Series 3

National Commodities Futures

Learning Guide / Workbook

v07
 Series 3 On-Demand Learning Guide

About the Series 3 Exam

1 2 3 4 5
120 True/False and Two Hours and 30 5 Additional Minimum Required 30-, 30-, 180-Day
Multiple-Choice Minutes Allotted to Questions are Passing Score on Waiting Period for
Questions Complete Exam Included as Each Part Failures
Experimental (don’t is 70%
count for
or against
the score)

Part 1 – Futures Trading Theory and

Chapters # of Questions
Basic Functions Terminology
1, 3, 7,
General Theory 16 (13% of exam)
9 and 11
Futures Margins, Options Premiums, Price Limits, Futures Settlements,
1, 4, 6 and 11 15 (13% of exam)
Delivery, Exercise, and Assignment

Types of Orders, Customer Accounts, Price Analysis 3, 4 and 5 11 (9% of exam)

Basic Hedging, Basis Calculations, Hedging Futures 9 and 10 19 (16% of exam)

Spreading 8 3 (3% of exam)

Speculating in Futures 3, 4, 7 and 10 16 (13% of exam)

Option Hedging, Speculating, Spreading 11 5 (4% of exam)

Part 2 – U.S. Regulations Chapter # of Questions

Regulations 2 35 (29% of exam)

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 Series 3 On-Demand Learning Guide

How to Begin
View On-Demand Video for Chapter 1

 Repeat these steps through Chapter 2, then

complete your first Progress Exam
Read Chapter 1 of Study Manual

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Chapter 1 – Commodity Futures

Futures Contract
Evolved from forward contracts
Like a forward contract, both parties to a futures contract have obligations

BUYER SELLER

 Also called a long position  Also called a short position

 Obligation to take delivery at expiration  Obligation to make delivery at expiration

Futures and Forwards

A contract between a buyer and seller who agree to trade a specific commodity or asset at a later date (i.e., in the
future)

Futures Forwards

A standardized quantity A variable quantity (as agreed)

Delivery at location and time

specified by exchange rules OTC-traded with negotiable terms
(i.e., regular for delivery warehouse)

Non-personal Personal

Can be offset Cannot be offset

If assigned, some exchanges force acceptance, which is referred to as being “stopped;”

others allow closing trades

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Activity #1 – Futures Contract

An investor sold a wheat futures contract at $5.16 per bushel. At the end of the contract, if the price of wheat has fallen
to $4.10 per bushel, which of the following statements is TRUE?
a. The investor makes delivery.
b. The investor takes delivery.
c. The contract expires worthless.
d. The investor neither makes nor takes delivery

Futures Exchanges
Exchanges will:
 Provide a place to trade
 Set contract terms which must be approved by CFTC
– Delivery size
– Basis grades, which may allow for delivery of superior grade (for a premium) or inferior grade (at a
discount)
– Time of delivery
– Place of delivery - approved locations are referred to as “regular for delivery warehouses”
– Margin requirements – both initial and variation
Exchanges will not:
 Own any contracts
 Buy or sell contracts
 Set prices of contracts

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CME Globex and

Intercontinental Exchange (ICE)
Both manage exchanges that provide a platform for investors to buy and sell futures (and other securities) on an
international basis
Contracts are fungible on an exchange of the same group (e.g., buy gold ICE futures U.S. and sell gold ICE futures
Europe)

CME Group ICE

Exchanges include: Exchanges include:

 Chicago Mercantile Exchange (CME)  ICE Futures U.S. (IFUS)
 Chicago Board of Trade (CBOT)  ICE Futures Europe (IFEU)
 Minneapolis Grain Exchange (MGEX)  ICE Futures Singapore (IFSG)
 Commodities Exchange (COMEX)  ICE Endex (NDEX)
 New York Mercantile Exchange (NYMEX) Retail and institutional investors have access to the
 Partnerships with exchanges in Brazil, Malaysia, same prices
Dubai, Korea and CME Europe Ltd.
Clearing is done by ICE Clear U.S., ICE Clear Europe,
Retail and institutional investors have access to the and ICE Clear Singapore
same prices
CME Clearing guarantees all contracts that are
traded on the CME Globex platform

Benefits of Futures Exchanges

Allows producers and users of the cash commodity to hedge by establishing a futures position that’s opposite the cash
position
 Substantially reduces risk of price fluctuations
 Enables producers and users to obtain credit at more favorable rates
 Reduces the price of the commodity to the public
Provides a central point to channel risk capital of speculators
 Increases liquidity and narrows price spreads
Provides a focal point to where all buy and sell orders are sent
 Price discovery
Price dissemination
Provides an alternate channel for marketing the cash commodity

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Exchange Committees
Committee that settles disputes which arise between members, member firms, and
Arbitration
the public

Committee that investigates complaints against members, acts to prevent price

Business Conduct
manipulation, and supervises members and their employees

Committee that establishes rules regarding trading on the floor of the exchange and
Floor
settles disputes related to transactions on the floor

Traders and Trading

Floor Brokers
 Execute orders on behalf of others
 Work for firms or independent
Types of Traders Floor Traders (Locals)
 Trade for their own account
 May also trade for a firm’s proprietary account
 Cannot take customer orders

Day Trading
 Trade and offset the same day
Types of Trading
Position Trading
 Establish longer open positions

The Clearinghouse
The clearinghouse is an agency that’s associated with an exchange which guarantees all trades, thereby assuring
contract delivery and/or financial settlement
Since the clearinghouse becomes the buyer for every seller and the seller for every buyer, it eliminates counter-party
risk
Exchange members collect and deposit funds (i.e., margin) with the appropriate clearinghouse

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Activity #2
Read each statement and determine whether it’s TRUE or FALSE.

FUTURES CONTRACTS MAY BE MODIFIED

TO FIT A SPECIFIC HEDGER’S NEEDS

DELIVERY OF A SUPERIOR GRADE

OF A COMMODITY WILL GIVE
THE SELLER A PREMIUM PRICE

THE FLOOR COMMITTEE IS CONCERNED WITH

PREVENTING SIDE AGREEMENTS
BETWEEN FLOOR BROKERS

THE BUYER DETERMINES WHICH

GRADE WILL BE DELIVERED

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Chapter 2 – Regulations

Regulatory / Supervision Overview

CFTC

National Futures Futures

Association (NFA) Exchanges

NFA Members

Futures Commission Merchant (FCM)

Introducing Broker (IB)
Commodity Pool Operator (CPO) Associated Persons
Commodity Trading Advisor (CTA)

The CFTC
The Commodity Futures Trading Commission is a federal agency that was created in 1975

Objectives of the CFTC:

 Prevent manipulation
 Prohibit the spread of false or misleading information
 Establish ethical trading standards
 Approve new futures and options contract specifications
 Regulate exchanges and floor members
 Provide for settlement of customer claims
 CFTC and NFA employees cannot trade futures

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CFTC Delegation
The CFTC delegates some of its authority to:

NFA Exchanges Clearinghouses

 The NFA is a self-regulatory  Carry out CFTC-delegated  Agency associated with an

agency of the futures industry responsibilities exchange that guarantees
 Handle trading activities of trades
contract markets  Becomes the buyer for all
 Activities are subject to CFTC sellers and the seller for all
review buyers
 Eliminates counter-party risk

CFTC Disciplinary Actions

The CFTC:
 Maintains disciplinary jurisdiction over floor brokers, traders, and exchanges
 Is empowered to go directly to the courts to seek a restraining order
(independent of the U.S. Attorney General)

Felony Convictions for Criminal Violations of the

Penalties and Actions:
Commodity Exchange Act:

 Suspension or revocation of CFTC registration  Suspension or expulsion

 Maximum civil monetary penalty is the greater of  Fines of up to $1 million ($500,000 for individuals)
$194,710 per violation (indexed for inflation, and/or 10 years imprisonment
originally $140,000), or three times the damages
(non-felony)
 Suspension or revocation of trading privileges
 Settlement may be achieved without admitting or
denying charges, with penalties carried as if they
were applied following a hearing

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Reporting Levels and Position Limits

