Futures and Options Basics
From FXPedia
Futures and options on futures – or simply options – are contracts that stipulate the details for a transaction scheduled to take place on a future date. Hence, the name futures for these types of contracts. Futures grew out of the use of forward contracts designed originally to ease the wildly fluctuating prices of seasonal commodities such as wheat and livestock.
In North America, the wheat market initiated the earliest use of forward contracts, and by the early 1840s, forward contracts were in common use. These contracts were private agreements between a single buyer and seller and provided a guaranteed price to the producer, while ensuring a supply of wheat at a guaranteed price for the retailer. Prior to the establishment of forward contracts, prices inevitably fell as producers brought their wheat to the markets and the availability of wheat increased; however, during the winter as wheat stockpiles dwindled, prices increased as supplies grew limited.
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Origin of the Futures Market
Chicago – because of its large population and proximity to the U.S. agricultural hub of the Midwest – became the gathering place for producers (i.e. sellers) and buyers to conduct their transactions. While the use of forward contracts did reduce price swings for the underlying commodity, there was little recourse if one party to the agreement defaulted on its obligation. It was not uncommon for a buyer with a contract to purchase ten tons of wheat for example, to refuse to honor the agreement if the buyer found another farmer willing to sell at a cheaper rate. Producers as well were not above breaking a deal if another buyer was found to be paying more.
To solve this situation, formal exchanges were developed and each party was required to deposit a certain percentage of the contract’s value which was held in trust by the new exchange. If one party then failed to complete the transaction as outlined in the agreement, the other party would receive the deposit to offset the loss of the deal. This became known as a performance bond.
Over time, forward contracts became standardized to include not only the underlying commodity, the price and the amount of the commodity, and the date to be delivered, but quality standards were also introduced. This led directly to a grading system still in use today for beef, pork, eggs, and other commodities.
| Note: | The Chicago Board of Trade (CBOT) created the first futures exchange in 1848. The first formal forward contract was issued by the CBOT in 1851.[1] |
With the introduction of contract standards, the contracts themselves became commodities that could be traded and this gave rise to a speculative market. Originally intended to ensure a delivery date for a commodity, investors now saw an opportunity to buy and sell contracts in an attempt to profit on the difference between a futures contract and the market price for the underlying commodity.
Clearing Positions
Of course these speculators did not intend to take physical delivery of the commodity so the practice of "clearing" positions became common. A contract to buy 10,000 pounds of live cattle for instance could be cleared by selling the contract, while a contract to deliver 10,000 pounds of live cattle could be cleared by buying a contract offsetting the original contract.
As exchanges became more sophisticated, contract holders were able to engage in cash settlements to close an outstanding position. This was facilitated by the practice of marking contracts to a market price ("mark-to-market") which placed a market value on a contract with the market value being credited to the holders account at the exchange. In order to keep these transactions straight, the exchange began a clearing service. Today, only about 3% of futures contracts result in physical delivery of the underlying commodity as most positions are cleared or settled for cash.[2]
The Modern Futures Market
Exchanges today offer a series of standard futures contracts which are listed for investors to review and evaluate. For example, the Chicago Mercantile Exchange (CME) lists a series of futures contracts including:
- Commodities (butter, milk, cattle, frozen pork bellies, lean hogs, etc.)
- Equity Indices (S&P 500, NASDAQ 100, Nikkei 225, etc.)
- Foreign Exchange (AUD, CAD, GBP, Euro, etc.)
- Interest Rates (Eurodollar, LIBOR)
In order to trade futures contracts, you typically require a broker account to access an exchange's listings.
