Futures and Options 101

Origin of the Futures Markets
Why Should I be Interested in Commodities?
How is Money Made and Lost Trading Commodity Futures?
Why do I Need a Broker
What are Options
What is a Spread?
What is Technical Analysis
Automated Trading Software

Origin Of The Futures Markets

EXCHANGES: The U.S. futures markets were developed out of necessity in the mid-1800’s. As our country was expanding and spreading west, farmers were having a difficult time reaching buyers efficiently. Farmers would carry tons of goods, hundreds of miles, only to have a prospective buyer back out of a deal. Quarrels repeatedly erupted relating to the quality, quantity, and price of the goods. A central marketplace where many willing and able buyers and sellers transacted business was the answer. Commodity exchanges were created to serve this function and also provide safeguards.

CONTRACTS: The unit of exchange that trades in the exchanges is the futures contract. Each contract provides for the future delivery of goods at a specified date, time, and place. Each particular commodity is bought and sold in standardized contractual units, which makes them completely interchangeable. For example, each sugar futures contract for a particular month is the same size, is of the same quality and grade, and is due for delivery at the same day and time.

Why Should I Be Interested In Commodities?

ADVANTAGES:

Leverage---Unlike the stock market, where you might have to actually spend up to $100,000 to buy $100,000 worth of a stock, through margin deposits, a commodities trader can leverage hundreds of thousands of dollars worth of a commodity for pennies on the dollar. Leverage may generate significant profits or losses from a small move in price.

Government regulated---The futures markets are so crucial to the well being of our nation, that the government established the Commodity Futures Trading Commission (CFTC) to oversee the industry. There is also a self-regulatory body, the National Futures Association (NFA), to further monitor the activity of all market professionals. We also encourage you to check our background.

Liquidity---The U.S. futures markets are the largest in the world in terms of trading volume and dollars, transacting hundreds of millions of dollars daily.

Low transaction costs---For example, if you thought the price of coffee was going higher, you could attempt to locate a seller and buy 37,500 lbs. of coffee, (the standardized size of one coffee futures contract). You could have the coffee shipped to a warehouse, and insure it until the price hopefully rose. When you felt the price wasn’t going any higher, you would have to find a buyer, ship it to them, and hopefully receive your money. Instead, by depositing margin, (approximately $4,200 in this example) from your Altavest Worldwide Trading, Inc. trading account, and going long a coffee futures contract, you could trade coffee (or any other commodity) without the hassle of locating a buyer and seller, and without incurring the extra costs of transportation, storage and insurance. Your only true cost would be your commissions and fees.

Options---Option buyers have virtually unlimited gain potential while the amount at risk is limited to the premium paid. Option sellers assume nearly unlimited risk in exchange for the premium received. Because option sellers assume such risks, we do not recommend holding uncovered ('naked') short options.

HEDGING & SPECULATING:

Almost every product you consume would likely cost dramatically more without the existence of the commodity futures markets...sugar, coffee, bread (wheat), gasoline, and borrowing costs, etc. Due to the intrinsic risks of being in business without the ability to shift risk, a manufacturer/producer of goods or services would be forced to charge higher prices, and the user of goods (you) would incur higher costs.

Shifting risk to someone willing to accept it is known as hedging. Manufacturers could effectively lock-in a sales price by going short an equivalent amount of goods with futures contracts. If a mining company knew they were going to sell 1000 oz of gold in several months, they could protect themselves from a future price decline by going short 10 gold futures contracts today. If the price of gold fell by $30 in the following months, they would receive that much less in the cash marketplace for their gold, but earn that much back when they offset (liquidated) their short gold futures position. The futures price will eventually become the cash price. A user or buyer of goods can use the futures markets in the same manner. They would need to protect themselves from a future price increase, and therefore go long futures contracts.