Established by CFTC and enforced by the Exchanges

 CFTC requires daily reports of gross long or short positions in each commodity
once it reaches a certain threshold level
Reporting Levels  FCM that carries position must also report
 One last report is filed on the day the account falls below threshold
 Applies to both hedgers and speculators

 Designed to prevent manipulation and distortion of prices

Position and Trading  Applies to only certain commodities
Limits  Applies to only speculators
 Bona fide hedgers are exempted

Market Participants
Futures Commission Merchant
FCM
 A large futures firm (B/D) that handles customer accounts

Introducing Broker
IB  A small futures firm (most online firms) that introduces and solicits clients for
associated FCMs

Commodity Pool Operators

CPO
 Operates and solicits funds for a commodity pool

Commodity Trading Advisor

CTA  Advises others in trading futures
 May work for an IB, FCM, CPO, or advise individual accounts for a fee

Associated Person (AP)

An AP is an individual who conducts the business of FCMs, IBs, CTAs, and CPOs
 Includes officers, partners, employees, solicitors, supervisors
Any person who’s required to register with the CFTC must be an associate member of the NFA
Qualifications
 Series 3
 Series 31 (for commodity pools only) Typically, prospective customers will
 Series 30 (for managers) discuss their financial goals with an
associated person and the AP will explain
An AP may have multiple registrations with approval the risks involved in futures trading.
of all firms

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Activity #3
Match each description to the appropriate term.

FCM A natural person that conducts the business of an NFA member

IB Manages a pool of investments in commodity futures or options

Advises others on the purchase or sale of commodity futures or

CTA
options

CPO Solicits and/or accepts orders for execution

Associated Solicits and/or accepts order for execution, but cannot accept
Person customer funds

National Futures Association (NFA)

The NFA is a self-regulatory agency of the futures industry that’s responsible for:
 Enforcing ethical standards
 Providing for arbitration of disputes
 Ensuring minimum financial standards
 Screening registrations
 Establishing training standards and proficiency testing
 Auditing members (spot and full scope)
– Unannounced spot audits
– Full scope audit every 24 months (no need for court approval to subpoena documents)
– NFA members are required to audit their branches at least annually
 Ethics training
– Firms must have a written policy
– Must demonstrate compliance upon audit

NFA Registration
All market participants are required to register with NFA
Exemptions from registration:
 Floor traders and brokers (subject to Exchange rules)
 Some CTAs and CPOs may also be exempt under specific circumstances (discussed later)
 Exchange members that are registered with CFTC (not with NFA) and are subject to fines by the CFTC
If any NFA member is required to notify the CFTC on any matter, it must also be reported to the NFA
NFA members cannot conduct business with non-member firms

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Futures Commission Merchant (FCM)

 May hold customer accounts and assets
 Must maintain minimum net capital of $1 million
 May be a clearing or non-clearing firm (may be a clearing firm on some exchanges, but a non-clearing firm on
others)
– Clearing FCMs are members of the clearing corporation that process and clear their own trades which are
executed on an exchange
– Non-Clearing FCMs process their trades through clearing firms

Trades are cleared through either an

omnibus account or fully disclosed
account
 Omnibus: Only discloses the
name of the non-clearing FCM
 Fully Disclosed: Discloses the
client’s information to the
Clearing FCM

Introducing Broker (IB)

An IB:
 Must have an affiliation with an FCM
 Does NOT hold customer accounts or assets
 Is not required to maintain a copy of customer statements
Two types:

 Able to find clients for any FCM

Independent IB
 Has a minimum required net capital of $45,000
 May be guaranteed by only one FCM
 FCM with which it has an agreement is responsible for GIB’s activities
– The agreement has no expiration
Guaranteed IB  FCM is required to audit its GIB at least annually
 Has no minimum required net capital
(i.e., the FCM satisfies the $45,000)
 Need not be exclusive

Essentially, an IB is a firm that solicits or accepts orders to

buy or sell futures contracts, but doesn’t accept money.

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Commodity Pool Operator (CPO)

Pools funds of several investors to trade as one account
 Funds are accepted in the name of the pool
 Customers are percentage owners in the pool
(similar to a limited partnership)
 CPO must run each pool as a separated entity
 CPO must maintain daily transaction records for the pool
 All withdrawals from a commodity pool must be properly disclosed to all participants

CPO Registration Exemptions

Pool operator is the NFA member
 May solicit one or more pools
 Required to register unless exempt

CPO Exemptions from Registration

De Minimis Commodities Investment Club

 Gross contributions to all pools is less than  Operates only one pool at a time
$400,000 and  Receives no compensation other than operating
 There are no more than 15 participants in any one expenses
pool (excluding the CPO and his family members)  Doesn’t advertise

An exempt CPO must file a statement with NFA to indicate the reasons for its
exemption and a copy must be sent to all participants

CPO Account Statements

CPOs must send account statements to all participants
Statement of Income/Loss
 Monthly – if pool is more than $500,000
 Quarterly – if pool is less than or equal to $500,000

Generally Accepted Accounting Principles (GAAP) must be used

It must show changes of NAV and reflect all fees (net of fees)

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Commodity Trading Advisor (CTA)

A CTA is any person who:
 Engages in the business of advising others as to buying or selling commodity futures or options
contracts
 Provides this service for compensation or profit

CTA cannot accept customer funds directly (only through FCM)

Managed Accounts
 If a CTA handles managed accounts, it must be carried on a fully disclosed basis by the FCM
 FCM (not the CTA) is responsible for sending account statements to clients

CTA Registration Exemptions

A CTA is required to register with the NFA unless:
 It’s registered as a CPO and only advises its own pool
– If it provides advice to other pools, it must register as CTA
 It advised no more than 15 persons within the last 12 months, and it doesn’t publicly hold itself out as an advisor
 It’s a publisher (newspapers and magazines)
 It’s a non-profit, voluntary membership organization (e.g., investment club), or a trade association

CTA/CPO Disclosure Document

Similar to a securities prospectus
A copy must be filed with the NFA at least 21 days prior to its first use
The front cover must indicate:
 Effective date – not earlier than 21 days after filing
– Information must be current (not older than three months)
– May be used for 12 months from this date
 Whether up-front fees apply; if so, net proceeds available
 “No approval clause;” also referred to as the “cautionary statement”
– CFTC has neither passed on the merit of this investment, nor has it passed on the adequacy or accuracy
of this disclosure document

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Risk Disclosure Document

The following must be reflected on the first page of the disclosure document
 High leverage
 Magnified risk and potential return – volatility, liquidity, counter-
party credit risk
 May be subject to substantial charges, with details of the Checklist of Information Included in
charges (e.g., management, advisory, and broker fees) Risk Disclosure Document
Other information within the document:
 Types of futures and options that will be traded  Business background
 Minimum and maximum size of the pool (if any)  CTA trading program and
pool investment program
 All applicable fees (up front and annual fees)
 Principal risk factors
 How the fund meets the margin call
 Fees
 Breakeven analysis
 Conflicts of interest
 Five-year business background of CPO and CTA trading  Litigation
principals
 Performance
 All civil and criminal actions (by CFTC, NFA, and clients) for
five years

Risk Disclosure Document

Actual and potential conflicts of interests must be disclosed
 Whether the CPO also operates as a CTA
 Whether the CPO (or an affiliate) receives a portion of the commissions
 The names of IB and FCM, if the customer is required to trade through them
 Whether the pool invests only in foreign futures and still needs to be registered

Risk Disclosure Document

Performance history must be disclosed by the CPO:
 Monthly rates of return must be displayed in either tabular form or by bar graph
 The number of outstanding units must be included at the beginning and the end of the period for which
performance is included
– If history is more than five years – show the last five years
– If history is between three and five years – show the entire history
– If history is less than three years – show the entire history plus:
• Lesser of five years or the entire history of any other pool operated by the CPO or CTA

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Activity #4
Determine the performance history disclosure requirement for each CPO.

