national commodities futures examination

Learning Guide

National Commodities Futures Examination

SerieS 3

v04

Series 3 On-Demand Learning Guide

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About the Series 3 Exam

Part 1 – Futures Trading Theory and Basic Functions Terminology Chapters # of Questions

General Theory 1, 3, 7, 9 and 11 16 (13% of exam)

Futures Margins, Options Premiums, Price Limits, Futures Settlements, Delivery, Exercise, and Assignment 1, 4, 6 and 11 15 (13% of exam)

Types of Orders, Customer Accounts, Price Analysis 3, 4 and 5 11 (9% of exam)

Basic Hedging, Basis Calculations, Hedging Futures 9 and 10 19 (16% of exam)

Spreading 8 3 (3% of exam)

Speculating in Futures 3, 4, 7 and 10 16 (13% of exam)

Option Hedging, Speculating, Spreading 11 5 (4% of exam)

Part 2 – U.S. Regulations Chapter # of Questions

Regulations 2 35 (29% of exam)

© Copyright 2021. All Rights Reserved. v04 The following presentation is owned by Securities Training Corporation and is protected by the United States Copyright Law and applicable international, federal, state, and local laws and treaties. The presentation is made available to you for your personal, non-commercial use as a study tool to assist you in preparing for the related examination and no other purpose. ALL OTHER RIGHTS ARE EXPRESSLY RESERVED. Any other use by you, including but not limited to, the reproduction, distribution, transmission or sharing of all or any portion of the presentation, without the prior written permission of Securities Training Corporation in each instance, is strictly prohibited.

1

120 True/False and Multiple-

Choice Questions

Two Hours and 30 Minutes Allotted to

Complete Exam

2

Minimum Required

Passing Score on Each Part

is 70%

4 30-, 30-, 180-Day

Waiting Period for Failures

5 5 Additional

Questions are Included as

Experimental (don’t count for

or against the score)

3


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How to Begin

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Chapter 1 – Commodity Futures

Futures Contract Evolved from forward contracts Like a forward contract, both parties to a futures contract have obligations

BUYER SELLER

Also called a long position Obligation to take delivery at expiration Also called a short position

Obligation to make delivery at expiration

Futures and Forwards A contract between a buyer and seller who agree to trade a specific commodity or asset at a later date (i.e., in the future)

Futures Forwards

A standardized quantity A variable quantity (as agreed)

Delivery at location and time specified by exchange rules

(i.e., regular for delivery warehouse) OTC-traded with negotiable terms

Non-personal Personal

Can be offset Cannot be offset If assigned, some exchanges force acceptance, which is referred to as being “stopped;” others allow closing trades


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Activity #1 – Futures Contract An investor sold a wheat futures contract at $5.16 per bushel. At the end of the contract, if the price of wheat has fallen to $4.10 per bushel, which of the following statements is TRUE? a. The investor makes delivery. b. The investor takes delivery. c. The contract expires worthless. d. The investor neither makes nor takes delivery.

Futures Exchanges Exchanges will: Provide a place to trade Set contract terms which must be approved by CFTC

– Delivery size – Basis grades, which may allow for delivery of superior grade (for a premium) or inferior

grade (at a discount) – Time of delivery – Place of delivery - approved locations are referred to as “regular for delivery

warehouses” – Margin requirements – both initial and variation

Exchanges will not: Own any contracts Buy or sell contracts Set prices of contracts


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CME Globex and Intercontinental Exchange (ICE) Both manage exchanges that provide a platform for investors to buy and sell futures (and other securities) on an international basis Contracts are fungible on an exchange of the same group (e.g., buy gold ICE futures U.S. and sell gold ICE futures Europe)

CME Group ICE

Exchanges include: Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT) Minneapolis Grain Exchange (MGEX) Commodities Exchange (COMEX) New York Mercantile Exchange (NYMEX) Partnerships with exchanges in Brazil,

Malaysia, Dubai, Korea and CME Europe Ltd.

Retail and institutional investors have access to the same prices CME Clearing guarantees all contracts that are traded on the CME Globex platform

Exchanges include: ICE Futures U.S. (IFUS) ICE Futures Europe (IFEU) ICE Futures Singapore (IFSG) ICE Endex (NDEX)

Retail and institutional investors have access to the same prices Clearing is done by ICE Clear U.S., ICE Clear Europe, and ICE Clear Singapore

Benefits of Futures Exchanges Allows producers and users of the cash commodity to hedge by establishing a futures position that’s opposite the cash position Substantially reduces risk of price fluctuations Enables producers and users to obtain credit at more favorable rates Reduces the price of the commodity to the public

Provides a central point to channel risk capital of speculators Increases liquidity and narrows price spreads

Provides a focal point to where all buy and sell orders are sent Price discovery

Price dissemination Provides an alternate channel for marketing the cash commodity


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Exchange Committees Arbitration Committee that settles disputes which arise between members,

member firms, and the public

Business Conduct Committee that investigates complaints against members, acts to prevent price manipulation, and supervises members and their employees

Floor Committee that establishes rules regarding trading on the floor of the exchange and settles disputes related to transactions on the floor

Traders and Trading

Types of Traders

Floor Brokers Execute orders on behalf of others Work for firms or independent

Floor Traders (Locals) Trade for their own account May also trade for a firm’s proprietary account Cannot take customer orders

Types of Trading

Day Trading Trade and offset the same day

Position Trading Establish longer open positions

The Clearinghouse The clearinghouse is an agency that’s associated with an exchange which guarantees all trades, thereby assuring contract delivery and/or financial settlement Since the clearinghouse becomes the buyer for every seller and the seller for every buyer, it eliminates counter-party risk Exchange members collect and deposit funds (i.e., margin) with the appropriate clearinghouse


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Activity #2 Read each statement and determine whether it’s TRUE or FALSE.

FUTURES CONTRACTS MAY BE MODIFIED TO FIT A SPECIFIC HEDGER’S NEEDS

DELIVERY OF A SUPERIOR GRADE OF A COMMODITY WILL GIVE

THE SELLER A PREMIUM PRICE

THE FLOOR COMMITTEE IS CONCERNED WITH PREVENTING SIDE AGREEMENTS

BETWEEN FLOOR BROKERS

THE BUYER DETERMINES WHICH GRADE WILL BE DELIVERED


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Chapter 2 – Regulations

Regulatory / Supervision Overview NFA Members Futures Commission Merchant (FCM)

Introducing Broker (IB) Commodity Pool Operator (CPO)

Commodity Trading Advisor (CTA)

The CFTC Objectives of the CFTC: Prevent manipulation Prohibit the spread of false or misleading information Establish ethical trading standards Approve new futures and options contract specifications Regulate exchanges and floor members Provide for settlement of customer claims CFTC and NFA employees cannot trade futures

CFTC

National Futures Association

(NFA)

Futures Exchanges

Associated Persons

The Commodity Futures Trading Commission is a federal agency that was created in 1975


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CFTC Delegation The CFTC delegates some of its authority to:

NFA Exchanges Clearinghouses

The NFA is a self-regulatory agency of the futures industry

Carry out CFTC-delegated responsibilities

Handle trading activities of contract markets

Activities are subject to CFTC review

Agency associated with an exchange that guarantees trades

Becomes the buyer for all sellers and the seller for all buyers

Eliminates counter-party risk

CFTC Disciplinary Actions The CFTC: Maintains disciplinary jurisdiction over floor brokers, traders, and exchanges Is empowered to go directly to the courts to seek a restraining order

(independent of the U.S. Attorney General)

Penalties and Actions: Felony Convictions for Criminal Violations of the Commodity Exchange Act:

Suspension or revocation of CFTC registration

Maximum civil monetary penalty is the greater of $168,142 per violation (indexed for inflation, originally $140,000), or three times the damages (non-felony)

