Understanding Futures & Options

futuresSince 1870, the agricultural, financial and index futures and options markets of the New York Board of Trade (NYBOT) have provided price discovery, risk management and price dissemination tools for industry users and ongoing investment opportunities for market participants. By developing and supporting effective and efficient markets, the New York Board of Trade reaffirms on a daily basis the historic role of the traditional futures and options exchange.

We will discuss following topics in this article:

The New York Board of Trade was formed in 1998 as the parent company of the Coffee, Sugar & Cocoa Exchange, Inc. (CSCE) and the New York Cotton Exchange (NYCE®). Through its two exchanges and their subsidiaries and divisions, which include Citrus Associates, FINEX® and the New York Futures Exchange (NYFE®), NYBOT provides futures and options markets for a broad range of products including cocoa, coffee, cotton, frozen concentrated orange juice (FCOJ), sugar, milk, currency cross-rates, the U.S. Dollar Index® (USDX®), the Russell 1000® Index, the New York Stock Exchange (NYSE) Composite Index®, the Bridge/CRBsm Index and the PSE Technology Indexsm.

The Cantor Exchange, a joint venture with eSpeed, Inc.(Cantor Fitzgerald), provides the first, full-time electronic marketplace for U.S. Treasury futures. This brochure – Understanding Futures and Options – offers an overview of the role and function of the modern exchange. It contains examples designed to foster better understanding of futures and options transactions. Readers are advised however, that brokerage fees and commissions are not included in the examples and that margin levels are subject to change. Contact a broker for fee and commission information and current margin requirements. Trading on the exchanges, subsidiaries and divisions of the New York Board of Trade is governed by specific rules and regulations set forth in exchange rules. These rules are subject to change.

NYFE® is a registered trademark of the New York Futures Exchange. NYCE®, FINEX®, U.S. Dollar Index® and USDX® are registered service marks of the New York Cotton Exchange. The NYSE Composite Index® is a registered trademark of the New York Stock Exchange, Inc., which is not a market for futures and options and not affiliated with NYFE. Russell 1000® Index is a trademark/service mark of Frank Russell Company. Bridge/CRBsm is a service mark of Bridge Information Systems. PSE Technology Indexsm is a service mark of the Pacific Exchange, Inc. Understanding Futures and Options

The Markets (Cash and Futures)

Trading of basic commodities represents one of humanity’s oldest commercial activities. Nearly every community throughout history developed some sort of central marketplace where people could meet and trade necessary or desirable foods, fibers and other basic commodities. Over time, more participants entered the physical (cash) market. This lengthening of the marketing chain directly affected the value (price) of each commodity.

Each link in the chain became more and more vulnerable to sudden price changes, increasing instability and supply/demand speculation. As the cash market risk increased, merchants joined together in the nineteenth century to establish a more organized and specialized marketplace where they could meet and negotiate price by trading contracts for delivery at some point in the future. Merchants already used forward contracts based on expected shipments of a commodity.

The creation of the futures market added a whole new dimension to commodity trading. The cash market still continued its day-to-day business of selling and buying a commodity at that day’s price. The futures exchange organized the trading of the value of the commodity at some future date – a futures contract on the commodity. This price became a benchmark for determining the day-to-day cash market price.

The Exchange

Historically, the futures and options exchange has been a not-for-profit membership organization that provides and operates the facilities for trading; establishes, monitors and enforces rules for trading; and keeps and disseminates trading data.

By establishing a visible, free market setting where the forces of supply and demand can come together for the trading of futures and options, the exchange can fulfill its pricing functions – price discovery (the negotiation of the current best price); price risk transfer (the shift of cash market price risk exposure to other hedgers with opposite risk profiles or to other futures market participants who are willing to assume risk in return for a profit opportunity); and price information (the regular and timely dissemination of pricing information to all interested parties around the world).

The Price

The current price of the “nearby” futures contract (the contract with the closest expiration date) represents a benchmark for the cash market price. The worldwide dissemination of the futures price information contributes to wider market participation, which reflects the conditions of the cash market as a whole more effectively. More buyers and sellers in the marketplace mean better pricing opportunities, therefore increasing the quality of the price discovery process. The exchange ensures the accuracy of the trading process through its clearly defined and monitored rules that include an arbitration process to resolve trading disputes.

The difference between the specific futures contract price and the cash price for the commodity at the local delivery point is called the “basis.” Normally, the futures price should be equal to the present cash price plus the amount of storage, insurance, etc. (carrying charges) necessary to carry the commodity to the delivery month of the contract. In addition, basis pricing can also reflect the location (port of delivery) and the quality of the commodity. For example, a particular growth of coffee from a specific country might trade at a negotiated premium or discount to the futures price.

The commodity pricing system works so well because, although the futures and cash prices have a basis difference, they tend to parallel each other over time. As the contract delivery date approaches, the nearby futures price and the cash price move closer together (convergence). While futures and options do have a strong parallel relationship, the basis figure is not constant. The basis tends to widen or narrow depending on such key factors as supply and demand at the local delivery point. The existence of price risk in the cash market makes futures and options markets necessary. Price volatility – the price movement in either direction – makes futures and options trading possible. Exchanges measure price volatility for a specific commodity to determine its suitability for futures/options trading. Futures and options markets do not create or remove volatility and risk.

The volatility and risk originate in the underlying cash market. That same volatility creates trading opportunities for all market participants. Futures and options markets provide risk management tools to help reduce price risk exposure.

