How to trade stock options and futures contracts

This process is known as marking to market. Although by law the commission regulates all transactions, each exchange can have its own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out. In Europe, formal futures markets appeared in the Dutch Republic during the 17th century. Nor is the contract standardized, as on the exchange. Initial margin is set by the exchange. The Dutch pioneered several financial instruments and helped lay the foundations of modern financial system. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. This money goes, via margin accounts, to the holder of the other side of the future. For a list of tradable commodities futures contracts, see List of traded commodities. In the case of physical delivery, the forward contract specifies to whom to make the delivery.

The price of entering a futures contract is equal to zero. This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Basingstoke, Hampshire: Macmillan Press. Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. Calls for margin are usually expected to be paid and received on the same day. Futures are often used since they are delta one instruments. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation. Forwards are basically unregulated, while future contract are regulated at the federal government level.

However, the exchanges require a minimum amount that varies depending on the contract and the trader. With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil, and experts are divided on the matter. We define the forward price to be the strike K such that the contract has 0 value at the present time. Margins, sometimes set as a percentage of the value of the futures contract, must be maintained throughout the life of the contract to guarantee the agreement, as over this time the price of the contract can vary as a function of supply and demand, causing one side of the exchange to lose money at the expense of the other. ICE Brent futures use this method. More typical would be for the parties to agree to true up, for example, every quarter. Thus there is no risk of counterparty default. Physical delivery is common with commodities and bonds. Pavaskar, Madhoo: Commodity Derivatives Trading: Theory and Regulation.

If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level. When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. They may transact only on the settlement date. This is a type of performance bond. Futures Commission Merchants are responsible for overseeing customer margin accounts. Boston: Harvard Business School Press.

In 1976, the IMM added interest rate futures on US treasury bills, and in 1982 they added stock market index futures. Thus futures have significantly less credit risk, and have different funding. For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Simply put, the risk of a forward contract is that the supplier will be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. Among the most notable of these early futures contracts were the tulip futures that developed during the height of the Dutch Tulipmania in 1636. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. This difference is generally quite small though. Option sellers are generally seen as taking on more risk because they are contractually obligated to take the opposite futures position if the options buyer exercises their right to the futures position specified in the option.

The counterparty for delivery on a futures contract is chosen by the clearing house. The low margin requirements of futures results in substantial leverage of the investment. In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. The social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences, from a hedger to a speculator, for example. The price of an option is determined by supply and demand principles and consists of the option premium, or the price paid to the option seller for offering the option and taking on risk. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. Friday of certain trading months. The first two characters identify the contract type, the third character identifies the month and the last two characters identify the year.

Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in their margin account. Thus, while under mark to market accounting, for both assets the profit or loss of money accrues over the holding period; for a futures this profit or loss of money is realized daily, while for a forward contract the profit or loss of money remains unrealized until expiry. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates. The buyer of a contract is said to be long position holder, and the selling party is said to be short position holder. In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship.

The first futures contracts were negotiated for agricultural commodities, and later futures contracts were negotiated for natural resources such as oil. Financial futures were introduced in 1972, and in recent decades, currency futures, interest rate futures and stock market index futures have played an increasingly large role in the overall futures markets. Retrieved 8 February 2011. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. Inactive market in Baltic Exchange shipping. Although futures contracts are oriented towards a future time point, their main purpose is to mitigate risk of default by either party in the intervening period. Also referred to as performance bond margin. In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract.

Bills, or the closing value of a stock market index. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. Forwards have credit risk, but futures do not because a clearing house guarantees against default risk by taking both sides of the trade and marking to market their positions every night. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. This contract was based on grain trading, and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world. Commodity Bubbles Caused by Speculators Need Intervention, UN Agency Says, Bloomberg, June 5, 2011. For options on futures, where the premium is not due until unwound, the positions are commonly referred to as a fution, as they act like options, however, they settle like futures.

It is also the same if the underlying asset is uncorrelated with interest rates. Report or simply COTR. Those that buy or sell commodity futures need to be careful. The result is that forwards have higher credit risk than futures, and that funding is charged differently. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. Futures are margined, while forwards are not. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss of money. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

Margins are determined on the basis of market risk and contract value. The original use of futures contracts was to mitigate the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions. Leo Melamed Biography on LeoMelamed. In practice, it occurs only on a minority of contracts. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. In case of loss of money or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available.

See also the futures exchange article. For example, a futures on a zero coupon bond will have a futures price lower than the forward price. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. By 1875 cotton futures were being traded in Bombay in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion. Scholes model for futures. Contracts are negotiated at futures exchanges, which act as a marketplace between buyers and sellers. Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date.

Because it is a function of an underlying asset, a futures contract is a derivative product. Initial margin is the equity required to initiate a futures position. Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. The broker may set the requirement higher, but may not set it lower. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. Most Futures contracts codes are five characters. The asset transacted is usually a commodity or financial instrument and the transaction is usually done on the trading floor of a futures exchange. If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account.

Assuming interest rates are constant the forward price of the futures is equal to the forward price of the forward contract with the same strike and maturity. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index. Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps. The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Forwards do not have a standard. An Educational Guide to Trading Futures and Options on Futures.

Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. The difference in futures prices is then a profit or loss of money. For information on futures markets in specific underlying commodity markets, follow the links. That is, the loss of money party wires cash to the other party. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day.

The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. In most cases involving institutional investors, the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash. Dynamic Asset Allocation with Forwards and Futures. This enables traders to transact without performing due diligence on their counterparty. Then there will be a range of expiration dates. Both options and futures trading provide the opportunity to place leveraged bets on the movement of the stock market or commodity prices.

The contract value is determined by the difference between the exercise price and the underlying asset price. The price of a futures contract will closely match the value of the underlying instrument, with some adjustment for futures with delivery dates further into the future. With each expiration date will be numerous strike prices. Options trade against thousands of individual stocks, hundreds of exchange traded funds, stock indexes and even futures contracts. With options, a large number of contracts trade against an asset. Options sellers have limited profit potential against large potential losses. What Is the Meaning of Futures Contract in the Stock Exchange? Can COMEX Default on Delivery?

The use of leverage lets traders multiply the gains of the price movements of the underlying instrument. Although there are futures contracts covering a wide range of commodities and financial instruments, only a few different contracts will trade against a specific underlyilng asset. First are separate puts and calls to cover the two sides of price movement. In spite of these similarities, there are major differences between options and futures contracts, and those differences tend to attract traders to one type or the other. What Is the Difference Between a Derivative and a Future? The actual value of a futures contract and an option contract will be very different. An options contract gives the right to buy or sell the underlying asset at a specific price. Options buyers have a limited amount of money at risk combined with a large profit potential.