Suspension or revocation of trading privileges

Settlement may be achieved without admitting or denying charges, with penalties carried as if they were applied following a hearing

Suspension or expulsion Fines of up to $1 million ($500,000 for

individuals) and/or 10 years imprisonment


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Reporting Levels and Position Limits Established by CFTC and enforced by the Exchanges

Reporting Levels

CFTC requires daily reports of gross long or short positions in each commodity once it reaches a certain threshold level

FCM that carries position must also report One last report is filed on the day the account falls below threshold Applies to both hedgers and speculators

Position and Trading Limits

Designed to prevent manipulation and distortion of prices Applies to only certain commodities Applies to only speculators Bona fide hedgers are exempted

Market Participants FCM Futures Commission Merchant

A large futures firm (B/D) that handles customer accounts

IB Introducing Broker A small futures firm (most online firms) that introduces and solicits

clients for associated FCMs

CPO Commodity Pool Operators Operates and solicits funds for a commodity pool

CTA Commodity Trading Advisor Advises others in trading futures May work for an IB, FCM, CPO, or advise individual accounts for a fee

Associated Person (AP) An AP is an individual who conducts the business of FCMs, IBs, CTAs, and CPOs Includes officers, partners, employees, solicitors, supervisors

Any person who’s required to register with the CFTC must be an associate member of the NFA Qualifications Series 3 Series 31 (for commodity pools only) Series 30 (for managers)

An AP may have multiple registrations with approval of all firms

Typically, prospective customers will discuss their financial goals with an associated person and

the AP will explain the risks involved in futures trading.


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Activity #3 Match each description to the appropriate term.

FCM A natural person that conducts the business

of an NFA member

IB Manages a pool of investments in commodity

futures or options

CTA Advises others on the purchase or sale of

commodity futures or options

CPO

Solicits and/or accepts orders for execution

Associated Person Solicits and/or accepts order for execution,

but cannot accept customer funds

National Futures Association (NFA) The NFA is a self-regulatory agency of the futures industry that’s responsible for: Enforcing ethical standards Providing for arbitration of disputes Ensuring minimum financial standards Screening registrations Establishing training standards and proficiency testing Auditing members (spot and full scope)

– Unannounced spot audits – Full scope audit every 24 months (no need for court approval to subpoena documents) – NFA members are required to audit their branches at least annually

Ethics training – Firms must have a written policy – Must demonstrate compliance upon audit


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NFA Registration All market participants are required to register with NFA Exemptions from registration: Floor traders and brokers (subject to Exchange rules) Some CTAs and CPOs may also be exempt under specific circumstances (discussed later) Exchange members that are registered with CFTC (not with NFA) and are subject to fines

by the CFTC If any NFA member is required to notify the CFTC on any matter, it must also be reported to the NFA NFA members cannot conduct business with non-member firms

Futures Commission Merchant (FCM) May hold customer accounts and assets Must maintain minimum net capital of $1 million May be a clearing or non-clearing firm (may be a clearing firm on some exchanges, but a

non-clearing firm on others) – Clearing FCMs are members of the clearing corporation that process and clear their

own trades which are executed on an exchange – Non-Clearing FCMs process their trades through clearing firms

Trades are cleared through either an omnibus account or fully disclosed account Omnibus: Only discloses

the name of the non-clearing FCM

Fully Disclosed: Discloses the client’s information to the Clearing FCM


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Introducing Broker (IB) An IB: Must have an affiliation with an FCM Does NOT hold customer accounts or assets Is not required to maintain a copy of customer statements

Two types:

Independent IB Able to find clients for any FCM Has a minimum required net capital of $45,000

Guaranteed IB

May be guaranteed by only one FCM FCM with which it has an agreement is responsible for GIB’s

activities – The agreement has no expiration

FCM is required to audit its GIB at least annually Has no minimum required net capital

(i.e., the FCM satisfies the $45,000) Need not be exclusive

Commodity Pool Operator (CPO) Pools funds of several investors to trade as one account Funds are accepted in the name of the pool Customers are percentage owners in the pool

(similar to a limited partnership) CPO must run each pool as a separated entity CPO must maintain daily transaction records for the pool All withdrawals from a commodity pool must be properly disclosed to all participants

Essentially, an IB is a firm that solicits or accepts orders to buy or sell futures contracts, but doesn’t accept money.


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CPO Registration Exemptions Pool operator is the NFA member May solicit one or more pools Required to register unless exempt

CPO Exemptions from Registration

De Minimis Commodities Investment Club

Gross contributions to all pools is less than $400,000 and

There are no more than 15 participants in any one pool (excluding the CPO and his family members)

Operates only one pool at a time Receives no compensation other than

operating expenses Doesn’t advertise

CPO Account Statements CPOs must send account statements to all participants Statement of Income/Loss Monthly – if pool is more than $500,000 Quarterly – if pool is less than or equal to $500,000

An exempt CPO must file a statement with NFA to indicate the reasons for its exemption and a copy must be sent to all participants

Generally Accepted Accounting Principles (GAAP) must be used

It must show changes of NAV and reflect all fees (net of fees)


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Commodity Trading Advisor (CTA)

CTA Registration Exemptions A CTA is required to register with the NFA unless: It’s registered as a CPO and only advises its own pool

– If it provides advice to other pools, it must register as CTA It advised no more than 15 persons within the last 12 months, and it doesn’t publicly hold

itself out as an advisor It’s a publisher (newspapers and magazines) It’s a non-profit, voluntary membership organization (e.g., investment club), or a trade

association

CTA/CPO Disclosure Document Similar to a securities prospectus A copy must be filed with the NFA at least 21 days prior to its first use The front cover must indicate: Effective date – not earlier than 21 days after filing

– Information must be current (not older than three months) – May be used for 12 months from this date

Whether up-front fees apply; if so, net proceeds available “No approval clause;” also referred to as the “cautionary statement”

– CFTC has neither passed on the merit of this investment, nor has it passed on the adequacy or accuracy of this disclosure document

Managed Accounts If a CTA handles managed accounts, it must be carried on a fully disclosed basis

by the FCM FCM (not the CTA) is responsible for sending account statements to clients

A CTA is any person who: Engages in the business of advising others as to buying or selling commodity

futures or options contracts Provides this service for compensation or profit

CTA cannot accept customer funds directly (only through FCM)


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Risk Disclosure Document The following must be reflected on the first page of the disclosure document High leverage Magnified risk and potential return – volatility,

liquidity, counter-party credit risk May be subject to substantial charges, with details of

the charges (e.g., management, advisory, and broker fees)

Other information within the document: Types of futures and options that will be traded Minimum and maximum size of the pool (if any) All applicable fees (up front and annual fees) How the fund meets the margin call Breakeven analysis Five-year business background of CPO and CTA

trading principals All civil and criminal actions (by CFTC, NFA, and clients) for five years

Risk Disclosure Document Actual and potential conflicts of interests must be disclosed Whether the CPO also operates as a CTA Whether the CPO (or an affiliate) receives a portion of the commissions The names of IB and FCM, if the customer is required to trade through them Whether the pool invests only in foreign futures and still needs to be registered

Risk Disclosure Document Performance history must be disclosed by the CPO: Monthly rates of return must be displayed in either tabular form or by bar graph The number of outstanding units must be included at the beginning and the end of the

period for which performance is included – If history is more than five years – show the last five years – If history is between three and five years – show the entire history – If history is less than three years – show the entire history plus:

• Lesser of five years or the entire history of any other pool operated by the CPO or CTA

Checklist of Information Included in Risk Disclosure Document

Business background CTA trading program and

pool investment program Principal risk factors Fees Conflicts of interest Litigation Performance


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Activity #4 Determine the performance history disclosure requirement for each CPO.