The Contract

The futures contract is a standardized legal commitment to deliver (or receive) a specific quantity of a commodity (or its cash equivalent) on a specified date at a specified delivery point. Cash market participants negotiate the buying and selling (the transfer of title) of a specific product; futures market participants focus on the buying and selling of a contract on the underlying product. With the contract standardized in terms of delivery months and locations, quantity and grade of the commodity, the only element left to negotiate in the exchange market is the price. Since price and not the commodity is the focus of the futures and options market, delivery of the actual commodity is a function that generally is assigned to the cash market.

The Marketplace

The futures market serves buyers and sellers equally; they may enter the market on either the buy or the sell side. New buyers of futures contracts establish a “long” position and new sellers of futures establish a “short” position. Most positions are closed out by completing an equal transaction on the opposite side of the original position: long positions are closed out by selling and short positions by buying. Physical delivery or cash settlement can also satisfy the obligation if the position is carried to contract expiration. Only a small percentage of total contracts traded, however, lead to actual physical delivery.

The Traders Futures exchanges serve essentially two types of traders – hedgers who seek to transfer their cash market price risk to other futures market participants and investor/speculators who are willing to assume that risk in exchange for the opportunity to profit from price movement in the futures market. The hedger enters the futures market to transfer/reduce risk associated with cash market transactions. The hedger may be protecting a buy or sell price.

Hedging involves establishing a position in the futures market equal to and opposite a position in the cash market. Hedging is not about taking risk. Hedging is the opposite of speculating. An effective hedging strategy reduces risk exposure. A gain in the futures market will offset a loss in the cash market, or vice versa. A grower who harvests coffee, for example, has coffee to sell. Therefore, the grower is said to be “long” physical/cash coffee. To hedge the crop, the grower would establish the opposite or “short” position in the futures market by selling futures contracts.

The grower protects the selling price of the cash market coffee. Other hedgers, such as a coffee roaster, need coffee (are “short” physical coffee) and therefore need to protect the buy price of cash market coffee. The roaster would take a long position in the futures market to place a hedge. Investors, on the other hand, are willing to assume the price risk by taking a position on either side of the market in order to pursue a profit from changing prices. Futures investors seek only to buy low and sell high. The unimportance of chronology in buying low and selling high illustrates a unique element of the futures market – the equality of opportunity in a rising or declining market.

Market participants can enter the market on either side (long or short). The presence of different participants in the marketplace – hedgers with opposing risk profiles, investors with different short- or long-term strategies and goals – creates ongoing trading opportunities on both sides. The participation of investors with a wide variety of goals and strategies contributes important liquidity to the market, increases price discovery efficiency and facilitates the hedging process. Types of investors may range from a “local trader” who seeks gains from small price movements within a short time frame (often holding a position for less than a day) all the way to large commodity funds that may establish a strategic position for a longer term until a specific price goal is reached.

Price volatility broadens the spectrum of opportunities for all market participants. The fact that prices can swing in either direction quickly and substantially can benefit both hedgers and investors. The same price volatility that makes futures and options markets effective tools for hedgers creates opportunities for investors. It should be understood, however, that price volatility in a commodity is inherent to the cash market, not the result of speculation in the futures market. Without volatility no reason exists for a futures market, because price risk is minimal.

The Transaction

Futures trades begin with one basic step. Buyers and sellers deposit funds – called margin – as a performance bond or good faith deposit with a brokerage firm to ensure that market participants will meet their contractual obligations. This system of initial (or original) margin deposits (usually a small percentage of the total value of the underlying contract) helps to maintain the financial integrity of the futures market and provides participants with the leverage that is a major feature of futures trading. Since a futures contract is not intended for use as a merchandising contract for transfer of title from seller to buyer, there is no need for the full contract value to change hands.

The New York Clearing Corporation (NYCC) – the clearinghouse for all trades in the NYBOT markets – guarantees contract performance to its members by establishing, with the exchanges, minimum margin levels for each market and periodically adjusting them to reflect current price volatility. The clearinghouse is made up primarily of brokerage firms who serve as clearing members and must meet certain financial requirements and responsibilities including a guaranty deposit at the clearinghouse. The NYCC serves as counterparty to every trade and guarantees the integrity of each contract in the NYBOT markets. The clearinghouse also oversees the transfer of money among members.

At the close of each trading day, each trader’s account equity is adjusted (marked to the market) to reflect price movements. If the market has moved against the trader’s position, variation margin payments are required to restore the trader’s equity to the required minimum level. In the traditional exchange, the actual transaction takes place in exchange-designated trading rings (pits) where members meet to make bids and offers to each other by voice and hand signals (open outcry). Trades are acknowledged by the participants and confirmed in writing or by electronic order routing system. Since only exchange members can trade on the floor, customer orders are delivered to floor brokers who execute them according to the customer’s instructions.

Among the common orders that are filled in the pit are market orders (executed immediately at the prevailing price in the pit); limit orders (to be executed at the stated price or better); and stop orders (instructs broker to execute an order at the market if a certain price is reached). Once the transaction has taken place, it is entered manually or electronically into NYBOT’s Trade Input Processing System (TIPS®) where it is matched, and assigned to a clearing member. Only clearing members can submit trades for clearing. When the trade is submitted, the clearinghouse then becomes the buyer to every seller and seller to every buyer.