CPO MANAGED ONE POOL

FOR THE LAST SIX YEARS

CPO MANAGED ONE POOL

FOR THE LAST FOUR YEARS

CPO MANAGED ONE POOL

FOR THE LAST TWO YEARS

CPO MANAGED TWO POOLS:

 NEW POOL: FOR LAST YEAR
 OLD POOL: FOR LAST 10 YEARS

Some Prominent Rules of the NFA

 NFA Rule 2-4: Members and associates must observe high standards of commercial honor and just and
equitable principles of trade in the conduct of their commodity futures business
 NFA Rule 2-38: All members must establish and maintain a written business continuity and disaster recovery
plan, which indicates the name and contact information for one or two individuals who are to be reached by the
NFA in case of an emergency
 NFA No Approval Clause: The CFTC and NFA don’t sponsor, approve, or recommend an AP
 Foreign brokers who work in U.S. branch offices overseas must be properly registered (Series 3 qualified)

NFA Compliance and Disciplinary Actions

Infractions are reported to the Regional NFA Business Conduct Committee
The NFA Compliance Director can:
 Require statements under oath from members
 Subpoena documents
While under investigation, a member may not resign, but may continue to do business
With agreement of the board, the President of the NFA can initiate a “Member Responsibility Action”
 Firm may be required to immediately cease doing business
 Doesn’t require a hearing beforehand

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NFA Compliance and Disciplinary Actions

Disciplinary Actions:

Original jurisdiction is given to the Hearing Panel which may decide on:
 Suspension or revocation of NFA membership
 Barring from association with NFA member firms
 Censure or reprimand
 Fine of up to $500,000 per violation (non-felony)
 Issuance of cease and desist order
 NOT prison
Formal rules of evidence need not apply

Appeals Process:

 Appeals committee of the NFA

 CFTC
 Federal courts

Arbitration
Used for the settlement of disputes between member firms, or member firm and customers
 Must be filed within two years of discovery
 Decisions cannot be appealed

Disputes of up to $50,000 Disputes of over $150,000 Judgments and Awards

 Normally handled by one  Normally handled by three  Judgments must be rendered
arbitrator arbitrators within 30 days of closing of
 Respondent must respond  Respondent must respond records
within 20 days of complaint within 45 days  Awards must be paid within 30
days of judgment, or the
respondent will be subject to
suspension

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Communication With the Public

Written communications with the public and all promotional material (including the text of standardized oral
presentations) require prior approval of a partner or officer of the firm
Copies of all promotional material, along with their approvals, must be maintained for five years
NFA prohibitions:
 False or misleading statements or omissions of material facts
 Emphasizing profits without giving equal weight to risks
 Citing past profits without cautioning that they may not represent future profits
 Using statistics which cannot be substantiated
 Using hypothetical performance without providing a special disclosure statement

Activity #5
Read each statement and fill in the blanks.
1. _____________________ is the maximum fine for violations of the Commodity Exchange Act.
2. The CTFC can assess a civil penalty of ______________________ per violation or __________ times the
damages.
3. The NFA will provide ___________ arbitrators for disputes exceeding ________________.
4. The maximum fine the NFA can assess is ______________ per violation.
5. Violations of _____________________ cannot be punished with a prison sentence.
6. A criminal violation of the _____________________________________ can result in a
______ year prison sentence.
7. Disputes of up to ______________ will be handled by __________ arbitrator(s).

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Opening Customer Accounts

1. Fill out Commodity Account Agreement

 Must be signed by all parties before trading

2. Read and sign Risk Disclosure Document

 AP is responsible for getting this document signed and dated at or prior to account opening
 A copy is retained by all parties involved (IB, FCM)

3. Information needed (NFA Rule 2-30 “Know Your Customer”)

 Name and address  Estimated annual income and net worth

 Legal age (age of majority)  Investment and futures trading experience
 Principal occupation

4. Account approval by a principal

 Information is not required to be verified (customer can by the only source of information)

Risk Disclosure
Proper Disclosure:
 For some customers, the best disclosure statement may be that trading futures is too risky for them
 Spread positions should not be described as having less risk
– Created by purchasing one futures contract and selling another
Additional Risk Disclosures:
 AP must determine whether they’re needed
 Option Disclosure Document is needed to open an option account (cannot be opened without a future account)

Customer Account Documentation

If customer refuses to disclose information, the necessary step is based on the type of customer:
 If customer is a U.S. citizen – A record of the refusal must be maintained
 If customer is a non-U.S. citizen – No record of the refusal needs to be maintained
Margin Agreement must be signed by all clients
 For commodities, there’s no cash account
Transfer Agreement or (“Supplementary Agreement”)
 Allows FCM to transfer monies to/from client’s securities account
 If no such agreement was signed, FCM must obtain the client’s specific, written approval for each transfer

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Types of Accounts
Individual One owner on the account

Multiple owners; information must be obtained from all owners

 Joint Tenants With Rights of Survivorship (JTWROS)
‒ Typically spouses
Joint ‒ Account passes whole without probate
 Tenancy In Common (TEN-COM)
‒ Typically business partners
‒ Account divided on death

Firms must obtain:

Corporate  Copy of charter and by-laws which allow for futures trading
 Resolution authorizing an individual(s) to act on the corporation’s behalf

Partnership Copy of the Partnership Agreement must be obtained

Trust Copy of the Trust Agreement must be obtained

Discretionary Account
If an AP is given discretion over an account
 Requires written power of attorney (PoA)
 All trades are reviewed by a principal within one business day
 AP must have two years’ experience (unless a CTA)
 PoA doesn’t need to be renewed, but will become void upon the customer’s death
If a third-party is given discretion over an account (i.e., a person other than an AP)
 Actual customer must give permission
 Duplicate confirmations must be sent to the customer
Review for churning:
 Excessive trading in the account to generate commission

Activity #6 – Discretionary Account

A discretionary account may be handled by:
a. An associated person who’s registered with the NFA
b. An associated person with one year’s experience
c. An associated person who was previously registered for one year and six months and has been registered
with your firm for six months
d. An associated person with four years’ experience

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Recordkeeping
Customer Account Statement – must be sent by FCM
 For active accounts (at least one transaction or an open position) – sent monthly
 For inactive accounts – sent at least quarterly
Customer Confirmations – must be sent by no later than the next business day
Customer Complaints (not public record) – firms are required to maintain a copy of all written complaints
 If an oral option complaint is received, firms must request that it be made in writing and must maintain a copy
Settlements (public records) – can be reached between firms and customers or regulators without admitting or
denying guilt

NFA members are generally required to maintain records for five years

Recordkeeping
If the customer is introduced by the IB CTA records:
to the FCM:  Powers of attorney
 Account form must be kept on file by both the IB  List of all positions
and FCM  Copies of each confirmation and
 FCM’s customer statement must statement from FCM
show the name of the IB  All communication with the public
(advertising and sales literature)
Necessary
Records
Upon death of a customer:
CPOs, CTAs, and their principals:
 Powers of attorney is automatically
 Must maintain detailed daily record of all personal canceled
transactions and all statements received from the
 Cancel all open (GTC) orders
FCM
 Liquidate all positions

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The USA PATRIOT Act

Currency and Monetary
Currency Transaction Reports (CTR)
Instrument Transaction Report (CMIR)

 Filed for all currency transactions executed by a

 Filed whenever a person physically transports or
single customer during one business day that
receives cash (or equivalents) exceeding $10,000
exceed $10,000
into, or out of, the U.S.
 Filed also for structured transactions

Suspicious Activity Report (SARs) Penalties

 Filed whenever a transaction (or group of  20 years in prison and the greater of a $500,000
transactions) equals or exceeds $5,000 and the fine per transaction or twice the amount of funds
firm suspects the transaction is designed to evade involved
reporting requirements or has no apparent
business purpose
 Confidential (client not informed)

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Chapter 3 – Price Forecasting

Relationship Between Cash and Futures

Since futures contracts are either physically delivered or settled
based on cash commodity prices, there’s a strong relationship
between cash and futures prices
 Prices between the two must converge
 Prices must converge on the first day delivery
 If prices don’t converge, an arbitrage opportunity will exist
– As a result of arbitrage activity, prices will then converge

Carrying Charges

Carrying Charge

Storage Insurance Interest

Transportation expenses are not included in carrying charges

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Activity #7 – Carrying Charge

Cash corn is trading at 600 cents per bushel. Storage costs are 4 cents per bushel, insurance expenses are 2 cents
per bushel, and shipping costs are 45 cents per bushel. If monthly interest rates are 1%, what’s the monthly carrying
charge?