CPO MANAGED ONE POOL FOR THE LAST SIX YEARS

CPO MANAGED ONE POOL FOR THE LAST FOUR YEARS

CPO MANAGED ONE POOL FOR THE LAST TWO YEARS

CPO MANAGED TWO POOLS: NEW POOL: FOR LAST YEAR OLD POOL: FOR LAST 10 YEARS

Some Prominent Rules of the NFA NFA Rule 2-4: Members and associates must observe high standards of commercial honor

and just and equitable principles of trade in the conduct of their commodity futures business NFA Rule 2-38: All members must establish and maintain a written business continuity and

disaster recovery plan, which indicates the name and contact information for one or two individuals who are to be reached by the NFA in case of an emergency

NFA No Approval Clause: The CFTC and NFA don’t sponsor, approve, or recommend an AP Foreign brokers who work in U.S. branch offices overseas must be properly registered

(Series 3 qualified)


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NFA Compliance and Disciplinary Actions Infractions are reported to the Regional NFA Business Conduct Committee The NFA Compliance Director can: Require statements under oath from members Subpoena documents

While under investigation, a member may not resign, but may continue to do business With agreement of the board, the President of the NFA can initiate a “Member Responsibility Action” Firm may be required to immediately cease doing business Doesn’t require a hearing beforehand

NFA Compliance and Disciplinary Actions Disciplinary Actions:

Original jurisdiction is given to the Hearing Panel which may decide on: Suspension or revocation of NFA membership Barring from association with NFA member firms Censure or reprimand Fine of up to $250,000 per violation (non-felony) Issuance of cease and desist order NOT prison

Formal rules of evidence need not apply

Appeals Process:

Appeals committee of the NFA CFTC Federal courts


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Arbitration Used for the settlement of disputes between member firms, or member firm and customers Must be filed within two years of discovery Decisions cannot be appealed

Disputes of up to $50,000 Disputes of over $250,000 Judgments and Awards

Normally handled by one arbitrator

Respondent must respond within 20 days of complaint

Normally handled by three arbitrators

Defendant must respond within 45 days

Judgments must be rendered within 30 days of closing of records

Awards must be paid within 30 days of judgment, or the respondent will be subject to suspension

Communication With the Public Written communications with the public and all promotional material (including the text of standardized oral presentations) require prior approval of a partner or officer of the firm Copies of all promotional material, along with their approvals, must be maintained for five years NFA prohibitions: False or misleading statements or omissions of material facts Emphasizing profits without giving equal weight to risks Citing past profits without cautioning that they may not represent future profits Using statistics which cannot be substantiated Using hypothetical performance without providing a special disclosure statement


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Activity #5 Read each statement and fill in the blanks. 1. _____________________ is the maximum fine for violations of the Commodity Exchange Act. 2. The CTFC can assess a civil penalty of ______________________ per violation or

__________ times the damages. 3. The NFA will provide ___________ arbitrators for disputes exceeding ________________. 4. The maximum fine the NFA can assess is ______________ per violation. 5. Violations of _____________________ cannot be punished with a prison sentence. 6. A criminal violation of the _____________________________________ can result in a

______ year prison sentence. 7. Disputes of up to ______________ will be handled by __________ arbitrator(s).

Opening Customer Accounts Must be signed by all parties before trading

AP is responsible for getting this document signed and dated at or prior to account opening A copy is retained by all parties involved (IB, FCM)

Name and address Legal age (age of majority) Principal occupation

Estimated annual income and net worth Investment and futures trading experience

Information is not required to be verified (customer can by the only source of information)

1. Fill out Commodity Account Agreement

4. Account approval by a principal

2. Read and sign Risk Disclosure Document

3. Information needed (NFA Rule 2-30 “Know Your Customer”)


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Risk Disclosure Proper Disclosure: For some customers, the best disclosure statement may be that trading futures is too risky

for them Spread positions should not be described as having less risk

– Created by purchasing one futures contract and selling another Additional Risk Disclosures: AP must determine whether they’re needed Option Disclosure Document is needed to open an option account (cannot be opened without

a future account)

Customer Account Documentation If customer refuses to disclose information, the necessary step is based on the type of customer: If customer is a U.S. citizen – A record of the refusal must be maintained If customer is a non-U.S. citizen – No record of the refusal needs to be maintained

Margin Agreement must be signed by all clients For commodities, there’s no cash account

Transfer Agreement or (“Supplementary Agreement”) Allows FCM to transfer monies to/from client’s securities account If no such agreement was signed, FCM must obtain the client’s specific, written approval for

each transfer


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Types of Accounts Individual One owner on the account

Joint

Multiple owners; information must be obtained from all owners Joint Tenants With Rights of Survivorship (JTWROS)

‒ Typically spouses ‒ Account passes whole without probate

Tenancy In Common (TEN-COM) ‒ Typically business partners ‒ Account divided on death

Corporate Firms must obtain: Copy of charter and by-laws which allow for futures trading Resolution authorizing an individual(s) to act on the corporation’s

behalf

Partnership Copy of the Partnership Agreement must be obtained

Trust Copy of the Trust Agreement must be obtained

Discretionary Account If an AP is given discretion over an account Requires written power of attorney (PoA) All trades are reviewed by a principal within one business day AP must have two years’ experience (unless a CTA) PoA doesn’t need to be renewed, but will become void upon the customer’s death

If a third-party is given discretion over an account (i.e., a person other than an AP) Actual customer must give permission Duplicate confirmations must be sent to the customer

Review for churning: Excessive trading in the account to generate commission


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Activity #6 – Discretionary Account A discretionary account may be handled by: a. An associated person who’s registered with the NFA b. An associated person with one year’s experience c. An associated person who was previously registered for one year and six months and has

been registered with your firm for six months d. An associated person with four years’ experience

Recordkeeping Customer Account Statement – must be sent by FCM For active accounts (at least one transaction or an open position) – sent monthly For inactive accounts – sent at least quarterly

Customer Confirmations – must be sent by no later than the next business day Customer Complaints (not public record) – firms are required to maintain a copy of all written complaints If an oral option complaint is received, firms must request that it be made in writing and must

maintain a copy Settlements (public records) – can be reached between firms and customers or regulators without admitting or denying guilt

NFA members are generally required to maintain records for five years


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Recordkeeping

If the customer is introduced by the IB to the FCM: Account form must be kept on file by both

the IB and FCM FCM’s customer statement must

show the name of the IB

CTA records: Powers of attorney List of all positions Copies of each confirmation

and statement from FCM All communication with the

public (advertising and sales literature)

CPOs, CTAs, and their principals: Must maintain detailed daily record of all

personal transactions and all statements received from the FCM

Upon death of a customer: Powers of attorney is

automatically canceled Cancel all open (GTC) orders Liquidate all positions

The USA PATRIOT Act Currency Transaction Reports (CTR) Currency and Monetary

Instrument Transaction Report (CMIR)

Filed for all currency transactions executed by a single customer during one business day that exceed $10,000

Filed also for structured transactions

Filed whenever a person physically transports or receives cash (or equivalents) exceeding $10,000 into, or out of, the U.S.

Suspicious Activity Report (SARs) Penalties

Filed whenever a transaction (or group of transactions) equals or exceeds $5,000 and the firm suspects the transaction is designed to evade reporting requirements or has no apparent business purpose

Confidential (client not informed)

20 years in prison and the greater of a $500,000 fine per transaction or twice the amount of funds involved

Necessary Records


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Chapter 3 – Price Forecasting

Relationship Between Cash and Futures Since futures contracts are either physically delivered or settled based on cash commodity prices, there’s a strong relationship between cash and futures prices Prices between the two must converge Prices must converge on the first day delivery If prices don’t converge, an arbitrage opportunity will

exist – As a result of arbitrage activity, prices will then

converge

Carrying Charges

Transportation expenses are not included in carrying charges

Carrying Charge

Storage Insurance Interest


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Activity #7 – Carrying Charge Cash corn is trading at 600 cents per bushel. Storage costs are 4 cents per bushel, insurance expenses are 2 cents per bushel, and shipping costs are 45 cents per bushel. If monthly interest rates are 1%, what’s the monthly carrying charge?

