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Basics
1. THE BASICS on Futures & Options Kansas City Board of Trade
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11. THE BASICS on Futures & Options Ideas for portions of this presentation came from “Understanding Opportunities and Risks in Futures Trading,” a publication of the National Futures Association. To order that publication or other NFA materials, please call the NFA’s Information Center toll-free at 1-800-621-3570. This presentation is in no way intended to provide a complete futures education. Sources for additional information include the NFA, the exchanges where various products are traded, and your broker or advisor. Value Line is a registered mark of Value Line, Inc., a New York corporation that provides financial services and publications. Since 1982, the Kansas City Board of Trade has been licensed to use the Value Line mark in connection with its efforts to establish futures markets tied to the Value Line index. The Kansas City Board of Trade and Value Line, Inc. are not affiliated corporate entities.
Editor's Notes
CURIOUS ABOUT FUTURES AND OPTIONS? This presentation was designed for you. It was not made to tell you whether or not to trade, or in which markets or in what ways. It was made to give you some basic insight into how futures and options markets work. It also was designed by the Kansas City Board of Trade, an exchange that offers trading in futures and options markets. Yet you can rest assured that in this presentation we're not trying to sell you on trading our markets. As we'll discuss further, futures and options trading is not for everyone. But for some investors, futures and options markets can provide the opportunity to diversify and to increase returns. And for all investors, being better informed about how futures and options markets work is an important part of a well-rounded financial education. Futures and options markets play a vital role in today's economy, and provide a valuable service both to industry and to individuals. So continue. We hope you'll enjoy the benefits.
A futures contract is just what it's called – a contract. It is not equity in a stock or commodity. It is a contract – a contract to make or take delivery of a product in the future, at a price set in the present. In formalized trading of futures contracts on exchanges, standardized agreements specify price, quantity and the month of delivery. Futures markets have their roots in agriculture, but today futures and options on futures are traded on a wide range of products from wheat to natural gas to stock indexes, precious metals and currencies. Options on futures can be thought of like insurance. An option buyer (the insured) pays a premium to an option seller (the insurance company) for the right to buy or sell a futures contract at a specific price. However, just like with insurance, the option buyer may or may not exercise his right (use his insurance).
If you agree in April with your Aunt Sue that you will buy two pounds of tomatoes from her garden for $5, to be delivered to you when they're ripe in July, you and Sue just entered into a futures contract.
Professionals such as grain merchants, energy firms and portfolio managers use futures and options to reduce the risk to their business associated with volatile prices. For example, a flour miller might use a futures contract to set a price now for wheat that he knows he will need to purchase in the future, rather than face the chance that prices could be even higher when he buys the wheat. Similarly, a natural gas producer might use a futures contract to set a price now for gas he will sell in the future, locking in a profit rather than being exposed to the possibility of lower prices. These types of futures and options users are known as hedgers, and are in the market specifically to reduce risk. People who assume risk take it on in exchange for the opportunity for profit. Thus the futures and options markets serve the important function of risk transfer. Futures and options markets also provide the economy with price discovery. Futures prices are determined by supply and demand. An exchange itself does not set prices; it simply provides a place where buyers and sellers can negotiate. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. The prices discovered through futures markets offer valuable economic information about supply and demand in a competitive business environment.
An added economic benefit of using futures and options markets for many investors is lowered transaction costs. For example, someone interested in investing in stocks can in one transaction purchase a Kansas City Board of Trade Value Line stock index futures contract representing 1650 stocks, rather than buying and paying a commission on each stock separately in 1650 different transactions. Similar to stocks, gains and losses in futures trading are the result of price changes. If you have sold a futures contract, your trade will show a profit if prices fall. If you have bought, higher prices will produce a profit. To make a profit on a futures trade you can first buy low and then sell high, or reverse the order and sell high, then buy low.
It is important to understand futures may be highly leveraged. This means that if the price moves in the direction you anticipated you could realize large profits in relation to your initial investment. Conversely, if prices move in the opposite direction of what you anticipated, you could realize large losses in relation to your initial investment. Options on futures are different from futures themselves in that the most a buyer can lose is the cost of purchasing the option, known as the premium, along with transaction costs. An option seller, however, has unlimited risk. Think of the insurance example we used earlier. The option buyer is like the insured and is paying only the insurance premium for his protection. The option seller is like the insurance company and is taking on unlimited risk in hopes that he can collect the premium and the insurance will not be used.