The person willingly accepting a risk does so because of the opportunity to profit from price movements, this is known as speculating. The lumber and mortgage for your home, the cereal and coffee you had for breakfast and the gas in your car would be priced many times higher without the participation of speculators (you) in the futures markets. Through supply and demand market forces, equilibrium prices are reached in an orderly and equitable manner within the exchanges, and world economies, and you, benefit tremendously from futures trading.

While trading commodities provides for unique opportunities, it is imperative that investors understand the risks before trading. The risk of loss in trading futures and options is substantial. You could lose your entire balance and in the event of a margin call, you may be required to deposit additional funds which means you could lose more than you intended on investing. Because of the risks, prospective investors should only invest 'risk capital' or money they can afford to lose.

How is Money Made and Lost Trading Commodity Futures?

GOING LONG & SHORT:

Going LONG & SHORT…to make a profit on anything requires that something be bought and sold, and that you sell at a higher price than you buy. When trading a futures contract it doesn’t matter if you initially sell or buy, as long as you do both before the contract comes due. If you were bearish you would sell, or another word would be go short. If you were bullish you would want to buy, or go long.

"How do I sell something that I don’t own, or why would I buy something I don’t need". The answer is simple. When trading futures, you never actually buy or sell anything tangible; you are just contracting to do so at a future date. You are merely taking a buying or selling position as a speculator, expecting to profit from rising or falling prices. You have no intention of making or taking delivery of the commodity you are trading, your only goal is to buy low and sell high, or vice-versa. Before the contract expires you will need to relieve your contractual obligation to take or make delivery by offsetting (also known as unwind, or liquidate) your initial position. Therefore, if you oiginally entered a short position, to exit you would buy, and if you had originally entered a long position, to exit you would sell.

LEVERAGE:

The following contains mathematical examples of leverage in the commodity markets. No representation is being made that any account has, or is likely to achieve profits similar to those shown in these examples.

If I buy a bushel of corn from a farmer for $2.65 per bushel, and it subsequently rises to $2.95 per bushel, haven’t I only made 30 cents?

If you only purchased one bushel of corn, you would be correct. What if you had purchased 5,000 bushels (the equivalent of 1 futures contracts) of corn? At $2.65/bushel X 5,000 bushels you would need to have spent $13,250 to initially purchase the corn. If you had a storage silo and the extra cash, and the price rose 30-cents, you would have made $1,500 (30 cents X 5,000 bushels = $1,500) less storage, insurance, transportation, and opportunity costs. If the price dropped 30-cents, you would have lost $1,500...less storage, insurance, transportation and opportunity costs.

What if you don’t have an extra $13,250 in your pocket, or a grain silo to store the corn? The good news is you don’t need $13,250, or a grain silo in the backyard. With only approximately $600 as a margin deposit, you could go long 1 corn futures contract with your Altavest Worldwide Trading, Inc. broker and if the price of the corn contract rose 30-cents, you would reap the same dollar reward...$1,500...earning 250% on margin, (less fees & commissions). You would incur no silo storage, delivery, or insurance costs.

Risk Disclosure -- However, it is important to realize that if you had bought a corn futures contract and prices dropped 30-cents you would be losing $1,500 plus fees and commissions. Leverage can work for or against you.

If you wanted to buy every stock listed in the S&P 500 index, it would take hundreds of thousands of dollars. As a commodity speculator, you could leverage the equivalent value of our country’s 500 largest stocks with one futures contract, using approximately 90% less money, and with far less in transaction costs.

Why Do I Need A Broker?

The vast majority of individuals, especially new traders, need a broker to execute trades on their behalf because trading futures is not as simple and straightforward as trading stocks. If you are experienced you may want to transmit orders online.

Altavest Worldwide Trading, Inc. exists to provide you with a link to the markets and offer you valuable trading resources, services, guidance and experience. As an Introducing Broker, we also need a conduit to the exchanges, and someone to act on our behalf. In our case, that is the role of R.J. O'Brien, one of the oldest retail Futures Commission Merchants (FCM), or clearinghouse, in the world. They are a full clearing member of all U.S. exchanges and you can be assured that when trading with us you will receive reliable, rapid, and efficient order execution and trading support.