Carrying Charge Market

Cash Price:

Interest Rate:

Interest Expense:

Storage:

Insurance:

Total Storage:

Total Carry Charge:

$1,755

$1,760

$1,765

$1,770

$1,775

$1,780

$1,785

$1,790

$1,795

$1,800

$1,805

Cash Aug Oct Dec

Contango, Normal, or Premium Market(Gold futures)


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Inverted Market

Activity #8 Determine whether the following statements are TRUE or FALSE.

1 Carrying charges include storage, interest, insurance and transportation.

2 A normal market is one in which cash prices are above futures prices.

3 An inverted market is one in which cash prices are above futures prices.

4 In a normal market, the price of a cash commodity is under futures prices.

5 A contango market is one in which futures are higher than cash.

6 Backwardation is a market in which futures are higher than cash

7 Cash and futures prices will converge on the first delivery date.

$1,725$1,730$1,735$1,740$1,745$1,750$1,755$1,760$1,765$1,770$1,775

Cash Aug Oct Dec

Backwardation or Discount Market(Gold futures)


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Fundamental Analysis Fundamental analysis focuses on the relationship between a commodity available for delivery and the price For grains, the supply typically includes stocks in elevators, in transit (e.g., on barges), and on docks at loading centers. However, the supply excludes grains still on farms.

Technical Analysis Volume and

Open Interest Support and

Resistance Levels Charts and

Price Patterns

Volume Total trades during a

day • Count either

purchases or sales, not both

• Sign of activity or liquidity in the market

Open Interest All open contracts that

have not been offset • Count either all

outstanding long or short positions, not both

Support Level at which prices stop

falling A temporary price floor

Resistance: Level at which prices stop

rising A temporary price ceiling

Technical Patterns Double bottom or top Head and shoulders Ascending or descending

triangle Moving average Flag and pennant

Price

Quantity

Demand

Supply

Supply – When supply increases, the price decreases

Demand – When demand increases, the price increases


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Volume and Open Interest First Trade: FCM A buys 10 contracts from FCM B

Accumulated Volume: Open Interest:

Second Trade: FCM B buys 10 contracts from FCM C


Third Trade: FCM C buys 10 contracts from FCM A


FCM A FCM B FCM C LONG SHORT LONG SHORT LONG SHORT

Open Interest and Prices

Price Open Interest

Price Open Interest

Technically Strong Bullish Trend Technically Strong Bearish Trend

Price Open Interest

Price Open Interest

Technically WEAK Technically WEAK


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Activity #9 – Liquidating Market A liquidating market is: a. When prices and open interest are both rising b. When prices are rising and open interest is falling c. When prices and open interest are both falling d. When open interest is rising and prices are falling

Technical Analysis Support Level at which prices tend to stop falling

Resistance Level at which prices tend to stop rising

Congestion Area Area between support and resistance; prices trapped in a range

Breakout When prices break through an area of support or resistance Breakout of an area of support is a bearish indicator Breakout of an area of resistance is a bullish indicator


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Resistance/Support Levels A breakout above resistance is bullish, a breakout below support is bearish

1. To take advantage of a potential breakout of support, what order could be entered?

A. Sell Limit above support C. Sell Stop below support

B. Buy Stop above resistance D. Market order 2. To take advantage of a potential breakout of resistance, what order could be entered?

A. Buy Limit above support C. Sell Stop below support

B. Buy Stop above resistance D. Market order

Congestion

81.50

79.70

Resistance

Support


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Head and Shoulders Patterns

Activity #10 Determine whether each indicator is BULLISH or BEARISH.

A BREAKOUT OF RESISTANCE

A BREAKOUT OF SUPPORT

HEAD AND SHOULDERS TOP

HEAD AND SHOULDERS BOTTOM

Head and Shoulders Top

Reversal of an __________________ trend

Bearish indicator

Head and Shoulders Bottom

Reversal of a __________________ trend

Bullish indicator

Head (Top)

Right Shoulder Left

Shoulder

Right Shoulder

Left Shoulder


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Chapter 4 – Pricing

Contract Sizes Grains (Corn, Wheat,

and Soybeans) 5,000 bushels

Treasury Bonds and Treasury Notes

(Long-Term)

$100,000 par value Quoted as percentage of par and 1/32 1% of $100,000 is $1,000 and 1/32 of $1,000 is $31.25

Treasury Bills and Eurodollars

(Short-Term)

$1,000,000 par value 13-week (3 months) Quoted in basis points; 100 bps = 1%

• 1 basis point equals $25

Bond Calculations Adding Fractions Subtracting Fractions

90 25/32 + 6 30/32 96 55/32

96 55/32

[96 + 1] [55/32 – 32/32]

90 25/32 – 6 30/32 84 – 5/32

90 25/32

[90 – 1] [25/32 + 32/32] 89 57/32

89 57/32 – 6 30/32

97 23/32

83 27/32


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Bond Price Analysis

Currency Price Analysis

Bond Prices

$ Market Interest Rates

$

INVERSE RELATIONSHIP

As market interest rates change, a bond’s price will change in the opposite direction. They have an inverse relationship.

$ €, £, ¥ or Gold

INVERSE RELATIONSHIP

The U.S. dollar has an inverse relationship with foreign currencies. Gold can also be a substitute for foreign currencies; it will also move in the opposite direction of the U.S. dollar.


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Price Limits The board of directors of an exchange will establish daily price limits for futures prices When the market reaches the upper or lower limit, trading will continue within the limits Buy and sell orders can be entered above or below the limits, but they cannot be executed Typically, the nearest expiration month and cash price don’t have any price restrictions

Activity #11 – Price Limits If futures trade at the daily limit: a. All buy and sell orders are immediately canceled b. Trading at prices in-between the limits could still occur c. Offsetting transactions are permitted, but no new positions maybe established d. Trading halts for the remainder of the day


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Chapter 5 – Orders

Market Order Limit Order Customer wants to buy or sell Order is immediately executed at the

best price available Customer specifies the futures and

size of the order only Execution is ______________

Customer only wants to buy or sell at a set price or better

Order is only executed if the price can be met

Buy limits: at set price or lower Sell limits: at set price or higher

Customer specifies the futures, size, and price

Execution is ______________

Stop Orders Stop Orders are a type of contingent order which are “triggered” (activated) by the market trading at or through the stop price Sell Stop will activate with a trade or offer at or below the stop price Buy Stop will activate with a trade or bid at or above the stop price

Once activated:

A firm may accept orders that are activated at a different trigger price (using a quote as the stop price) provided they’re not labeled as stop orders and proper disclosures are made

Stop order becomes

Stop limit order becomes


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Stop Order Example A customer is long November crude oil at $50.70. Today, crude oil opens at $46.25. Afraid of suffering large losses, your customer enters a protective order:

Sell November crude oil at $42.00 stop

Later: 42.10 42.06 42.03 41.98 41.97 41.91

Trigger? Execution?

If the customer entered a sell stop limit: Sell November crude oil at $42.00 stop

Later: 42.10 42.06 42.03 41.98 41.97 41.91

Trigger? Execution?

Market-If-Touched (MIT) Orders Entered on the same side of the market as limit orders, but activated or triggered like stop orders Sell MIT orders are placed above the market Sell MIT orders are activated when futures trade or bid at or above the MIT price Buy MIT orders are placed below the market Buy MIT orders are activated when futures trade or offered at or below the MIT price

Once activated, Market-If-Touched orders become market orders and are executed at the market price


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Activity #12 – MIT Order Frank wants to take a long position in September Sugar futures if the price drops to 10.80 cents. Today, Sep Sugar opens at 10.90 Frank places the following order:

Buy Sep Sugar at 10.80 MIT

Later: 10.87 10.84 10.80 10.81 10.77 10.76

Trigger? Execution?