Cash Price: Storage:

Interest Rate: Insurance:

Interest Expense: Total Storage:

Total Carry Charge:

Carrying Charge Market

Contango, Normal, or Premium Market
(Gold futures)
$1,805
$1,800
$1,795
$1,790
$1,785
$1,780
$1,775
$1,770
$1,765
$1,760
$1,755
Cash Aug Oct Dec

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Inverted Market
Backwardation or Discount Market
(Gold futures)
$1,775
$1,770
$1,765
$1,760
$1,755
$1,750
$1,745
$1,740
$1,735
$1,730
$1,725
Cash Aug Oct Dec

Activity #8
Determine whether the following statements are TRUE or FALSE.

Carrying charges include storage,

1
interest, insurance and transportation.

A normal market is one in which

2
cash prices are above futures prices.

An inverted market is one in which

3
cash prices are above futures prices.

In a normal market, the price of a

4
cash commodity is under futures prices.

5 A contango market is one in which futures are higher than cash.

6 Backwardation is a market in which futures are higher than cash

7 Cash and futures prices will converge on the first delivery date.

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Fundamental Analysis
Fundamental analysis focuses on the relationship between a commodity available for delivery and the price
For grains, the supply typically includes stocks in elevators, in transit (e.g., on barges), and on docks at loading
centers. However, the supply excludes grains still on farms.

Demand
Supply

Price
Supply – When supply increases, the
price decreases

Demand – When demand increases, the

price increases

Quantity

Technical Analysis
Volume and Support and Charts and
Open Interest Resistance Levels Price Patterns

Volume Support Technical Patterns

 Total trades during a day  Level at which prices stop  Double bottom or top
• Count either purchases or falling  Head and shoulders
sales, not both  A temporary price floor  Ascending or descending
• Sign of activity or liquidity triangle
Resistance:
in the market  Moving average
 Level at which prices stop
 Flag and pennant
Open Interest rising
 All open contracts that have  A temporary price ceiling
not been offset
• Count either all
outstanding long or short
positions, not both

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Volume and Open Interest

First Trade: FCM A buys 10 contracts from FCM B

Accumulated Volume: Open Interest:

Second Trade: FCM B buys 10 contracts from FCM C

Accumulated Volume: Open Interest:

Third Trade: FCM C buys 10 contracts from FCM A

Accumulated Volume: Open Interest:

FCM A FCM B FCM C

LONG SHORT LONG SHORT LONG SHORT

Open Interest and Prices

Price Open
Interest
Price Open
Interest

Technically Strong Bullish Trend Technically Strong Bearish Trend

Price Open
Interest
Price Open
Interest

Technically WEAK Technically WEAK

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Activity #9 – Liquidating Market

A liquidating market is:
a. When prices and open interest are both rising
b. When prices are rising and open interest is falling
c. When prices and open interest are both falling
d. When open interest is rising and prices are falling

Technical Analysis
Support Level at which prices tend to stop falling

Resistance Level at which prices tend to stop rising

Congestion Area Area between support and resistance; prices trapped in a range

When prices break through an area of support or resistance

Breakout  Breakout of an area of support is a bearish indicator
 Breakout of an area of resistance is a bullish indicator

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Resistance/Support Levels
A breakout above resistance is bullish, a breakout below support is bearish

81.50 Resistance

Congestion

79.70 Support

1. To take advantage of a potential breakout of support, what order could be entered?

A. Sell Limit above support C. Sell Stop below support

B. Buy Stop above resistance D. Market order

2. To take advantage of a potential breakout of resistance, what order could be entered?

A. Buy Limit above support C. Sell Stop below support

B. Buy Stop above resistance D. Market order

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Head and Shoulders Patterns

Head
(Top)
Right
Head and Shoulders Top Left Shoulder
Shoulder
 Reversal of an __________________ trend
 Bearish indicator

Head and Shoulders Bottom

 Reversal of a __________________ trend
 Bullish indicator

Left Right
Shoulder Shoulder

Activity #10
Determine whether each indicator is BULLISH or BEARISH.

A BREAKOUT OF RESISTANCE

A BREAKOUT OF SUPPORT

HEAD AND SHOULDERS TOP

HEAD AND SHOULDERS BOTTOM

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Chapter 4 – Pricing

Contract Sizes
Grains (Corn, Wheat,
5,000 bushels
and Soybeans)

Treasury Bonds $100,000 par value

and Treasury Notes  Quoted as percentage of par and 1/32
(Long-Term)  1% of $100,000 is $1,000 and 1/32 of $1,000 is $31.25

Treasury Bills $1,000,000 par value 13-week (3 months)

and Eurodollars  Quoted in basis points; 100 bps = 1%
(Short-Term) • 1 basis point equals $25

Bond Calculations
Adding Fractions

90 25/32
+ 6 30/32 96 55/32 97 23/32
96 55/32 [96 + 1] [55/32 – 32/32]

Subtracting Fractions

90 25/32 89 57/32
– 6 30/32 90 25/32 – 6 30/32
84 – 5/32 [90 – 1] [25/32 + 32/32]
83 27/32
89 57/32

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Bond Price Analysis

$ Bond $ Market
Prices Interest
Rates

INVERSE RELATIONSHIP
As market interest rates change, a bond’s price will change
in the opposite direction. They have an inverse relationship.

Currency Price Analysis

€, £, ¥
$ or Gold

INVERSE RELATIONSHIP
The U.S. dollar has an inverse relationship with foreign currencies. Gold can also be
a substitute for foreign currencies; it will also move in the opposite direction of the U.S. dollar.

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Price Limits
The board of directors of an exchange will establish daily price limits for futures prices
 When the market reaches the upper or lower limit, trading will continue within the limits
 Buy and sell orders can be entered above or below the limits, but they cannot be executed
 Typically, the nearest expiration month and cash price don’t have any price restrictions

Activity #11 – Price Limits

If futures trade at the daily limit:
a. All buy and sell orders are immediately canceled
b. Trading at prices in-between the limits could still occur
c. Offsetting transactions are permitted, but no new positions maybe established
d. Trading halts for the remainder of the day

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Chapter 5 – Orders

Market Order Limit Order

 Customer wants to buy or sell  Customer only wants to buy or sell at a set
 Order is immediately executed at the best price or better
price available  Order is only executed if the price can be
 Customer specifies the futures and size of met
the order only Buy limits: at set price or lower
Sell limits: at set price or higher
 Execution is ______________
 Customer specifies the futures, size, and
price
 Execution is ______________

Stop Orders
Stop Orders are a type of contingent order which are “triggered” (activated) by the market trading at or through the
stop price
 Sell Stop will activate with a trade or offer at or below the stop price
 Buy Stop will activate with a trade or bid at or above the stop price
Once activated:

Stop order becomes

Stop limit order becomes

 A firm may accept orders that are activated at a different trigger price (using a quote as the stop price) provided
they’re not labeled as stop orders and proper disclosures are made

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Stop Order Example

A customer is long November crude oil at $50.70. Today, crude oil opens at $46.25. Afraid of suffering large losses,
your customer enters a protective order:
Sell November crude oil at $42.00 stop

Later: 42.10 42.06 42.03 41.98 41.97 41.91

Trigger? Execution?

If the customer entered a sell stop limit:

Sell November crude oil at $42.00 stop

Later: 42.10 42.06 42.03 41.98 41.97 41.91

Trigger? Execution?

Market-If-Touched (MIT) Orders

Entered on the same side of the market as limit orders, but activated or triggered like stop orders
 Sell MIT orders are placed above the market
 Sell MIT orders are activated when futures trade or bid at or above the MIT price
 Buy MIT orders are placed below the market
 Buy MIT orders are activated when futures trade or offered at or below the MIT price
Once activated, Market-If-Touched orders become market orders and are executed at the market price

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Activity #12 – MIT Order

Frank wants to take a long position in September Sugar futures if the price drops to 10.80 cents. Today, Sep Sugar
opens at 10.90 Frank places the following order:
Buy Sep Sugar at 10.80 MIT

Later: 10.87 10.84 10.80 10.81 10.77 10.76

Trigger? Execution?