As our client you won't be placed on hold for an eternity when you are attempting to enter a trade, nor will your order be placed in a pile with hundreds of other orders. Delays like that can cost you money! To transact trades more efficiently we transmit your orders electronically.

What Are Options?

There are many people who choose not to trade futures contracts because they feel the potential gains do not outweigh the potential losses. For those people, options are the investment vehicle of choice. An option is simply the right, but not the obligation to buy or sell a futures contract, at a pre-determined price, (strike price) on or before a pre-determined expiration date. To go long (buy) an option requires the buyer (holder) to pay a premium. When going short an option, the seller (writer or grantor) receives the premium. The following contains mathematical examples of leverage in the commodity option markets. No representation is being made that any account has, or is likely to achieve profits similar to those shown in the examples.

CALLS:

A call option is simply the right to buy, (go long). You can choose to be either long or short a call. For example, If you felt crude prices were going to rise, you could purchase (go long) a call, and pay the premium to the seller (grantor or writer). Lets look at what would happen if Crude was trading near $22/barrel, and you purchased an at-the-money July $22 (strike price) Crude call option. You would have paid a $600 premium (estimated example price for illustration use only, plus fees and commissions) for the option. The call option you now own represents the right to buy 1,000 barrels of July crude at $22 barrel. For $600 plus fees and commissions, you would be leveraging 1,000 barrels of crude oil.

Every dollar July Crude moved above your strike price, your call option position would gain $1,000 of intrinsic value. If the price rose just $3/barrel to $25, each option would be $3 in-the-money, and your call option would have an intrinsic value of $3,000. Depending on how much time value remains, and the volatility of the market, the option position could actually be worth much more. If prices didn’t rise, your maximum risk would be limited to your original investment, ($600) plus fees and commissions.

It is also important to realize that at any time prior to the expiration date, you could place an order with your Altavest Worldwide Trading, Inc. broker to liquidate all or part of your option position. This would further limit your risk by allowing you to recover whatever premium remained. For example, with a month of time value left, and Crude hovering around $21/barrel, let’s say your option is now worth only $200, the value having fallen from our original purchase price of $600. You may tell your broker to sell your July Crude option because you feel the underlying market, and therefore your options, will not increase in value within a month. By doing this, you would be recovering $200 from your original investment, and implementing money-management.

If you thought the price of July Crude was going to fall, you could sell a July Crude call option, and receive the premium from the buyer. You would do this because if prices did fall, the value of the call to the owner (the person you sold the call to, and who paid you the premium) would drop, because the option is less likely to become in-the-money. If prices didn’t rise before the option expired, the value of the call would drop to zero, expire worthless in the owners’ hands, and you would keep the entire premium the buyer originally paid you.

As an example, if July Crude were trading near $22/barrel and you felt that prices were going to drop, you could short a July $23 out-of-the-money call. To do this would require the suitable margin deposit for a Crude futures contract because you have unlimited risk, assuming the option is uncovered (naked). You would essentially be selling to the purchaser (holder) of the call, the right to go long July Crude at $23 per barrel, no matter where the July futures price settles. You would receive a $600 premium (estimated example for illustration purposes) from the purchaser to assume this risk.

If prices were to rise to $25 per barrel, and you had not offset your short call, (by placing an order with your broker to buy it back) the owner of the call could exercise his right to buy (which you sold him) crude at $23. Then he would be assigned a long position in a July Crude contract from $23, and you would end up assigned a short position from $23. He would be sitting on a $2,000 gain (1000 barrels per contract X $2/barrel= $2,000), and you would be sitting on a $2,000 loss.

PUTS:

A put option is simply the right to sell, (go short). You can choose to be either short or long a put option. For example, if you felt July Crude prices were going to fall from $22, you could purchase (go long) puts, and pay the premiums to the seller (grantor or writer). Imagine you purchased a July Crude $22 at-the-money put for a premium of $600, less fees and commissions. The option you now own represents the right to sell 1,000 barrels of July crude, at $22/barrel, regardless of where the futures price settles. Every dollar the July Crude market falls below your strike price, your put would gain $1,000 of intrinsic value. If the July Crude price fell to $19, your put would be worth a minimum of $3,000. If prices didn’t rise, your maximum risk would be limited to your original investment, $600, less fees and commissions.