Order Placement

SL o BS

BL e SS

Types of Orders Type of Order Placed How Triggered How Executed

Market N/A N/A Best price Buy Limit Below Market N/A At or lower Sell Limit Above Market N/A At or higher Buy Stop Above Market Traded at, through, or bid at or above Best price Sell Stop Below Market Traded at, below, or offered at or below Best price

Buy Stop Limit Above Market Traded at, above, or bid at or above At or lower Sell Stop Limit Below Market Traded at, below, or offered at or below At or higher

Buy MIT Below Market Traded at, below, or offered at or below Best price Sell MIT Above Market Traded at, above, or bid at or above Best price


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Activity #13 Determine whether each order is typically entered ABOVE or BELOW the current market price.

BUY LIMIT

SELL LIMIT

BUY STOP

SELL STOP LIMIT

BUY MIT

SELL MIT

Other Orders

Not Held (NH)

Broker is given discretion as to time and price Broker is given authority as to whether to take the position Broker cannot be held responsible for any action it takes or

fails to take

One Cancels Other (OCO)

Instructs the broker to do one of two alternative orders Whichever is done first automatically cancels the other Prevents a double fill

Other Orders Give Up

One FCM “gives up” orders to other FCMs to protect the client’s anonymity

FCMs share commissions

Switch Liquidate and roll the existing position to a later delivery month Primarily used by the speculators prior to the first notice day

Allocation of Bunched Orders

Doesn’t need to be specified by CTA at the time of order entry It must be done by the CTA or the account manager before the

end of the day Subject to fair, equitable, and non-preferential standards


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Chapter 6 – Margin

Margin Margin is established by the exchange as a “good faith deposit” and is not part of the cost Bona fide hedger’s margin is lower than speculation margin Initial equity – requirement to establish a position Maintenance (Variation) margin – requirement to keep a position Equity is calculated daily based on the contract’s settlement value

Calculating Equity Total equity in a position is equal to the money deposited, net of withdrawals, and is referred to as the Account Cash Balance The Account Cash Balance plus or minus the gains or losses to date is referred to as the Open Trade Equity (OTE) The cash deposit is equal to the initial margin requirement plus any additional deposits for

variation margin The open trade equity is calculated daily based on the contract’s settlement price

Margin requirements are the same for long and

short positions

If equity falls below the maintenance level, the client’s required to bring equity back to initial margin

Total Equity = Account Cash Balance +/- Open Trade Equity


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Equity Example Wheat futures contracts have an initial margin of $0.80 per bushel and maintenance margin of $0.60 per bushel. The contract size is 5,000 bushels. A customer goes long one May wheat contract when the price is $6.00 per bushel.

Deposit/Withdrawal Account Cash Balance OTE Equity

Initial Margin

May Wheat to $5.90

May Wheat to $5.75

Margin Call

May Wheat to $5.95

Equity Example Gold futures have an initial margin requirement of $70.00 per ounce, a maintenance requirement of $50.00 per ounce, and a contract size of 100 troy ounces. A customer shorts one December gold contract when the price is $1,400.00.

Deposit or Withdrawal Cash Balance OTE Equity

Initial Margin

Dec Gold to $1,425

Receive a margin call

Equity above the initial margin (i.e., excess) may be withdrawn. Excess equity can also be used for margin on new positions, which is referred to as “pyramiding.”


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Activity #14 – Calculating Equity A client shorts five June S&P 500 futures at 1,305.5. The initial margin on S&P 500 futures is $25,000 per contract and it has a multiplier (i.e., size) of $250 per index point. If the June S&P 500 contract settles at 1,295.5, what’s the equity in the customer’s account? a. $27,500 b. $137,500 c. $22,500 d. $112,500


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Chapter 7 – Speculation

Speculators Buy and sell for the purpose of making a profit and will take: A long position (buy futures) when they anticipate a rise in prices A short position (sell futures) when they anticipate a decline in prices

Speculators add liquidity and reduce price volatility to markets

Rate of Return An investor who is bullish on May wheat takes a long position when the price of the May wheat contract is $5.10. The contract size is 5,000 bushels. The investor later offsets when the price is $5.50. If round-turn commissions are $50 and initial margin is $0.50 per bushel, what’s the investor’s rate of return?

Sold: Bought: Profit: Contract size: Gross profit:

Commissions: Net profit:

Initial Margin: Rate of Return:

Commissions on futures trades are typically “round-turn,” which includes both a purchase and a sale

Half-turn commissions only include one transaction


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Rate of Return A trader believes July corn futures will fall; therefore, he shorts three contracts at $6.75. The contract size is 5,000 bushels. When the price has risen to $7.05, the trader offsets the contracts. If round-turn commissions are $25 per contract and the initial margin $0.60 per bushel, what’s the trader’s rate of return?

Sold: Bought: Loss: Contract size: Gross loss:

Commissions: Net loss:


Rate of Return November soybean futures are trading at 1260 cents per bushel. The contract size is 5,000 bushels and the initial margin requirement is $3,500 per contract. An investor establishes a long position in the November contract at the current price. Later, she liquidates her position when the November soybean futures have increased by 5%. What’s the investor’s rate of return?

Long Increase: Profit: Contract size: Gross profit:



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Profit or Loss An investor expects yields on T-bonds to rise and takes the appropriate position on 10 September T-bond futures at 88-24. Later, the investor offsets the contracts at 90-20. If round-turn commissions are $40, what’s the investor’s profit or loss?

Should the investor take a Long or Short position?

Short: Loss:

Offsets: Commissions:

Loss: Loss per contract:

No. of contracts:

Total Loss:

or

Profit or Loss Investor expects the interest rates to decline and takes the appropriate position in four T-bill contracts at 92.05. The investor later offsets three contracts at 93.04 and liquidates the last one at 93.14. What’s the total profit or loss for this investor?

Should the investor take a Long or Short position?

Long: Long:

Sell: Sell:

Profit: Profit:

Multiplier: Multiplier:

Profit per contract: Total Profit:

No. of contracts:

Profit:


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Activity #15 – Speculation A client buys a May silver futures at $17.240. The initial margin on silver futures is $12,000 per contract and requires acceptance of 5,000 troy ounces. At what value does the May contract need to settle for the customer to realize a $5,000 profit? a. $1.000 b. $5,000 c. $16.240 d. $18.240

Activity #16 – Speculation A client sells a December corn futures at 319.25 cents. The initial margin on corn futures is $1,500 per contract and requires delivery of 5,000 bushels of corn. At what value does the December contract need to settle for the customer to realize a $3,500 profit? a. $0.70 b. $2.4925 c. $3.8925 d. $3.1995


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Chapter 8 – Spreads

Commodity Spreads

Intramarket or Interdelivery Spreads

Purchase and sale of the same commodity, on the same exchange, but in different expiration months

Example: • Buy March wheat on CME and sell July wheat on CME

Intermarket Spreads

Purchase and sale of the same commodity on different exchanges Example:

• Buy gold on COMEX (U.S. delivery) and sell gold on ICE (U.K. delivery)

Intercommodity Spreads

Purchase and sale of different commodities Examples:

• Corn and wheat • Corn and oats • Gold and silver • T-notes over T-bonds

‒ Yield curve flattens: Short T-note futures and go long T-bond futures

‒ Yield curve steepens: Long T-note futures and short T-bond futures

Commodity Product Spreads

Hedgers or speculators take positions in raw commodities and opposite positions in the refined or processed commodity

