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Introduction toIntroduction to

Futures and Options ContractsFutures and Options Contracts

Risk Management Solutions to the Dairy Industry

This information brought to you by:

edairy.fcstone.com

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OutlineOutline

Futures Contracts•Basic Concepts•Characteristics of Market Participants

Futures Exchanges•Open-Outcry vs Electronic Trading•The Trading Process•Margins

Options on Futures•Terminology•Option Volatility

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An obligation to buy, sell, or cash-settle a commodity An obligation to buy, sell, or cash-settle a commodity that meets set grades and standards on some future that meets set grades and standards on some future date.date.

Futures contracts are standardized based on:Futures contracts are standardized based on:

Commodity:Commodity: What is being traded What is being traded including grade and quality including grade and quality

specificationsspecifications

Contract month:Contract month: When the contract will expireWhen the contract will expire open contracts must be delivered or open contracts must be delivered or

cash-cash- settledsettled

Quantity:Quantity: The size of one contractThe size of one contract pounds, bushels, barrels, etc.pounds, bushels, barrels, etc.

What is a Futures Contract?What is a Futures Contract?

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Examples of Futures ContractsExamples of Futures Contracts

Commodity:Commodity: Number 2 yellow corn Number 2 yellow corn

Contract month:Contract month: Nov, Dec, Jan, Mar, May, Jul, SepNov, Dec, Jan, Mar, May, Jul, Sep Quantity:Quantity: 5,000 bushels5,000 bushels

Commodity:Commodity: Class III fluid Class III fluid milk milk

Contract month:Contract month: All months availableAll months available

Quantity:Quantity: 200,000 pounds200,000 pounds

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What About Price?What About Price?

The price of a futures contract is determined through The price of a futures contract is determined through a competitive auction.a competitive auction.

Someone who wants to Someone who wants to buy the commodity will buy the commodity will

bidbid

Someone who wants to Someone who wants to sell the commodity will sell the commodity will

offeroffer

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Who trades commodities?Who trades commodities?

HedgersHedgers

• Produce or use the commodity tradedProduce or use the commodity traded

• Utilize futures contracts to manage price riskUtilize futures contracts to manage price risk

SpeculatorsSpeculators

• Trade solely for profitTrade solely for profit

• Add liquidity to the marketAdd liquidity to the market

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Buyers and SellersBuyers and Sellers

Buyers and sellers meet two different Buyers and sellers meet two different ways:ways:

• In personIn person, on an exchange trading , on an exchange trading floorfloor

The “open outcry” system still accounts for The “open outcry” system still accounts for the majority of domestic futures volumethe majority of domestic futures volume

• ElectronicallyElectronically

Increasingly popular, especially in foreign Increasingly popular, especially in foreign countriescountries

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Futures ExchangesFutures Exchanges

Futures exchanges are organized gatherings of Futures exchanges are organized gatherings of buyers and sellers.buyers and sellers.

Futures exchanges are located throughout the Futures exchanges are located throughout the United States and the world. A few examples:United States and the world. A few examples:

Chicago Mercantile Exchange

Chicago Board of Trade

Tokyo Grain Exchange

London International Financial Futures and Options Exchange

Chicago Mercantile Exchange

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Futures ExchangesFutures Exchanges

Each commodity has its own Each commodity has its own trading pittrading pit on the on the exchange floor where buyers and sellers meet.exchange floor where buyers and sellers meet.

Traders on the floor of the Chicago Mercantile Traders on the floor of the Chicago Mercantile ExchangeExchange

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Futures ExchangesFutures Exchanges

Traders in the pits use voice or hand Traders in the pits use voice or hand signals to bid, offer, and trade commodity signals to bid, offer, and trade commodity contractscontracts

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Below is an example of an electronic trading Below is an example of an electronic trading platform screen.platform screen.

Electronic TradingElectronic Trading

Many CME Many CME contracts are contracts are traded both in traded both in trading pits and trading pits and on the on the GLOBEX® GLOBEX® platform platform (right).(right).

GLOBEX® terminalGLOBEX® terminal

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Electronic TradingElectronic Trading

Similar to open-outcry trading, except:Similar to open-outcry trading, except:

• Bids and offers are posted electronicallyBids and offers are posted electronically

• An order-matching system executes An order-matching system executes tradestrades

Electronic trading dominates in Europe Electronic trading dominates in Europe and is rapidly gaining popularity in the and is rapidly gaining popularity in the U.S.U.S.