If you thought the price of July Crude was going to rise, you could go short a July Crude put option, and receive the premium from the buyer. You would do this because, if prices did rise, the value of the put to the owner (the person you sold the put to, and who paid you the premium) would drop. If prices didn’t fall before the option expired, the value of the put option would drop to zero, expire worthless in the owners’ hands, and you would keep the entire premium the buyer originally paid you.

What Is A Spread?

FUTURES SPREAD:

A spread is the simultaneous purchase and sale of the same or similar commodity, in different or the same contract months. Spread trading is usually considered to be a lower risk strategy than an outright long or short futures position, and therefore margin requirements are usually less. For example, if the price trend of soybeans is currently up, and you are in a soybean spread, the gain on a long position would offset the loss in a short position. If the trend is lower, the gains on the short side will negate the loss of the long side.

You must be asking "How do I make money if I am both long and short the same commodity?" The answer is you are hoping to profit from the difference in the two contract months, not from a move higher or lower in soybeans. With a spread, you follow the relationship, or difference between the contracts, without having to pick a market direction.

For example, if July Soybeans were trading at $8.50/bushel, and November Soybeans were at $6.90, the spread would be $1.60 to the July side. If you bought a July/November bean spread at this level, and July went to $9.00, while November went to $7.20, the spread would now be $1.80. You could then sell the position, and make 20 cents/bushel * 5000 bushels=$1,000. If July Soybeans went to $7.50, while November Soybeans went to $6.10, the spread would shrink to $1.40. If you sold this position, you would lose 20 cents/bushel * 5000 bushels = $1,000. This example is known as an intra-commodity spread, buying one month and selling another in the same commodity. An inter-commodity spread is buying a commodity month in one market, and selling another related commodity in the same or similar month. Ask an Altavest Worldwide Trading, Inc. broker for further explanations and strategies. For Spread Charts click here.

OPTION SPREADS

Not only can spreads be utilized in futures markets, but options provide even more opportunities for successful spread trading. Options can even be utilized in conjunction with futures spreads to limit risk. With so many variables including strike prices, trading months, and different markets available, the permutations and combinations of option strategies are tremendous. The explanations are a bit more detailed, and beyond the scope of this brief introductory course. We do invite you to call one of our brokers for further explanations.

While spread trading offers many benefits, it is important to note that there is a high degree of risk, so you should only trade with money you can afford to lose. Spread trading is the simultaneous buying and selling of multiple contracts, therefore commission costs may be higher for spread trades than for single contract trades. Market forces may make the execution of spread trades more complicated as multiple contracts must be traded simultaneously. This may cause a delay in entering/exiting trades and may increase risk.

Some of the advantages of spreads are:
  1. typically require smaller margin deposits;
  2. it is possible to make money no matter which way a market moves; and
  3. seasonal patterns exist among spread relationships.

What Is Technical Analysis, And Why Do I Need To Learn More About It?

The answer is quite simple…because it is another tool available to assist you in your quest for profits. Find out more about charts in spreads, candlesticks, seasonals, scale trading and Elliot wave.

Automated Trading Software

Becoming a successful trader in the futures markets requires a disciplined approach. Discipline suggests controlling powerful human emotions such as fear and greed. Becoming a disciplined self-directed trader can take years of trading experience and sometimes a few costly mistakes along the way. For many traders, automated trading software may be the best solution to avoiding the time and money investment it can take to become a successful self-directed trader. There is no time investment with automated trading software. All the trade selection and trade management tasks are done for you. While risk is not eliminated by subscribing to automated trading software, we believe the average trader’s odds of success can be improved dramatically by choosing an automated trading system from our iSystems marketplace.