The Crush Long soybeans → Short soybean oil and meal

The Crack Long crude oil → Short gasoline and heating oil

Reverse crush or crack spreads reverse the long and short positions


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Bullish and Bearish Spreads Generally, the spreader’s market sentiment will be reflected in their position in the near month Bullish investors will buy the near month Bearish investors will sell the near month

However, foreign currencies and stock index futures spreads are exceptions When spreading those contracts, the sentiment will be reflected in the position in the deferred month Bullish investors will buy the deferred month Bearish investors will sell the deferred month

Spread Profit and Loss Spread trades get their name from the difference or “spread” between the prices of the two contracts bought and sold Traders that buy the more expensive leg will profit if the spread between the prices increases

or widens BUYER = WIDEN

Traders that sell the more expensive leg will profit if the spread between the prices decreases or narrows

SELLER = NARROW

Example: An investor shorts March corn at 319 cents and buys July corn at 323 cents

Bullish or Bearish? Bearish, since the investor sold the near month (March)

Widen or Narrow? Widen, since the investor bought the more expensive leg (323)


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Spread – Example Sell January soybeans at 841 cents Buy May soybeans at 844 cents

(Soybean futures have a 5,000-bushel size)

Spread: 3 cents, or $0.03

Bullish or Bearish: Bearish, sold the near month (January)

Widen or Narrow: Widen, bought more expensive (844)

Later, the positions are offset when:

January soybeans are 840 cents May soybeans are 847 cents

Spread: 7 cents, or $0.07

Widened or Narrowed: Widened

Profit or Loss: Profit

Amount: $200 ($0.04 widening x 5,000 bu.)

Spread – Example Sell September E-mini S&P 500 at 2853.10 points Buy December E-mini S&P 500 at 2830.75 points

(E-mini S&P 500 futures have a $50 multiplier)

Spread: 22.35 points

Bullish or Bearish: Bullish, bought the deferred month (December)

Widen or Narrow: Narrow, sold more expensive (2853.10)

Later, the positions are offset when:

September E-mini S&P 500 are 2840.20 points December E-mini S&P 500 are 2807.50 points

Spread: 32.70 points

Widened or Narrowed: Widened

Profit or Loss: Loss

Amount: $517.50 (10.35 widening x $50 per point)


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Activity #17 – Spreads 1. A client believes that there will be a

bullish run on soybeans. Which of the following spreads is the most appropriate?

2. A client believes that there will be a bullish run on euros. Which of the following spreads is the most appropriate?

a. Buy the nearby and sell the deferred b. Sell the nearby and buy the deferred c. Sell the nearby and sell the deferred d. Buy the nearby and buy the deferred

a. Buy the nearby and sell the deferred b. Sell the nearby and buy the deferred c. Sell the nearby and sell the deferred d. Buy the nearby and buy the deferred

Activity #18 – Spread – Profit or Loss A customer has a spread position in pork bellies. She’s long July at 38.50 cents and short December at 52.50 cents. Later, she liquidates her spread when July is at 46.25 and December is at 63.75. The size of the contract is 40,000 lbs. What’s her profit or loss, excluding commissions?

a. $1,400 profit b. $1,400 loss c. $140,000 profit d. $140,000 loss


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Chapter 9 – Hedging

Hedgers Through hedging, producers and users may pass most of the risk of price change to speculators Producers are businesses that either currently possess or will produce the commodity for sale and delivery at some future date Producers are long the cash commodity and fearful of falling prices

Users are currently without the commodity, but have an absolute use for the commodity and will need to buy at some future date Users are short the cash commodity and fearful of rising prices

Overview of Hedgers Producer Overview Item User

Long ← Cash Commodity (Basis) → Short

Falling Prices ← Fear → Rising Prices

Selling Hedge/Short Futures ← Establishes → Buying Hedge/Long Futures

Short Hedger ← What Kind of Hedger? → Long Hedger


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Activity #19 Determine whether each hedger is a PRODUCER or USER.

CORN FARMER

GOLD JEWELRY COMPANY

AMERICAN IMPORTER

A CORPORATE BOND ISSUER

OIL REFINERY

AMERICAN EXPORTER

Basis and Basis Charge A hedger’s basis is the difference between the hedger’s cash price and futures price In a normal market, cash is less than futures – “cash under” In an inverted market cash is more than futures – “cash over”

$3.00$3.10$3.20$3.30$3.40$3.50

Cash July September December

Corn Prices Basis Change from Entering to Lifting Hedge Producer User

Gain on the Hedge if:

In a normal market, this means the basis:

Basis is $0.10 under if July futures are used to hedge


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Basis Change Cash Futures Basis

Now: $3.45 $3.57

Later: $3.62 $3.70

Did the basis strengthen or weaken?

Did the basis widen or narrow?


Now: $7.58 $7.64

Later: $7.65 $7.75



0 ¢

- 5 ¢

- 10 ¢

- 15 ¢

Strengthen Remember – A strengthening basis will be profitable for producers

0 ¢

- 5 ¢

- 10 ¢

- 15 ¢

Weaken Remember – A weakening basis will be profitable for users


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Now: $8.45 $8.37

Later: $8.60 $8.44




Now: $12.79 $12.68

Later: $12.70 $12.66



0 ¢

10 ¢

5 ¢

15 ¢

Strengthen Remember – A strengthening basis will be profitable for producers

0 ¢

10 ¢

5 ¢

15 ¢

Weaken Remember – A weakening basis will be profitable for users


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Activity #20 Determine whether each statement is TRUE or FALSE.

1 A producer is short the basis.

2 A user will profit if the basis strengthens.

3 A user is short the basis.

4 In a normal market, a strengthening basis will be narrower.

5 In an inverted market, a weakening basis will be narrower.

6 A producer that establishes a hedge with a basis of $0.40 over will lose if the basis ends at $0.50 over.

7 A user that establishes a hedge with a basis of $0.50 under will profit if the basis ends at $0.60 under.

The Result of the Hedge With the spot market for wheat at $5.87, a farmer with wheat in her silo chooses to hold it for later sale. She hedges by selling futures at $5.99. Later, in July, she sells the wheat in the spot market for $5.82 and covers the short position for $5.90. What’s the net result of the hedge?

Cash Futures Basis

March Long at $5.87 Short at $5.99

July Sells at $5.82 Long at $5.90

Change -$0.05 +$0.09

The overall result of the hedge is an increase in the “cash now” price of $0.04


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Effective Selling Price 1) Cash

Now +/- Hedge Result

$5.87 cash now + $.04 profit on hedge = $5.91

2) Cash Later +/- Futures

Result

$5.82 cash later + $.09 profit on futures = $5.91

Effective Selling Price Producers A gain on the hedge or futures will increase the producer’s selling price (i.e., revenue) A loss will decrease the producer’s effective selling price

1) Effective Selling Price = Cash Now + Profit on Hedge or Cash Now – Loss on Hedge 2) Effective Selling Price = Cash Later + Profit on Futures or Cash Later – Loss on Futures

Effective Cost Producers A gain on the hedge or futures will decrease the user’s cost (i.e., expenses) A loss will increase the user’s effective cost

1) Effective Cost = Cash Now – Profit on Hedge or Cash Now + Loss on Hedge 2) Effective Cost = Cash Later – Profit on Futures or Cash Later + Loss on Futures

Two Methods:


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Hedging Exercise Exercise 1: A farmer is long cash soybeans. The current cash price is $7.00 bushel. He sells futures at $7.25 per bushel. Three months later, the farmer sells his cash soybeans at $6.90 and simultaneously buys his futures back at $7.05. What’s the result of the hedge?

Producer (long cash) or User (short cash)? What type of hedge? Cash Futures Basis

Now

Later

Change

Hedging Exercise Exercise 1 Continued: What’s the hedger’s effective selling price or effective cost?

