Series 3 Ch. 1 - Futures trading theory, basic functions and terminology

Rate of return

amount of money made or lost minus commission (if appropriate), divided by the amount of money invested (or margin requirements).

Commodity Classification

A given futures contract specifies a range of acceptable de-livery grades, assuming the base grade when pricing futures, and allows quality adjustments to the settlement price for delivery of other acceptable grades. The buyer pays the seller a premium for better than the base grade and a discount for an acceptable, but poorer, grade.

Excess margin

can be withdrawn or used as margin to establish additional positions. can come from additional deposits by the customer or profits on open positions

Premium Basis

An inverted market in which the cash prices are higher than distant futures contracts

Downstream users

Bakeries, food companies, retailers, meat product preparers, canned/frozen food manufacturers, automakers and consumer goods manufacturers, oil marketing companies and independent retailers.

Short Hedge (Selling Hedge)

Benefits from a strengthening basis. Long the spot and short the futures

Long hedge (Buying hedge)

Benefits from a weakening basis. Short the spot and long the futures

Normal Market

Cash "Under" Futures - Strengthening basis toward convergence

Basis

Cash - Futures

No carrying charges

Live hogs, live or feeder cattle. Things that are "alive"

Primary Users

Millers and food supply distributors, slaughterhouses and meat packers, electrical wire and motor builders, oil refineries

Normal Futures Market

Nearby futures price < Deferred (Distant) Futures price. When distant months are selling at a premium. Reflects an adequate supply of the commodity, or discount basis. AKA Carrying charge market or Futures price in contango

Inverted Futures Market (Backwardation)

Nearby futures price > Deferred futures contract. Reflects a premium basis. Occur when supplies are not adequate, and they translate to relatively high cash market prices.

Haircutting

Discounting securities used as margin by a certain per-centage (bonds by 10% or stocks by 25%)

Middlement

Elevator operators and grain merchants, feedlot operators and independent buyers, copper fabricators and industrial supply houses, importers, exporters and pipeline operators

Producers

Family and corporate farms, breeders and ranchers, commercial mining companies, foreign and domestic oil producers

Soybeans

Has no quality adjustment, only one standard grade is eligible for delivery

Margin Percentage formulas

Investment margin per unit / unit price margin investment / total contract value

Futures contract specifications

Quantity Quality Time Location

Arbitrage

The opportunity to profit from temporary abnormal price differences

Forward contracts

direct commitment negotiated between one buyer and one seller and if traded, the transaction would take place OTC (over-the-counter) and deemed illiquid. A forward contract is nonstandardized in that the contract terms and provisions are defined only by the parties to the contract, with no third-party intervention or true-ups. The person selling is obligated to make delivery; the person buying forward is obligated to take delivery at a set future date. There is a risk that either party may ultimately renege

Margin

earnest money deposited in cash an exchange requires an investor to have on account to establish and maintain positions in futures contracts. Covers potential liability from adverse price changes to the investor's futures position.

Cash trading

involves the immediate exchange of ownership of a commodity or good for an agreed-upon amount of money. also called actuals or physical trading, is typically a privately negotiated agreement between a buyer and a seller to deliver a specified quantity and quality of a good at a time and place to which both parties have agreed.

Carrying charges

only apply to commodities that are storable and deliverable, such as wheat, corn, cotton, coffee, gold, and copper.

Initial margin

the minimum amount needed to open, or establish, a futures position.

Maintenance margin

the minimum amount of money that must be present in a commodity contract at all times. If the margin prescribed by the exchange or brokerage firm in the position falls to or below a prespecified level a call for additional funds will be made in order to restore the account back up to the initial margin level. These funds are due the next business day additional money that the customer has to deposit into the account if the market moves against him.

Carrying charge factors

time, interest (financing costs), insurance; supply and demand (domestic and foreign); transportation; production cost; storage cost; and expectations about the future.

Weakening Basis

when either cash market prices increase more slowly than futures prices or cash prices decrease more quickly than the futures prices. In other words, the basis becomes more negative or less positive.

Strengthening Basis

when the cash market prices increases relative to the futures prices. In other words, the difference between cash and futures prices narrows,