Order Placement

SL o BS

BL e SS

Types of Orders
Type of Order Placed How Triggered How Executed
Market N/A N/A Best price
Buy Limit Below Market N/A At or lower
Sell Limit Above Market N/A At or higher
Buy Stop Above Market Traded at, through, or bid at or above Best price
Sell Stop Below Market Traded at, below, or offered at or below Best price
Buy Stop Limit Above Market Traded at, above, or bid at or above At or lower
Sell Stop Limit Below Market Traded at, below, or offered at or below At or higher
Buy MIT Below Market Traded at, below, or offered at or below Best price
Sell MIT Above Market Traded at, above, or bid at or above Best price

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Activity #13
Determine whether each order is typically entered ABOVE or BELOW the current market price.

BUY LIMIT

SELL LIMIT

BUY STOP

SELL STOP LIMIT

BUY MIT

SELL MIT

Other Orders
 Broker is given discretion as to time and price
 Broker is given authority as to whether to take the position
Not Held (NH)
 Broker cannot be held responsible for any action it takes or
fails to take

 Instructs the broker to do one of two alternative orders

One Cancels Other
 Whichever is done first automatically cancels the other
(OCO)
 Prevents a double fill

Other Orders
 One FCM “gives up” orders to other FCMs to protect the client’s anonymity
Give Up
 FCMs share commissions

 Liquidate and roll the existing position to a later delivery month

Switch
 Primarily used by the speculators prior to the first notice day

 Doesn’t need to be specified by CTA at the time of order entry

Allocation of  It must be done by the CTA or the account manager before the
Bunched Orders end of the day
 Subject to fair, equitable, and non-preferential standards

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Chapter 6 – Margin

Margin
Margin is established by the exchange as a “good faith deposit” and is not part of the cost
 Bona fide hedger’s margin is lower than speculation margin
 Initial equity – requirement to establish a position Margin requirements are
the same for long and
 Maintenance (Variation) margin – requirement to keep a position
short positions
 Equity is calculated daily based on the contract’s settlement value

If equity falls below the maintenance level,

the client’s required to bring equity back to initial margin

Calculating Equity
Total Equity = Account Cash Balance +/- Open Trade Equity

Total equity in a position is equal to the money deposited, net of withdrawals, and is referred to as the Account Cash
Balance
The Account Cash Balance plus or minus the gains or losses to date is referred to as the Open Trade Equity (OTE)
 The cash deposit is equal to the initial margin requirement plus any additional deposits for variation margin
 The open trade equity is calculated daily based on the contract’s settlement price

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Equity Example
Wheat futures contracts have an initial margin of $0.80 per bushel and maintenance margin of $0.60 per bushel. The
contract size is 5,000 bushels. A customer goes long one May wheat contract when the price is $6.00 per bushel.

Deposit/Withdrawal Account Cash Balance OTE Equity

Initial Margin

May Wheat to
$5.90

May Wheat to
$5.75

Margin Call

May Wheat to
$5.95

Equity above the initial margin (i.e., excess) may be withdrawn. Excess equity
can also be used for margin on new positions, which is referred to as “pyramiding.”

Equity Example
Gold futures have an initial margin requirement of $70.00 per ounce, a maintenance requirement of $50.00 per ounce,
and a contract size of 100 troy ounces. A customer shorts one December gold contract when the price is $1,400.00.

Deposit or
Cash Balance OTE Equity
Withdrawal

Initial Margin

Dec Gold
to $1,425

Receive a
margin call

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Activity #14 – Calculating Equity

A client shorts five June S&P 500 futures at 1,305.5. The initial margin on S&P 500 futures is $25,000 per contract and
it has a multiplier (i.e., size) of $250 per index point. If the June S&P 500 contract settles at 1,295.5, what’s the equity
in the customer’s account?
a. $27,500 b. $137,500 c. $22,500 d. $112,500

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Chapter 7 – Speculation

Speculators
Buy and sell for the purpose of making a profit and will take:
 A long position (buy futures) when they anticipate a rise in prices
 A short position (sell futures) when they anticipate a decline in prices
Speculators add liquidity and reduce price volatility to markets

Commissions on futures trades are typically “round-turn,” which includes

both a purchase and a sale
 Half-turn commissions only include one transaction

Rate of Return
An investor who is bullish on May wheat takes a long position when the price of the May wheat contract is $5.10. The
contract size is 5,000 bushels. The investor later offsets when the price is $5.50. If round-turn commissions are $50
and initial margin is $0.50 per bushel, what’s the investor’s rate of return?
Sold:
Bought:
Profit:
Contract size:
Gross profit:

Commissions:
Net profit:

Initial Margin:
Rate of Return:

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Rate of Return
A trader believes July corn futures will fall; therefore, he shorts three contracts at $6.75. The contract size is 5,000
bushels. When the price has risen to $7.05, the trader offsets the contracts. If round-turn commissions are $25 per
contract and the initial margin $0.60 per bushel, what’s the trader’s rate of return?
Sold:
Bought:
Loss:
Contract size:
Gross loss:

Commissions:
Net loss:

Initial Margin:
Rate of Return:

Rate of Return
November soybean futures are trading at 1260 cents per bushel. The contract size is 5,000 bushels and the initial
margin requirement is $3,500 per contract. An investor establishes a long position in the November contract at the
current price. Later, she liquidates her position when the November soybean futures have increased by 5%. What’s the
investor’s rate of return?
Long
Increase:
Profit:
Contract size:
Gross profit:

Initial Margin:
Rate of Return:

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Profit or Loss
An investor expects yields on T-bonds to rise and takes the appropriate position on 10 September T-bond futures at
88-24. Later, the investor offsets the contracts at 90-20. If round-turn commissions are $40, what’s the investor’s profit
or loss?

Should the investor take a Long or Short position?

Short: Loss:

Offsets: Commissions:

Loss: Loss per contract:

No. of contracts:

Total Loss:

or

Profit or Loss
Investor expects the interest rates to decline and takes the appropriate position in four T-bill contracts at 92.05. The
investor later offsets three contracts at 93.04 and liquidates the last one at 93.14. What’s the total profit or loss for this
investor?

Should the investor take a Long or Short position?

Long: Long:

Sell: Sell:

Profit: Profit:

Multiplier: Multiplier:

Profit per contract: Total Profit:

No. of contracts:

Profit:

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Activity #15 – Speculation

A client buys a May silver futures at $17.240. The initial margin on silver futures is $12,000 per contract and requires
acceptance of 5,000 troy ounces. At what value does the May contract need to settle for the customer to realize a
$5,000 profit?
a. $1.000
b. $5,000
c. $16.240
d. $18.240

Activity #16 – Speculation

A client sells a December corn futures at 319.25 cents. The initial margin on corn futures is $1,500 per contract and
requires delivery of 5,000 bushels of corn. At what value does the December contract need to settle for the customer
to realize a $3,500 profit?
a. $0.70
b. $2.4925
c. $3.8925
d. $3.1995

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Chapter 8 – Spreads

Commodity Spreads
 Purchase and sale of the same commodity, on the same exchange, but in
Intramarket or different expiration months
Interdelivery Spreads  Example:
• Buy March wheat on CME and sell July wheat on CME

 Purchase and sale of the same commodity on different exchanges

Intermarket  Example:
Spreads • Buy gold on COMEX (U.S. delivery) and
sell gold on ICE (U.K. delivery)

 Purchase and sale of different commodities

 Examples:
• Corn and wheat
• Corn and oats
Intercommodity Spreads • Gold and silver
• T-notes over T-bonds
‒ Yield curve flattens: Short T-note futures and go long
T-bond futures
‒ Yield curve steepens: Long T-note futures and short
T-bond futures

 Hedgers or speculators take positions in raw commodities and opposite

positions in the refined or processed commodity
 The Crush
Commodity Long soybeans → Short soybean oil and meal
Product Spreads
 The Crack
Long crude oil → Short gasoline and heating oil
 Reverse crush or crack spreads reverse the long and short positions