Effective selling price or cost? Cash Futures Basis

Now Long at $7.00 Short at $7.25 $0.25 under

Later Sell at $6.90 Long at $7.05 $0.15 under

Change -$0.10 +$0.20 $0.10 str. 1) Cash Now +/- Hedge Result

$7.00 + $0.10 =

2) Cash Later +/- Futures Result

$6.90 + $0.20 =


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Hedging Exercise Exercise 2: An American importer places an order with a Swiss manufacturer. The order, which is to be delivered in August, is valued at 2,000,000 Swiss francs. The cash price for the franc is $1.5975 and September futures are trading at $1.5715. When the hedge is lifted, the cash price of the francs is $1.6135 and the futures are at $1.5855. What’s the result of the hedge?

Producer (long cash) or User (short cash)? What type of hedge? Cash Futures Basis

Now

Later

Change



Now S $1.5975 L $1.5715 $0.0260 over

Later L $1.6135 S $1.5855 $0.0280 over

Change -$0.160 +$0.0140 $0.0020 str. 1) Cash Now +/- Hedge Result

$1.5975 + $0.0020 =


$1.6135 – $0.0140 =


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Activity #21 – Calculating Effective Cost A firm that’s short the basis establishes a hedge using two corn futures contracts. When the hedge is placed, the cash price is at $5.00 and futures are at 5.30 and the firm's basis is 30 cents under. When the hedge is lifted, the basis is 24 cents under. The futures contract size is 5,000 bushels. When the hedge is lifted, the company buys corn. The change in basis means that the company will have an effective cost of: a. $0.06 b. $5.06 c. $4.94 d. $5.00

Hedging Exercise Exercise 3:

A corporation issues bonds with a price of 94-17. The corporation intends to issue another $10 million in April and wants to hedge its anticipated offering. T-Bond futures prices are as follows:

March: 96-10 Sept: 95-29 June: 96-19 Dec: 90-02

Later, the bonds are issued at 90-06 and futures are offset at 91-27. What’s the result of the hedge?

Producer (long cash) or User (short cash)?

What type of hedge? Cash Futures Basis

Now

Later

Change


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Now L 94 17/32 S 96 19/32 2 2/32 under

Later S 90 6/32 L 91 27/32 1 21/32 under

Change -4 11/32 +4 24/32 0 13/32 str. 1) Cash Now +/- Hedge Result

94 17/32 + 0 13/32 =


90 6/32 + 4 24/32 =

Hedging Exercise Exercise 3 Continued: What’s the total amount raised from the issuance of the bonds?

What did the hedge do to the issuer’s interest costs? Cash Futures Basis

Now L 94 17/32 S 96 19/32 2 2/32 under

Later S 90 6/32 L 91 27/32 1 21/32 under

Change -4 11/32 +4 24/32 13/32 str. Total Issuance? Interest Costs?


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Hedging Exercise Exercise 4: An electrical wire manufacturer enters a hedge when cash copper is at 366 cents and the December futures are at 367.75 cents. The manufacturer closes the hedge when cash is at 367.10 cents and the futures are at 368.85 cents. What’s its effective cost for the copper?


Now S $3.6600 L $3.6775 $0.0175 under

Later L $3.6710 S $3.6885 $0.0175 under

Change -$0.0110 +$0.0110 No Change 1) Cash Now +/- Hedge Result

$3.66 + $0.0000 =


$3.6710 – $0.0110 =

Activity #22 – Calculating Effective Cost An oil refinery needs 45,000 barrels of crude oil. When its hedge is placed, the cash price of crude oil is $60.75 per barrel. It hedges by using 45 July crude oil futures contracts. The futures hedge is established at a price of $61.05. When the hedge is lifted, the refinery buys crude oil in the cash market at $80.62 and its futures position is offset at $83.10. The net price per barrel the oil driller pays as a result of the hedge is: a. $58.57 b. $82.80 c. $85.28 d. $80.92

Cash Futures Basis

Now S $60.75 L $61.05 $0.30 under

Later L $80.62 S $83.10 $2.48 under

Change - $19.87 + $22.05 + $2.18 weak (profit for user)


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Chapter 10 – Stock Index Futures

Stock Index Futures Index futures contracts use a multiplier to convert an index value or average into a dollar value

Non-Systematic Risk Individual stock risk A combination of industry risk and

company risk

Systematic Risk Overall market risk Cannot be eliminated through

diversification

Stock Indexes Multiplier Minimum Tick Value

S&P 500 $250 0.10 points = $25

E-mini S&P 500 $50 0.25 index points = $12.50

E-mini Nasdaq 100 $20 0.25 index points = $5.00

DJIA $10 1 index point = $10

E-mini DJIA $5 1 index point = $5

E-mini Russell 2000 $50 0.10 index points = $5.00

Index futures contracts are cash settled

Stock index futures are used to hedge systematic risk

Non-systematic risk can be reduced through diversification


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Stock Index Futures Application A customer places an order to buy three S&P 500 futures contracts. The multiplier is $250 per index point. The initial margin requirement is $66,000 per contract and the maintenance is $60,000 per contract. The customer deposits the required margin in his account. The customer's order is filled and a long position of three contracts is established at 2833.30. That night, the settlement price for the December futures contract is 2825.80. Calculate the current equity in the customer's account.

Settlement: 2825.80 Loss: 7.5 points

Long: -2833.30 Multiplier: x $250

Loss: 7.5 points Total Loss: ($1,875) open trade equity (OTE)

Cash Balance OTE Equity

Equity per contract $66,000 ($1,875) $64,125 Total Equity: $64,125 equity per contract x 3 contracts = $192,375

Activity #23 – Hedging Stock Portfolios A customer has a large blue-chip stock portfolio. She anticipates a market decline and wants to hedge $5,000,000 of the portfolio using the S&P 500 futures. Each index point equals $250. The futures price is currently 2,995.20. Which of the following is the best hedging strategy? a. Buy 20 S&P 500 contracts b. Sell 20 S&P 500 contracts c. Buy 6 S&P 500 contracts d. Sell 6 S&P 500 contracts


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Chapter 11 – Commodity Options

Options Overview An option is a contract between two parties

BUYER SELLER Long the option Pays the premium (DEBIT) Acquires a right/control

Short the option Receives the premium (CREDIT) Assumes an obligation

Types of Contracts If an option is exercised…

BUYER’S RIGHT SELLER’S OBLIGATION

CALL

PUT

For an option, the underlying asset is a futures position, not a cash position


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In-the-Money Versus Out-of-the-Money

In, At, or Out-of-the-Money Option Market Price In, At, or Out-of-the-Money?

September 320 Corn Call at 16.75 336.50 cents

September 320 Corn Put at .50 336.50 cents

Oct 1750 Gold Put at 11.70 $1,739

Feb 1.0500 Gasoline Call at 0.35 $1.05

June 110 T-bond Call at 4-22 113-17

STRIKE PRICE

$50 $50

$70 $70

$60 $60

CALLS: In-the-Money

PUTS: Out-of-the-Money

CALLS: Out-of-the-Money

PUTS: In-the-Money

Market Price

Market Price

Calls and Puts are At-the-Money if the option’s strike price is equal to the future’s market price.


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An Option’s Premium

A contract has intrinsic value if it’s in-the-money. Its intrinsic value equals its in-the-money amount. It has zero intrinsic value if it’s out-of-the-money or at-the-money.

Time value is set in the market (negotiated) and is based on: Time left until expiration Market volatility

Intrinsic Value and Time Value Option Market Price Intrinsic Value Time Value

September 320 Corn Call at 16.75 336.50 cents

September 320 Corn Put at .50 336.50 cents

Oct 1750 Gold Put at 11.70 $1,739

Feb 1.0500 Gasoline Call at 0.35 $1.05

June 110 T-bond Call at 4-22 113-17

PREMIUM = Intrinsic Value + Time Value

The amount by which an option is in-the-money

The portion of an option’s premium that exceeds its intrinsic value

INtrinsic value is only created if an option is IN-the-money.