Eurex:Eurex: Fully electronicFully electronic

CME:CME: Electronic (GLOBEX®) and open outcryElectronic (GLOBEX®) and open outcry

CBOT:CBOT: Electronic (a/c/e) and open outcryElectronic (a/c/e) and open outcry

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Annual CME Volume

050

100150200250300350400450

1996 1997 1998 1999 2000 2001

MM contracts

Total GLOBEX

Most CME contracts are still traded by open-outcry

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Where Do I Begin?Where Do I Begin?

Establish a hedging account with a broker.Establish a hedging account with a broker.

•Brokers place buy and sell orders for their Brokers place buy and sell orders for their customers.customers.

•A fee, or commission, is charged for this A fee, or commission, is charged for this service.service.

Your broker may also:Your broker may also:•Help you open your accountHelp you open your account•Provide advice on appropriate trading strategiesProvide advice on appropriate trading strategies•Answer your questions about futures tradingAnswer your questions about futures trading

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How Do I Trade a Futures Contract?How Do I Trade a Futures Contract?

1.1.Call your broker and place an orderCall your broker and place an order

2.2.The broker routes your order to the The broker routes your order to the trading pit via the brokerage firm’s trading pit via the brokerage firm’s central order deskcentral order desk

3.3.A floor broker executes the tradeA floor broker executes the trade

4.4.Your broker calls you back to confirm Your broker calls you back to confirm your order has been filledyour order has been filled

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MarginsMargins

You have taken a position in the futures You have taken a position in the futures market. Now what?market. Now what?

Initial margin funds must be posted for Initial margin funds must be posted for each contract bought or sold.each contract bought or sold.

Since futures contracts are simply an agreement Since futures contracts are simply an agreement to buy or sell something at a future date, no cash to buy or sell something at a future date, no cash changes hands when the position is opened. changes hands when the position is opened. Instead, a good-faith deposit must be made to Instead, a good-faith deposit must be made to guarantee performance.guarantee performance.

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Class III/IV MarginsClass III/IV Margins

• Initial margin: deposit made when Initial margin: deposit made when position is entered, $800/contract for position is entered, $800/contract for hedgershedgers

• Maintenance margin: minimum balance Maintenance margin: minimum balance that must remain in the account, that must remain in the account, $800/contract$800/contract

•Exchanges set minimum margins for Exchanges set minimum margins for each commodity based on historical each commodity based on historical volatility and expected market conditionsvolatility and expected market conditions

• Margin funds may be withdrawn when Margin funds may be withdrawn when the hedge is exitedthe hedge is exited

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MarginsMargins

Margin accounts are “marked to market” Margin accounts are “marked to market” each day to reflect changes in position each day to reflect changes in position value.value.

Buyer SellerPrice Rises May withdraw

margin excessMust deposit additional margin

Price Declines

Must deposit additional margin

May withdraw margin excess

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Margin ExampleMargin Example

On March 7, a dairy producer sold one Class III On March 7, a dairy producer sold one Class III contract at $12.20 and an end-user purchased an contract at $12.20 and an end-user purchased an identical contractidentical contract

Margin Adjustment

Date Price Producer End-User

March 7 $12.20 Post $800 initial margin

March 8 $12.26 -$120 $120

March 11 $12.27 -$20 $20

March 12 $12.21 $120 -$120

March 13 $12.26 -$100 $100

March 14 $12.26 $0 $0

March 15 $12.22 $80 -$80

March 18 $12.05 $340 -$340

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The Clearing HouseThe Clearing House

For each matched trade, the exchange’s For each matched trade, the exchange’s Clearing House:Clearing House:

1.1. Is substituted as the buyer to the sellerIs substituted as the buyer to the seller

2.2. Is substituted as the seller to the buyerIs substituted as the seller to the buyer

• Eliminates counter-party credit risk (the Eliminates counter-party credit risk (the clearing house guarantees performance)clearing house guarantees performance)

• Futures positions can be offset by executing an Futures positions can be offset by executing an equal but opposite transaction with equal but opposite transaction with anyoneanyone, , not necessarily the original partynot necessarily the original party

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The Clearing HouseThe Clearing House

The Clearing House is made up of The Clearing House is made up of brokerage firms that are clearing brokerage firms that are clearing members.members.