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Bullish and Bearish Spreads

Generally, the spreader’s market sentiment will be reflected in their position in the near month
 Bullish investors will buy the near month
 Bearish investors will sell the near month
However, foreign currencies and stock index futures spreads are exceptions
When spreading those contracts, the sentiment will be reflected in the position in the deferred month
 Bullish investors will buy the deferred month
 Bearish investors will sell the deferred month

Spread Profit and Loss

Spread trades get their name from the difference or “spread” between the prices of the two contracts bought and sold
 Traders that buy the more expensive leg will profit if the spread between the prices increases or widens
BUYER = WIDEN
 Traders that sell the more expensive leg will profit if the spread between the prices decreases or narrows
SELLER = NARROW

Example: An investor shorts March corn at 319 cents and buys July corn at 323 cents

Bullish or Bearish? Bearish, since the investor sold the near month (March)

Widen or Narrow? Widen, since the investor bought the more expensive leg (323)

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Spread – Example
Sell January soybeans at 841 cents
Buy May soybeans at 844 cents
(Soybean futures have a 5,000-bushel size)

Spread: 3 cents, or $0.03

Bullish or Bearish: Bearish, sold the near month (January)

Widen or Narrow: Widen, bought more expensive (844)

Later, the positions are offset when:

January soybeans are 840 cents

May soybeans are 847 cents

Spread: 7 cents, or $0.07

Widened or Narrowed: Widened

Profit or Loss: Profit

Amount: $200 ($0.04 widening x 5,000 bu.)

Spread – Example
Sell September E-mini S&P 500 at 2853.10 points
Buy December E-mini S&P 500 at 2830.75 points
(E-mini S&P 500 futures have a $50 multiplier)

Spread: 22.35 points

Bullish or Bearish: Bullish, bought the deferred month (December)

Widen or Narrow: Narrow, sold more expensive (2853.10)

Later, the positions are offset when:

September E-mini S&P 500 are 2840.20 points

December E-mini S&P 500 are 2807.50 points

Spread: 32.70 points

Widened or Narrowed: Widened

Profit or Loss: Loss

Amount: $517.50 (10.35 widening x $50 per point)

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Activity #17 – Spreads

1. A client believes that there will be a bullish run 2. A client believes that there will be a bullish run
on soybeans. Which of the following spreads is on euros. Which of the following spreads is the
the most appropriate? most appropriate?

a. Buy the nearby and sell the deferred a. Buy the nearby and sell the deferred
b. Sell the nearby and buy the deferred b. Sell the nearby and buy the deferred
c. Sell the nearby and sell the deferred c. Sell the nearby and sell the deferred
d. Buy the nearby and buy the deferred d. Buy the nearby and buy the deferred

Activity #18 – Spread – Profit or Loss

A customer has a spread position in pork bellies. She’s long July at 38.50 cents and short December at 52.50
cents. Later, she liquidates her spread when July is at 46.25 and December is at 63.75. The size of the contract
is 40,000 lbs. What’s her profit or loss, excluding commissions?

a. $1,400 profit
b. $1,400 loss
c. $140,000 profit
d. $140,000 loss

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Chapter 9 – Hedging

Hedgers
Through hedging, producers and users may pass most of the risk of price change to speculators
Producers are businesses that either currently possess or will produce the commodity for sale and delivery at some
future date
 Producers are long the cash commodity and fearful of falling prices
Users are currently without the commodity, but have an absolute use for the commodity and will need to buy at some
future date
 Users are short the cash commodity and fearful of rising prices

Overview of Hedgers
Producer Overview Item User

Long ← Cash Commodity (Basis) → Short

Falling Prices ← Fear → Rising Prices

Selling Hedge/Short Futures ← Establishes → Buying Hedge/Long Futures

Short Hedger ← What Kind of Hedger? → Long Hedger

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Activity #19
Determine whether each hedger is a PRODUCER or USER.

CORN FARMER

GOLD JEWELRY COMPANY

AMERICAN IMPORTER

A CORPORATE BOND ISSUER

OIL REFINERY

AMERICAN EXPORTER

Basis and Basis Charge

A hedger’s basis is the difference between the hedger’s cash price and futures price
 In a normal market, cash is less than futures – “cash under”
 In an inverted market cash is more than futures – “cash over”

Corn Prices Basis Change from Entering to Lifting Hedge

$3.50 Producer User
$3.40 Gain on the
$3.30 Hedge if:
$3.20
In a normal
$3.10 market, this
$3.00 means the
Cash July September December basis:

Basis is $0.10 under if July futures are used to hedge

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Basis Change
Cash Futures Basis

Now: $3.45 $3.57

Later: $3.62 $3.70

Did the basis strengthen or weaken?

Did the basis widen or narrow?

0¢

-5¢
Remember – A strengthening basis will
Strengthen - 10 ¢ be profitable for producers
- 15 ¢

Basis Change
Cash Futures Basis

Now: $7.58 $7.64

Later: $7.65 $7.75

Did the basis strengthen or weaken?

Did the basis widen or narrow?

0¢

-5¢
Remember – A weakening basis will
Weaken - 10 ¢ be profitable for users

- 15 ¢

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Basis Change
Cash Futures Basis

Now: $8.45 $8.37

Later: $8.60 $8.44

Did the basis strengthen or weaken?

Did the basis widen or narrow?

15 ¢

10 ¢ Remember – A strengthening basis will

Strengthen be profitable for producers
5¢

0¢

Basis Change
Cash Futures Basis

Now: $12.79 $12.68

Later: $12.70 $12.66

Did the basis strengthen or weaken?

Did the basis widen or narrow?

15 ¢

10 ¢ Remember – A weakening basis will be

Weaken profitable for users
5¢

0¢

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Activity #20
Determine whether each statement is TRUE or FALSE.

1 A producer is short the basis.

2 A user will profit if the basis strengthens.

3 A user is short the basis.

4 In a normal market, a strengthening basis will be narrower.

5 In an inverted market, a weakening basis will be narrower.

A producer that establishes a hedge with a basis of $0.40 over

6
will lose if the basis ends at $0.50 over.

A user that establishes a hedge with a basis of $0.50 under will

7
profit if the basis ends at $0.60 under.

The Result of the Hedge

With the spot market for wheat at $5.87, a farmer with wheat in her silo chooses to hold it for later sale. She hedges by
selling futures at $5.99. Later, in July, she sells the wheat in the spot market for $5.82 and covers the short position for
$5.90. What’s the net result of the hedge?

Cash Futures Basis

March Long at $5.87 Short at $5.99

July Sells at $5.82 Long at $5.90

Change -$0.05 +$0.09

The overall result of the hedge is

an increase in the “cash now”
price of $0.04

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Effective Selling Price

Cash Hedge
1) +/-
Now Result

$5.87 cash now + $.04 profit on hedge = $5.91

Two
Methods:

Cash Futures
2) +/-
Later Result

$5.82 cash later + $.09 profit on futures = $5.91

Effective Selling Price

Producers
A gain on the hedge or futures will increase the producer’s selling price (i.e., revenue)
A loss will decrease the producer’s effective selling price

1) Effective Selling Price = Cash Now + Profit on Hedge or Cash Now – Loss on Hedge

2) Effective Selling Price = Cash Later + Profit on Futures or Cash Later – Loss on Futures

Effective Cost
Producers
A gain on the hedge or futures will decrease the user’s cost (i.e., expenses)
A loss will increase the user’s effective cost

1) Effective Cost = Cash Now – Profit on Hedge or Cash Now + Loss on Hedge

2) Effective Cost = Cash Later – Profit on Futures or Cash Later + Loss on Futures

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Hedging Exercise
Exercise 1:
A farmer is long cash soybeans. The current cash price is $7.00 bushel. He sells futures at $7.25 per bushel. Three
months later, the farmer sells his cash soybeans at $6.90 and simultaneously buys his futures back at $7.05. What’s
the result of the hedge?

Producer (long cash) or User (short cash)?

What type of hedge?

Cash Futures Basis

Now

Later

Change

Hedging Exercise
Exercise 1 Continued:
What’s the hedger’s effective selling price or effective cost?

Effective selling price or cost?

Cash Futures Basis

Now Long at $7.00 Short at $7.25 $0.25 under

Later Sell at $6.90 Long at $7.05 $0.15 under

Change -$0.10 +$0.20 $0.10 str.