T-bond Option premiums are quoted in 1/64ths

T-bonds are quoted in 32nds


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Bond Calculations Converting 32nds into 64ths

113 17/32 - 100 0/32 3 17/32

Subtracting Fractions

4 22/64 - 3 34/64 1 12/32

Activity #24 – T-Bond Options A customer sells a T-bond call at 5-30. Later, if she covers the call at 4-22, the result is: a. Profit of $1,125 b. Loss of $1,125 c. Profit of $1,250 d. Loss of $1,250

Basic Options: Long and Short Calls CALLS BUYER, OWNER, LONG SELLER, WRITER, SHORT

RIGHTS Buy futures at strike price None

OBLIGATIONS None Sell futures at strike price

STRATEGY Bullish ↑ Bearish ↓

BREAKEVEN Strike price + premium Strike price + premium

MAXIMUM GAIN Unlimited Premium

MAXIMUM LOSS Premium Unlimited

3 17/32 x 2/2 [3] [17 x 2] / [32 x 2]

Remember: 1/32 = $31.25 and 1/64 = $15.625

4 22/64

[4 – 1] [22/64 + 64/64]

3 86/32

3 86/64 - 3 34/64


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Long Call – Analysis When the current market value of feeder cattle is:

Buy 1 May Feeder Cattle 130 Call at 1.50

BREAKEVEN:

Basic Options: Long and Short Puts PUTS BUYER, OWNER, LONG SELLER, WRITER, SHORT

RIGHTS Sell futures at strike price None

OBLIGATIONS None Buy futures at strike price

STRATEGY Bearish ↓ Bullish ↑

BREAKEVEN Strike price – premium Strike price – premium

MAXIMUM GAIN (Strike price – premium) x contract size Premium

MAXIMUM LOSS Premium (Strike price – premium) x contract size

130 cents per pound (50,000 lbs. per contract)

DEBIT CREDIT

STRATEGY:

MAXIMUM GAIN:

MAXIMUM LOSS:

Later, with feeder cattle at 140 cents, the investor exercises the option and immediately sells the futures contract. Result?

0

130

131.5


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Short Put – Analysis When the current market value of the euro is:

Buy 1 May Euro 1.10 Put at 0.0350

BREAKEVEN:

Straddles and Combinations Created by either: Buying both a call and a put on the same underlying futures contract OR Selling both a call and a put on the same underlying futures contract

Strategy Long straddle or combination: Short straddle or combination:

STRADDLE: Same expiration months and strike

prices

COMBINATION: Different expiration months and/or

strike prices

$1.10 (125,000 euros per contract)

DEBIT CREDIT

STRATEGY:

MAXIMUM GAIN:

MAXIMUM LOSS:

Later, when euros are $0.95, the investor’s option is exercised and the futures contract is sold. Result?

0

$1.065

$1.10

If an investor has one option component and adds another to create a multiple option position, he’s considered to have legged into the position.


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Long Straddle – Analysis Uncertain of the exact direction in which golf is going to move, an investor:

BREAKEVEN POINTS:

STRATEGY:

MAXIMUM GAIN:

MAXIMUM LOSS:

Spreads Positions which allow an investor to limit losses in exchange for limiting gains Created with the sale and purchase of two options of the same class, but different series

− Class: options of the same type on the same underlying security − Series: options of the same class, same expiration, and same strike prices

Spreads may be either bullish or bearish and either debit or credit

Price/Dollar/Vertical Buy 1 Jul Wheat 500 Call Sell 1 Jul Wheat 510 Call

Time/Calendar/Horizontal

Buy 1 Dec Silver 18 Call Sell 1 Aug Silver 18 Call

Diagonal

Buy 1 Aug Hog 58 Put Sell 1 Oct Hog 50 Put

Buys 1 June Gold 1750 Call at 33 Buys 1 June Gold 1750 Put at 28 (contract size 100 troy ounces)

The total (combined) premium is __________ 1,750

0


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Call Spread – Analysis An investor who’s bullish on the S&P 500 establishes the following positions:

SPREAD RULES: The breakeven must be between the strikes. The max gain PLUS the max loss will equal the

difference in the strike prices.

Put Spread – Analysis An investor who’s bullish on the price of soybeans establishes the following positions:

SPREAD RULES: The breakeven must be between the strikes. The max gain PLUS the max loss will equal the

difference in the strike prices.

Long 1 S&P 500 Mar 2910 Call at 49 Short 1 S&P 500 Mar 2950 Call at 32 ($250 per point)

Net Premium: Buyer or Seller: Debit or Credit: Widen or Narrow: Breakeven: Bull or Bear: Maximum Gain: Maximum Loss:

2950

2910

Short 1 Sept Soybeans 810 Put at 7 Long 1 Sept Soybeans 800 Put at 3 (5,000 bushels)

Net Premium: Buyer or Seller: Debit or Credit: Widen or Narrow: Breakeven: Bull or Bear: Maximum Gain: Maximum Loss:

810

800


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Delta When the price of May wheat is $3.80, an investor buys a May Wheat 400 call for $0.35. Later, May wheat rises to $4.20 and the call’s premium has increased to $0.55. What’s the call’s delta?

Activity #25 Estimating Option Premium with Delta

June gold futures are trading at $1,752 per ounce. The June 1760 gold call option is trading at $10.20 per ounce. The call’s delta is 40%. If gold rallies to $1,774 per ounce, what’s the expected premium on the call?

Change in futures price: Change in option premium: New option premium:

Using Options to Hedge Since option premiums only move a percentage of the underlying futures, hedgers will need to buy more options to effectively hedge Out-of-the-money options have low deltas At-the-money options have deltas around 50% In-the-money options have high deltas, approaching 100%

= Change in Option Premium

Change in Futures Price

Rather than using futures, hedgers can use options to protect their cash positions Producers will buy puts Users will buy calls

Number of Options = Number of Futures

Option’s Delta


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Activity #26 – Using Options to Hedge A farmer needs 60 futures contracts to hedge this year’s production. How many put contracts will she need if:

The delta is 0.5? The delta is 0.9? The delta is 0.08?

Margin on Options Buying Options Selling Options

The margin deposit is 100% of the option’s premium A trader buys a June copper 2.5000

call for a premium of $0.0500. If the copper contract size is 25,000 pounds, what’s the margin deposit?

• Margin = $0.05 premium x 25,000 lbs.

• Margin = $1,250

The margin deposit for selling options is:

The initial margin on the futures contract

+ The option’s premium

– 50% of the out-of-the-money amount

Activity #27 – Short Option Margin When Dec corn is trading at $3.70, an investor shorts 1 Dec corn $3.80 corn call at $0.15. Dec corn has an initial margin requirement of $0.40 and a size of 5,000 bushels. What’s the investor’s margin requirement?

Futures margin? Premium? 50% of the out-of-the-money? Total?


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Synthetic Positions Synthetic Long Futures = Long Call and Short Put

Synthetic Short Futures = Long Put and Short Call

Synthetic Long Call = Long Put and Long Futures

Synthetic Long Put = Long Call and Short Futures

Conversion = Long Futures and Long Put and Short Call

Reversal = Short Futures and Long Call and Short Put

Mastering Synthetics Algebra: 5 – 2 = 3

Start: Long Call = Long Put + Long Futures

Synthetic Short Futures?

Start: Long Call = Long Put + Long Futures

Answer:


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Activity #28 – Synthetics 1. Which of the following is equivalent to a long futures position?

a. Long two puts b. Short a call and long a put c. Short a call and short a put d. Long a call and short a put

2. Which of the following is equivalent to a short put position?

a. Long a call and long a put b. Short a call and long a futures contract c. Short a call and short a futures contract d. Long a call and short a put

national commodities futures examination

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