Should an investor decide to participate in futures or options trading, just as with stocks, there are a number of factors to consider. Similar to trading stocks, in futures you can trade your own account – with or without the recommendations of a brokerage firm. Another alternative is an account that is still your individual account, but you give someone else written power of attorney to make and execute trading decisions on your behalf. You can also choose to use an individual or firm that for a fee provides advice on commodity trading. Yet another choice is to participate in a commodity pool, similar in concept to a stock mutual fund. Your money is combined with other participants and traded as a single account, and you share in profits or losses in the pool. Just as with trading stocks, before you can start trading futures you'll need a registered broker. This may or may not be a person who also trades stocks, but it must be a person who is licensed to trade futures. Just as with any other financial endeavor, we urge you to feel comfortable with all aspects of your relationship with a potential broker before entering into a business arrangement. Before you select a broker, we encourage you to call the National Futures Association at 800-676-4632 to check on whether any disciplinary action has been taken against the broker by the NFA, the Commodity Futures Trading Commission or an exchange. Again, as with trading stocks, when you apply with a broker to open an account, you can expect to be asked to provide information on topics such as your income, net worth and investment experience. At a minimum, the person or firm that handles your account is required to provide you with risk disclosure documents or statements specified by the Commodity Futures Trading Commission and obtain written acknowledgement that you have received and understood them.
To better understand the process an individual interested in trading futures might go through, let's use our friend, K.C. Isgreat, for a simplified, hypothetical trading example. Let's assume K.C. has already done his homework, as any wise investor does before making an investment, and he has decided that futures would fit nicely into his portfolio. He has also chosen to make trading decisions for himself, and has elected to trade Kansas City Board of Trade Value Line stock index futures. What does K.C. do next? 1) Choose a broker. A futures broker, that is. This person may or may not also be a stock broker. 2) Enter into an agreement with the broker and set up an account. To trade futures, you must deposit what is known as initial margin. Initial margin is the amount of money a customer must deposit for each futures contract to be traded. Exchanges set minimum margin requirements, while individual brokerage firms may require higher margin deposits from their customers. Note that in futures markets, margin has a different meaning and purpose than it does in stocks. In futures, margin money is earnest money made solely as a deposit of good faith. A trader's brokerage firm can draw upon the money to cover losses that may be incurred in the course of futures trading. Once margin is deposited and a futures contract is bought or sold, profits on the open futures position will be added to the margin account, and losses will be deducted from the margin account. If and when funds in a margin account are reduced by losses to below a level known as the maintenance margin, a broker will require that additional funds be deposited to the account to bring it back to the level of the initial margin. This is known as a margin call. Before trading, it is important to understand a brokerage firm's margin agreement and how and when the firm expects margin calls to be met.
3) Make your first trade. In this instance, K.C. has decided to hedge. He has a substantial, diversified portfolio in the stock market, but he is concerned that the U.S. economy could be headed into a recession and that the stock market may be headed downward in the near term. He doesn't want to sell his stocks because of the time and expense in commissions and later possibly rebuilding the portfolio, but he does want to protect himself against potential near-term losses. Through futures, K.C. can protect himself against the near-term losses without liquidating his stock portfolio, with one transaction and one brokerage commission.
K.C. calls his broker and places an order to sell one KCBT nearby Value Line futures contract at the market. The order is filled at a stock index level of 950.00 points, representing $95,000. The U.S. economy does indeed take a downturn, and the stock market falls. K.C.'s stock portfolio suffers losses. However, when K.C. decides to buy back his Value Line contract, the index is trading at 939.00. Since each index point in KCBT Value Line futures is worth $100, K.C.'s trade, in which he sold at 950.00 and bought at 939.00 (a difference of 11.00 points) shows a profit of $1,100 ($100 times 11.00), minus his broker's commission. This profit offsets losses in his stock portfolio. If the stock market had risen when K.C. decided to buy back his contract, let's say to 959.00, his futures trade would have showed a loss of $900 (950.00 –959.00 is –9.00, and 9.00 times $100 is $900). However, properly hedged, gains in his stock portfolio offset the futures losses.
As we stated at the outset, futures and options trading is not for everyone. But it does provide opportunities for some investors to diversify and enhance their rate of return in exchange for taking on certain risks. And for all of us, whether we are involved directly in the markets or not, futures and options serve important functions of risk transfer and price discovery that benefit our economy. At the Kansas City Board of Trade we're proud of our industry, and we hope you've enjoyed hearing some of our story.
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