Futures - An Introduction

A Futures contract is simply and agreement made today to transact at a certain price at a certain date in the future. For example, I may agree today to pay $425 for an ounce of gold at some determined date in the future. If the price of gold on that date is lower than $425 per ounce then my position will incur a loss as I will be paying more than what the market value of gold is on that day. If the price of gold, however, is higher than $425 on that date then my position will be profitable. I will be paying less than what the market value of gold is per ounce on that day.

With contracts traded on a wide variety of commodities, fixed income products and financial indexes, futures and options trading has become quite a popular financial vehicle for both classes of market participants: hedgers and speculators.

For hedgers, exchange-traded futures and options provide several important economic benefits, including the ability to shift or otherwise manage the price risk of the underlying cash markets.

For speculators, these markets provide a vehicle to potentially profit from these price fluctuations.

Futures markets are among the most liquid of all global financial markets, providing low transaction costs and ease of entry and exit. This, in turn, fosters their use by an array of business enterprises and investors to manage their price risks. And the savings resulting from effective risk management can be passed on to the final consumers of the commodities, currencies and financial instruments that underlie the futures and options contracts.

Today's futures industry functions with a number of time-tested institutional arrangements, including clearinghouse guarantees and exchange self-regulation. Futures and options markets also reflect a tradition of innovation and growth, with new products, new exchanges and record trading volumes appearing each year. And while the U.S. markets have continued their pattern of steady expansion, recent increases in trading activity have been most pronounced outside the United States in the newer markets of Europe, Asia, Australia and Latin America.

Historically, futures market participants have been divided into two broad categories: hedgers, who seek to reduce risks associated with dealing in the underlying commodity or security, and speculators (including professional floor traders), who seek to profit from price changes. More recently, a new category of participant has emerged, the portfolio manager who uses futures and options as essential elements of portfolio management. For speculators, the attraction of futures markets includes their leverage, the diversification they add to a portfolio, the ease of assuming short as well as long positions, and the low cost of market entry and exit. Speculators and market-makers assume the risk transferred by hedgers and provide the liquidity that assures low transaction costs and reliable price discovery in futures markets.

Hedging is central to futures and options markets, and a familiarity with hedging practices is necessary to understand how these markets work. In simplest terms, hedgers:

Identify their price risk, Decide how much to hedge, and Decide where and how to hedge.

In futures markets, hedging involves taking a futures position opposite to that of a cash market position. That is, a corn farmer would sell corn futures against his crop; an importer of Japanese cars would buy yen futures against her yen liability; a precious metals merchant would purchase gold futures against a fixed-price gold sales contract; and a pension fund manager would sell stock index futures against the fund's portfolio of equities in anticipation of a market decline.

Examples of the types of risk - management activities that rely on the use of futures include:

Stabilizing cash flows; Setting purchase or sale prices of commodities and securities; Diversifying holdings; More closely matching balance sheet assets
and liabilities; Reducing transaction costs; Decreasing costs of storage; and Minimizing the capital needed to carry inventories.

Options – An Introduction

An option on a futures contract is nothing more than the right, but not the obligation, to buy or sell the underlying future at a specified price on or before a specified date. For example, if I buy an April gold 425 call(which gives the right to buy) for 5 dollars, then I own the right to buy gold at $425 per ounce anytime on or before the expiration date of the option. If the price of gold never gets up to 425 by expiration then my option will expire worthless and I will lose the 5 dollars I paid for it. On the other hand, if the April gold rallies up above $425, I will be presented with two opportunities. At this point I may decide to sell the option in the open market, or exercise it and take possession of the underlying gold future at $425 per ounce. If the trader opts to exercise the option, however, it is important to calculate the breakeven price for the option. In this case, excluding commissions and fees, your breakeven price in the underlying gold will be $430. The breakeven price of $430(less commissions and fees) is calculated by adding $5(the price you pay for the option) to $425(the price at which you have the right to buy).

Options on futures are traded on the same exchanges that trade the underlying futures contracts and are standardized with respect to the quantity of the underlying futures contracts (by custom, one futures contract), expiration date, and exercise or strike price (the price at which the underlying futures contract can be bought or sold).

Most futures exchanges also provide the opportunity to participate in options trading.