Options on Futures Contracts
As noted earlier, a futures agreement is a binding contract obligating both parties to perform specific duties as outlined in the contract. However, when buying an option on a futures contract in return for paying a premium, the buyer of the option earns the right but not the obligation to buy or sell the underlying futures contract. This means that the option buyer can chose to exercise the option and take on the futures contract on which the option is based, or they can let the option expire.
| Note: | Options are traded as Over-The-Counter (OTC) or exchange-traded securities. OTC transactions are private agreements between two counterparties with terms negotiated by each side. Exchange-traded transactions on the other hand, are standardized contracts based on underlying futures contracts with a public exchange that advertises the goods to be bought or sold, the quantity and quality of the goods, the price to be paid, and the delivery date. Therefore, for the purposes of this article, we will be using the term “options” to refer to exchange-traded options. |
Futures trading - like most forms of investing - has inherent risks and options were created to provide some relief from this risk. The concept of an option is that instead of buying (going long) or selling (going short) a futures contract that commits you to fulfilling the terms of the deal, you can instead buy an option on a futures contract. In return for paying the premium, you can purchase an option on the futures contract. Then, if the market price for the commodity in the futures contract changes so that it is more profitable for you to buy or sell at the market price, you have the option of letting the option expire – note that if instead of having an options contract you actually held the underlying futures contract, you would be forced to complete the deal as outlined in the futures agreement.
By letting an options contract expire, you do loose the premium you paid, but depending on the situation, this amount could be considerably less than if you were forced to deal at the market price at the contract expiry date. For this reason, options can be thought of as a form of insurance to limit losses. See Hedging and Speculating with Futures for more information.
Terms Used in Options Trading
| Calls and Putts | An option that gives the holder the right to buy a futures contract is referred to as a call, while an option giving the holder the right to sell a futures contract, is a put. There is one twist to keep in mind when dealing with calls and puts, and that is that it is possible to buy or sell either a call or a put and this comes into play when designing a hedging or speculative strategy.
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| Long / Short | As in equity or forex trading, to be long means to hold a futures contract as in “long 1000 wheat contracts”. If you are “short 1000 wheat contracts” this means that you have sold short 1000 contracts. In either case, you must clear your position before the expiry date. |
| Option Writer | The option writer is the person selling the contract. As the option writer, you can write either a call or a put options contract. |
| Strike Price | The strike price – also known as the exercise price – is the price at which the option is exercised. This means that for a call option, you will be long in the underlying futures contract, while you will be short the underlying futures contract in the case of a put.
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| Premium | This is the price paid to purchase an options contract. Do not confuse the premium with a futures contract performance bond or a deposit – the premium remains with the option writer whether the option is exercised or is allowed to expire.
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| Expiration | Options contract expiry dates are the last day the contract can be exercised by paying the strike price. Failure to act results in the options expiring worthless.
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| Exercise | Call option buyers exercise the option by paying the strike price thus converting the option to a long futures position – exercising a put option results in a short futures position. The price for the futures contract will be the price stipulated in the option despite the current market price for the underlying commodity. |
Options Contract Speculation
Because options contracts are bought and sold on established exchanges, they are popular speculative instruments. They are highly liquid and it is easy to clear a contract without taking physical delivery of the underlying commodity by simply entering into an opposite position.
Currency futures in particular have risen to prominence as a means to speculate on rate changes. For example, if a Canadian dollar option on a U.S.-based exchange is quoted at 1.58 per tick (one one/hundredth of a dollar), the cost of an option contract on a single Canadian dollar would be $0.0158 USD:
- 1.58 x 0.01 = $0.0158 USD
Of course, you would not buy an option on a single Canadian dollar – on this exchange, assume that USD / CAD options are sold in $100,000 USD lots. Therefore, the cash price (i.e. the premium) for one CAD option is calculated as follows:
- (1.58 x 0.01) x 100,000 = 1,580
Where:
- 1.58 is the per tick price
- 0.01 is a single tick
- 100,000 is the lot size of the options contract
- Therefore, the premium of a single CAD option contract is $1,580 USD
If the price of the option rises to 1.60 after you buy it at 1.58, you are in a winning position with a profit (not including any brokerage fees) of $20 USD:
- (1.60 x 0.01) x 100,000 = 1,600
The following example illustrates a typical exchange options listing:
- June CME CAD call
This contract consists of the following elements:
- June expiry date
- CAD is the underlying futures contract (sold in $100,000 USD lots)
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