order, is only executed once a specific price is reached, but the motivation for the transaction is different. Whereas the limit order is typically used to enter into a futures position at a specific price, a stop order is usually used to exit or close a futures position at a specific price. Stop orders are most often used to close a position that is losing money, and are hence regarded as a useful risk management tool. A stop order to buy has a price that is above the market price and would be used by a customer having a short futures position. If prices rise so that loss accrues on the customer's short position, the stop loss provides a limit to the loss

- as soon as prices rise to the stop price, the order is executed as a market order. For instance, with September Canadian dollar futures at $.7225, a customer who is short 10 futures might enter a stop loss order to buy 10 September Canadian dollar futures at $.7300. If prices rise to the stop price, the order is executed as a market order and the resulting long position offsets or closes out their initial short position. Similarly, a stop order to sell has a price that is below the market price and would be used by a customer having a long futures position. If prices fall so that loss accrues on the customer's long position, the stop loss provides a limit to the loss - as soon as prices fall to the stop price, the order is executed, thereby closing out the initial long position. Stop orders do not guarantee that the loss on a futures position will be confined to the stop price. Prices may continue to move adversely as the stop order is being executed resulting in larger loss than anticipated. This should be taken into account when using stop orders as a risk management tool. Who Uses Future Contracts?

There are two reasons to use futures contracts: 1) To hedge a price risk, and 2) To speculate in the changing price. A hedger is someone who owns or plans to purchase an inventory of a commodity and wishes to reduce risk associated with this ownership. Hedgers make their purchases or sales solely for the purpose of establishing a known price level in advance for something they later intend to buy or sell in the cash market. They do this by taking an equal and opposite position in the futures market than they have in the cash market. As the price of the commodity fluctuates, the hedger is protected because gains in one market are offset by losses in the other market, regardless of which direction the price moves. Hedgers willingly give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes. Speculators, on the other hand, are willing to accept the risk the hedger wishes to relinquish. Speculators take positions on their expectations of future price movement often with no intention of making or taking delivery of the commodity. They buy when they anticipate rising prices and sell when they anticipate declining prices. The speculator provides a very important function in the futures market because without him, the market would not be liquid and the price protection sought by the hedger would be very costly.

References

www.wikinvest.com/wiki/Futures www.marketwatch.com/tools/marketsummary/futures/contracts.asp futures.tradingcharts.com/marketquotes/CL.html www.bloomberg.com/markets/stocks/futures/