1) Cash Now +/- Hedge Result

$7.00 + $0.10 =

2) Cash Later +/- Futures Result

$6.90 + $0.20 =

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Hedging Exercise
Exercise 2:
An American importer places an order with a Swiss manufacturer. The order, which is to be delivered in August, is
valued at 2,000,000 Swiss francs. The cash price for the franc is $1.5975 and September futures are trading at
$1.5715. When the hedge is lifted, the cash price of the francs is $1.6135 and the futures are at $1.5855. What’s the
result of the hedge?

Producer (long cash) or User (short cash)?

What type of hedge?

Cash Futures Basis

Now

Later

Change

Hedging Exercise
Exercise 2 Continued:
What’s the hedger’s effective selling price or effective cost?

Effective selling price or cost?

Cash Futures Basis

Now S $1.5975 L $1.5715 $0.0260 over

Later L $1.6135 S $1.5855 $0.0280 over

Change -$0.160 +$0.0140 $0.0020 str.

1) Cash Now +/- Hedge Result

$1.5975 + $0.0020 =

2) Cash Later +/- Futures Result

$1.6135 – $0.0140 =

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Activity #21 – Calculating Effective Cost

A firm that’s short the basis establishes a hedge using two corn futures contracts. When the hedge is placed, the cash
price is at $5.00 and futures are at 5.30 and the firm's basis is 30 cents under. When the hedge is lifted, the basis is 24
cents under. The futures contract size is 5,000 bushels. When the hedge is lifted, the company buys corn. The change
in basis means that the company will have an effective cost of:
a. $0.06
b. $5.06
c. $4.94
d. $5.00

Hedging Exercise
Exercise 3:

A corporation issues bonds with a price of 94-17. The corporation intends to issue another $10 million in April and
wants to hedge its anticipated offering. T-Bond futures prices are as follows:
March: 96-10 Sept: 95-29
June: 96-19 Dec: 90-02
Later, the bonds are issued at 90-06 and futures are offset at 91-27. What’s the result of the hedge?

Producer (long cash) or User (short cash)?

What type of hedge?

Cash Futures Basis

Now

Later

Change

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Hedging Exercise
Exercise 3 Continued:
What’s the hedger’s effective selling price or effective cost?

Effective selling price or cost?

Cash Futures Basis

Now L 94 17/32 S 96 19/32 2 2/32 under

Later S 90 6/32 L 91 27/32 1 21/32 under

Change -4 11/32 +4 24/32 0 13/32 str.

1) Cash Now +/- Hedge Result

94 17/32 + 0 13/32 =

2) Cash Later +/- Futures Result

90 6/32 + 4 24/32 =

Hedging Exercise
Exercise 3 Continued:
What’s the total amount raised from the issuance of the bonds?

What did the hedge do to the issuer’s interest costs?

Cash Futures Basis

Now L 94 17/32 S 96 19/32 2 2/32 under

Later S 90 6/32 L 91 27/32 1 21/32 under

Change -4 11/32 +4 24/32 13/32 str.

Total Issuance?

Interest Costs?

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Hedging Exercise
Exercise 4:
An electrical wire manufacturer enters a hedge when cash copper is at 366 cents and the December futures are at
367.75 cents. The manufacturer closes the hedge when cash is at 367.10 cents and the futures are at 368.85 cents.
What’s its effective cost for the copper?
Effective selling price or cost?

Cash Futures Basis

Now S $3.6600 L $3.6775 $0.0175 under

Later L $3.6710 S $3.6885 $0.0175 under

Change -$0.0110 +$0.0110 No Change

1) Cash Now +/- Hedge Result

$3.66 + $0.0000 =

2) Cash Later +/- Futures Result

$3.6710 – $0.0110 =

Activity #22 – Calculating Effective Cost

An oil refinery needs 45,000 barrels of crude oil. When its hedge is placed, the cash price of crude oil is $60.75 per
barrel. It hedges by using 45 July crude oil futures contracts. The futures hedge is established at a price of $61.05.
When the hedge is lifted, the refinery buys crude oil in the cash market at $80.62 and its futures position is offset at
$83.10. The net price per barrel the oil driller pays as a result of the hedge is:
a. $58.57
b. $82.80 Cash Futures Basis
c. $85.28 Now S $60.75 L $61.05 $0.30 under
d. $80.92
Later L $80.62 S $83.10 $2.48 under

+ $2.18 weak
Change - $19.87 + $22.05
(profit for user)

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Chapter 10 – Stock Index Futures

Stock Index Futures

Index futures contracts use a multiplier to convert an index value or average into a dollar value

Non-Systematic Risk Systematic Risk

 Individual stock risk  Overall market risk
 A combination of industry risk and  Cannot be eliminated through
company risk diversification

Stock index futures are used to hedge systematic risk

Non-systematic risk can be reduced through diversification

Stock Indexes
Multiplier Minimum Tick Value

S&P 500 $250 0.10 points = $25

E-mini S&P 500 $50 0.25 index points = $12.50

E-mini Nasdaq 100 $20 0.25 index points = $5.00

DJIA $10 1 index point = $10

E-mini DJIA $5 1 index point = $5

E-mini Russell 2000 $50 0.10 index points = $5.00

Index futures contracts are cash settled

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Stock Index Futures Application

A customer places an order to buy three S&P 500 futures contracts. The multiplier is $250 per index point. The initial
margin requirement is $66,000 per contract and the maintenance is $60,000 per contract. The customer deposits the
required margin in his account. The customer's order is filled and a long position of three contracts is established at
2833.30. That night, the settlement price for the December futures contract is 2825.80. Calculate the current equity in
the customer's account.

Settlement: 2825.80 Loss: 7.5 points

Long: -2833.30 Multiplier: x $250

Loss: 7.5 points Total Loss: ($1,875) open trade equity (OTE)

Cash Balance OTE Equity

Equity per contract $66,000 ($1,875) $64,125

Total Equity: $64,125 equity per contract x 3 contracts = $192,375

Activity #23 – Hedging Stock Portfolios

A customer has a large blue-chip stock portfolio. She anticipates a market decline and wants to hedge $5,000,000 of
the portfolio using the S&P 500 futures. Each index point equals $250. The futures price is currently 2,995.20. Which
of the following is the best hedging strategy?
a. Buy 20 S&P 500 contracts
b. Sell 20 S&P 500 contracts
c. Buy 6 S&P 500 contracts
d. Sell 6 S&P 500 contracts

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Chapter 11 – Commodity Options

Options Overview
An option is a contract between two parties

BUYER SELLER

 Long the option  Short the option

 Pays the premium (DEBIT)  Receives the premium (CREDIT)
 Acquires a right/control  Assumes an obligation

Types of Contracts
If an option is exercised…

BUYER’S RIGHT SELLER’S OBLIGATION

CALL

PUT

For an option, the underlying asset is a futures position, not a cash position

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In-the-Money Versus Out-of-the-Money

CALLS: PUTS:
In-the-Money Out-of-the-Money

$70 $70

Market Price

$60 STRIKE PRICE $60

Market Price

$50 $50

CALLS: PUTS:
Out-of-the-Money In-the-Money

Calls and Puts are At-the-Money if the

option’s strike price is equal to the future’s market price.

In, At, or Out-of-the-Money

Option Market Price In, At, or Out-of-the-Money?

September 320 Corn Call at 16.75 336.50 cents

September 320 Corn Put at .50 336.50 cents

Oct 1750 Gold Put at 11.70 $1,739

Feb 1.0500 Gasoline Call at 0.35 $1.05

June 110 T-bond Call at 4-22 113-17

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An Option’s Premium
PREMIUM = Intrinsic Value + Time Value

The amount by which an The portion of an option’s premium

option is in-the-money that exceeds its intrinsic value

A contract has intrinsic value if it’s in-the-money.

 Its intrinsic value equals its in-the-money amount.
 It has zero intrinsic value if it’s out-of-the-money or at-the-money.
Time value is set in the market (negotiated) and is based on:
 Time left until expiration
 Market volatility

INtrinsic value is only created if an

option is IN-the-money.