In the case of a customer default, financial In the case of a customer default, financial liability rests with:liability rests with:

1.1. The customer’s margin money/equityThe customer’s margin money/equity

2.2. The customer’s clearing member firmThe customer’s clearing member firm

3.3. All clearing member firmsAll clearing member firms

4.4. The exchangeThe exchange

No clearing firm has ever defaulted on its No clearing firm has ever defaulted on its financial obligations.financial obligations.

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Options on FuturesOptions on Futures

Options are the right, but not the Options are the right, but not the obligation, to buy or sell a futures contract obligation, to buy or sell a futures contract at a specified price.at a specified price. Call Option: The right to Call Option: The right to buybuy futures at a futures at a predetermined pricepredetermined price Put Option: The right to Put Option: The right to sellsell futures at a futures at a predetermined pricepredetermined price

For every option buyer, there must be a For every option buyer, there must be a seller.seller.

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Options on FuturesOptions on Futures

Option buyers:Option buyers:

• Receive price insuranceReceive price insurance

• Protect against rising or falling pricesProtect against rising or falling prices

• Must pay a premiumMust pay a premium• Risk limited to the premium paid Risk limited to the premium paid (plus commissions (plus commissions and fees)and fees)

Option Sellers:Option Sellers:

• Collect the premiumCollect the premium

• Are obligated to take the opposite side of a Are obligated to take the opposite side of a futures trade if the buyer choosesfutures trade if the buyer chooses

• Risk unlimited (unless position is covered with Risk unlimited (unless position is covered with futures, another option, or the cash commodity)futures, another option, or the cash commodity)

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Option ExampleOption Example

July Class III Milk $12.50 putJuly Class III Milk $12.50 put

CommodiCommoditytyMonthMonth Strike PriceStrike Price

Put/CallPut/Call

BuyerBuyer

Has the right to sell one July Class III contract at Has the right to sell one July Class III contract at $12.50$12.50

SellerSeller

Has the obligation to buy one July Class III contract Has the obligation to buy one July Class III contract at $12.50 at $12.50 if the owner of the put chooses to if the owner of the put chooses to exercise itexercise it

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Options TerminologyOptions Terminology

Intrinsic value: The value of the option if it were Intrinsic value: The value of the option if it were exercised todayexercised today

Time value: The remainder of the option premiumTime value: The remainder of the option premium

Date: April 10Date: April 10

August futures price: $13.20August futures price: $13.20

Strike / Type Premium Intrinsic Value Time value

Aug $12.75 Put $.48 $0.00 $0.48

Aug $13.25 Put $.72 $0.05 $0.67

Aug $13.00 Call $.79 $0.20 $0.59

Aug $13.50 Call $.56 $0.00 $0.56

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Options TerminologyOptions Terminology

At-the-money option: Option strike price is At-the-money option: Option strike price is identical to the price of the futures contractidentical to the price of the futures contract

In-the-money option: An option with intrinsic In-the-money option: An option with intrinsic valuevalue

Out-of-the-money option: An option with no Out-of-the-money option: An option with no intrinsic value (only time value)intrinsic value (only time value)

In-the-money call: Futures price is currently In-the-money call: Futures price is currently above option strike priceabove option strike price

In-the-money put: Futures price is currently below In-the-money put: Futures price is currently below option strike priceoption strike price

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Margins on OptionsMargins on Options

Buyers:Buyers:

• Pay entire option premium up frontPay entire option premium up front• No margin callsNo margin calls

Sellers:Sellers:

• Margin will varyMargin will vary• Based on risk characteristics of the Based on risk characteristics of the optionoption• Never exceeds the futures marginNever exceeds the futures margin

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Option Valuation

The 4 primary factors that impact the price of an option:

1. Option strike priceIn-the-money vs. Out-of-the-money

2. Current underlying price

3. Time until option expiration

4. Volatility of the underlying

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What is Volatility?

The degree to which prices fluctuate over timeThe price of the underlying, not the price of the option itself!

Measured as the standard deviation of daily price changes

Rising volatility(usually accompanies a big move or report)

Falling volatility(market settling down)

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Types of Volatility

Historical: Based on daily data from past trading days

Implied: Use quoted option price to back out volatility

(market’s estimate of future volatility)

Future volatility is the key to option value!

The more volatile the underlying commodity is expected to be, the more an option is worth. Historical volatility is a guide to what future volatility may be.