Intrinsic Value and Time Value

Option Market Price Intrinsic Value Time Value

September 320 Corn Call at 16.75 336.50 cents

September 320 Corn Put at .50 336.50 cents

Oct 1750 Gold Put at 11.70 $1,739

Feb 1.0500 Gasoline Call at 0.35 $1.05

June 110 T-bond Call at 4-22 113-17

T-bond Option premiums T-bonds are quoted

are quoted in 1/64ths in 32nds

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Bond Calculations
Remember:
Converting 32nds into 64ths
1/32 = $31.25 and 1/64 = $15.625

113 17/32
3 17/32 x 2/2
- 100 0/32
[3] [17 x 2] / [32 x 2]
3 17/32

Subtracting Fractions

4 22/64 4 22/64 3 86/64

- 3 34/64 [4 – 1] [22/64 + 64/64] - 3 34/64
1 12/32 3 86/32

Activity #24 – T-Bond Options

A customer sells a T-bond call at 5-30. Later, if she covers the call at 4-22, the result is:
a. Profit of $1,125
b. Loss of $1,125
c. Profit of $1,250
d. Loss of $1,250

Basic Options: Long and Short Calls

CALLS
BUYER, OWNER, LONG SELLER, WRITER, SHORT

RIGHTS Buy futures at strike price None

OBLIGATIONS None Sell futures at strike price

STRATEGY Bullish ↑ Bearish ↓

BREAKEVEN Strike price + premium Strike price + premium

MAXIMUM GAIN Unlimited Premium

MAXIMUM LOSS Premium Unlimited

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Long Call – Analysis

When the current market value of feeder cattle is: STRATEGY:

130 cents per pound MAXIMUM GAIN:

(50,000 lbs. per contract)
MAXIMUM LOSS:

Later, with feeder cattle at 140 cents, the

investor exercises the option and immediately
Buy 1 May Feeder Cattle 130 Call at 1.50 sells the futures contract. Result?

BREAKEVEN:
DEBIT CREDIT

131.5

130

Basic Options: Long and Short Puts

PUTS
BUYER, OWNER, LONG SELLER, WRITER, SHORT

RIGHTS Sell futures at strike price None

OBLIGATIONS None Buy futures at strike price

STRATEGY Bearish ↓ Bullish ↑

BREAKEVEN Strike price – premium Strike price – premium

(Strike price – premium)

MAXIMUM GAIN Premium
x contract size

(Strike price – premium)

MAXIMUM LOSS Premium
x contract size

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Short Put – Analysis

When the current market value of the euro is: STRATEGY:

$1.10 MAXIMUM GAIN:

(125,000 euros per contract)

MAXIMUM LOSS:

Buy 1 May Euro 1.10 Put at 0.0350 Later, when euros are $0.95, the investor’s
option is exercised and the futures contract is
sold. Result?

BREAKEVEN:

DEBIT CREDIT

$1.10

$1.065

Straddles and Combinations

Created by either:
 Buying both a call and a put on the same underlying futures contract OR
 Selling both a call and a put on the same underlying futures contract
Strategy
 Long straddle or combination:
 Short straddle or combination:

STRADDLE: COMBINATION:
 Same expiration months and strike prices  Different expiration months and/or strike prices

If an investor has one option component and adds another to create a multiple option
position, he’s considered to have legged into the position.

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Long Straddle – Analysis

Uncertain of the exact direction in which
golf is going to move, an investor:

Buys 1 June Gold 1750 Call at 33

Buys 1 June Gold 1750 Put at 28
(contract size 100 troy ounces)

1,750
The total (combined) premium is __________

BREAKEVEN POINTS:

STRATEGY:

MAXIMUM GAIN:

MAXIMUM LOSS:

Spreads
Positions which allow an investor to limit losses in exchange for limiting gains
 Created with the sale and purchase of two options of the same class, but different series
− Class: options of the same type on the same underlying security
− Series: options of the same class, same expiration, and same strike prices
 Spreads may be either bullish or bearish and either debit or credit

Price/Dollar/Vertical Time/Calendar/Horizontal Diagonal

Buy 1 Jul Wheat 500 Call Buy 1 Dec Silver 18 Call Buy 1 Aug Hog 58 Put
Sell 1 Jul Wheat 510 Call Sell 1 Aug Silver 18 Call Sell 1 Oct Hog 50 Put

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Call Spread – Analysis

An investor who’s bullish on the S&P 500
establishes the following positions: Net Premium:
Buyer or Seller:
Long 1 S&P 500 Mar 2910 Call at 49 Debit or Credit:
Short 1 S&P 500 Mar 2950 Call at 32 Widen or Narrow:
($250 per point) Breakeven:
Bull or Bear:
SPREAD RULES: Maximum Gain:
 The breakeven must be between the strikes. Maximum Loss:
 The max gain PLUS the max loss will equal the
difference in the strike prices.
2950

2910

Put Spread – Analysis

An investor who’s bullish on the price of Net Premium:
soybeans establishes the following positions:
Buyer or Seller:
Debit or Credit:
Short 1 Sept Soybeans 810 Put at 7
Widen or Narrow:
Long 1 Sept Soybeans 800 Put at 3
Breakeven:
(5,000 bushels)
Bull or Bear:
Maximum Gain:
SPREAD RULES: Maximum Loss:
 The breakeven must be between the strikes.
 The max gain PLUS the max loss will equal the
difference in the strike prices.
810

800

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Delta
Change in Option Premium
= Change in Futures Price

When the price of May wheat is $3.80, an investor buys a May Wheat 400 call for $0.35. Later, May wheat rises to
$4.20 and the call’s premium has increased to $0.55. What’s the call’s delta?

Activity #25
Estimating Option Premium with Delta

June gold futures are trading at $1,752 per ounce. The June 1760 gold call option is trading at $10.20 per ounce. The
call’s delta is 40%. If gold rallies to $1,774 per ounce, what’s the expected premium on the call?

Change in futures price:

Change in option premium:

New option premium:

Using Options to Hedge

Since option premiums only move a percentage of the underlying futures,
hedgers will need to buy more options to effectively hedge Rather than using futures,
hedgers can use options to
 Out-of-the-money options have low deltas protect their cash positions
 At-the-money options have deltas around 50%  Producers will buy puts
 In-the-money options have high deltas, approaching 100%  Users will buy calls

Number of Futures
Number of Options =
Option’s Delta

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Activity #26 – Using Options to Hedge

A farmer needs 60 futures contracts to hedge this year’s production. How many put contracts will she need if:

The delta is 0.5?

The delta is 0.9?

The delta is 0.08?

Margin on Options
Buying Options Selling Options
The margin deposit is 100% of the option’s premium The margin deposit for selling options is:
 A trader buys a June copper 2.5000 call for a
premium of $0.0500. If the copper contract The initial margin on the futures contract
size is 25,000 pounds, what’s the margin + The option’s premium
deposit?
• Margin = $0.05 premium – 50% of the out-of-the-money amount
x 25,000 lbs.
• Margin = $1,250

Activity #27 – Short Option Margin

When Dec corn is trading at $3.70, an investor shorts 1 Dec corn $3.80 corn call at $0.15. Dec corn has an initial
margin requirement of $0.40 and a size of 5,000 bushels. What’s the investor’s margin requirement?

Futures margin?

Premium?

50% of the out-of-the-money?

Total?

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Synthetic Positions
Synthetic Long Futures = Long Call and Short Put

Synthetic Short Futures = Long Put and Short Call

Synthetic Long Call = Long Put and Long Futures

Synthetic Long Put = Long Call and Short Futures

Conversion = Long Futures and Long Put and Short Call

Reversal = Short Futures and Long Call and Short Put

Mastering Synthetics
Algebra: 5 – 2 = 3

Start: Long Call = Long Put + Long Futures

Synthetic Short Futures?

Start: Long Call = Long Put + Long Futures

Answer:

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Activity #28 – Synthetics

1. Which of the following is equivalent to a long futures position?
a. Long two puts
b. Short a call and long a put
c. Short a call and short a put
d. Long a call and short a put

2. Which of the following is equivalent to a short put position?

a. Long a call and long a put
b. Short a call and long a futures contract
c. Short a call and short a futures contract
d. Long a call and short a put

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