Reference manual futures options

Level 5 Diploma in Applied Financial Trading --- Introduction to Futures & Options Trading --- Course Manual Introduction to Futures Markets • Definition of a futures contract • Fut

Level 5 Diploma in Applied Financial

Trading - Introduction to Futures & Options

Trading - Course Manual

Introduction to Futures Markets

• Definition of a futures contract

• Futures market jargon

Profit and Loss Profiles

• Long position profile

• Short position profile Closing Out

Futures Pricing Fair

Value

• Calculation of fair value

• Cash and carry and Reverse cash and carry arbitrage

• Concept of convergence

Basis

• How to calculate basis

• The effect of basis strengthening and weakening on hedging strategies

• Contango & Backwardation

Options

• The basic mechanics of options from the buyer's & seller’s viewpoint

• The difference between a future and an option

• Terminology surrounding options contracts

• The four basic options positions

• Profit and loss profiles for call & put options

• Option uses – speculation, hedging & arbitrage

What is a Future?

A futures contract is a legally binding agreement between a buyer and seller to buy or sell a particular asset (e.g shares, bonds, FX, etc.) or an index representing such assets at some time in the future, at

a price agreed today The asset is called the “underlying”

If you buy a future you have entered into an agreement

to buy the underlying at some time in the future, at a price agreed today

If you sell a future you have entered into an agreement

to sell the underlying at some time in the future, at a price agreed today

Note that the terms and conditions of the future

transaction (i.e price, size, quality, etc.) are agreed in

advance (i.e now)

All futures are exchange-traded contracts and they're standardised in terms of:

• Delivery date (or “expiry”)

• Amount of the underlying they relate to

• Contract terms

Futures contracts can be cash settled or require physical delivery Most equity futures are cash settled, which means the contract requires a cash amount to be paid on the settlement day, reflecting the difference between the initial futures price and the price of the underlying share or index when the futures contract reaches maturity

Futures contracts can also be freely bought and sold before the contract expires (i.e before the point

at which the underlying must be delivered or the contract cash settled) The value of the contract fluctuates before the settlement date to reflect the changing price of the underlying

Also note that futures are geared (or leveraged) instruments, since positions can be taken in the underlying instrument by means of a relatively small cash outlay, called the “margin”

Example:

FUTURES CONTRACT

Buyer (Long position) Seller (Short position)

I agree to buy 1,000 barrels of oil from

you in 3 months time at $100 a barrel

I agree to sell 1,000 barrels of oil to you

in 3 months time at $100 a barrel

Note that nothing is bought, sold or delivered today – this is simply an agreement to complete a transaction at a future date

Usually, a contract specification includes:

• Quantity of the underlying

• Quality of the underlying

• Time and place of delivery Advantages

• Liquidity - Since the terms and conditions of the contract are standardised, futures markets are very liquid, so futures can be easily traded by many participants and hence it's easy to open and close positions

• Gearing or Leverage - You can buy exposure to price movements in a large amount of a given underlying with a relatively small outlay

• Fixed contract size

• Shorting - You can take long or short positions – i.e you can sell a future short with the intention of benefiting from a future fall in price

Disadvantages

Inflexibility – The fact that futures are standardised (fixed price, expiry, etc.) means that futures are not flexible for people wanting slightly different conditions Forwards are used in these cases

Long Position

By taking a long futures position, you are committing to take delivery of the underlying (or its cash value at maturity) on a certain future date Taking a long position indicates you think the value of the future will increase You can close out your position at any time by selling your futures position (either for a profit or a loss, depending on the current price)

Example: If you bought a futures contract at £10 and

its price increased to £12, your profit is £2, but if it fell

to £8 you would make a loss of £2

Note: Unlike shares, you don't pay the full price when

you open the contract You only pay a small

percentage of the actual value of the underlying, called “margin” In this case, £10 is simply used as a reference price to calculate your profit or loss

Short Position

If you think the value of the future will fall, then you should take a short position, thus committing yourself to deliver the underlying (or its cash value at maturity) on a certain future date You can close out (or “cover”) your short position at any time by buying the same number of futures contracts Depending on the movement of the price, you may realise a profit (if the future price has declined) or loss (if the price has risen)

Example: If you sold short a futures contract at £10

and its price increased to £12, your loss is £2, but if it

fell to £8 you would make a profit of £2

Underlying Asset

The value (or price) of a future is derived from the value of the underlying asset The underlying asset

is often referred to as the “underlying” or cash or spot asset Futures are derived from various underlyings, such as currencies, bonds, equities, live cattle, crude oil, etc

Basis

Basis quantifies the difference between the cash price of an underlying asset and its futures price

BASIS = CASH PRICE - FUTURES PRICE

Basis is usually negative because the futures price is usually higher than the cash (underlying) price This is due to costs of carry (to be explained later) The calculation of basis is also referred to as “crude basis” and it is possible to “trade basis” This means an investor takes a position in both the future & the underlying (e.g long underlying, short future) to try to take advantage of fluctuations in basis

Contracts for Difference (CFD’s)

Many futures are physically settled, which means that the underlying asset is actually delivered at expiry E.g The Long Gilt contract on NYSE.liffe or the Natural Gas contract on ICE Futures

A CFD is a term describing a cash settled derivative in which no physical delivery actually takes place Instead, the contract is settled for the difference between the agreed price and the settlement price E.g Equity index futures contracts

A spread bet is a type of CFD available outside a formal exchange-based framework from companies such as FXCM, CMC Markets, City Index, IG Index and many others The concept of a spread-bet is exactly the same as a future, i.e a position is taken depending on what you think will happen to the price of the underlying, such as the FTSE Index, cricket scores or even the number of Oscars a film might win

enabling greater flexibility Advantages

• Flexibility – Forwards allow the parties to set up any contract specifications that are mutually

acceptable (e.g exact size, specific expiry date, etc.) Disadvantages

• Direct Counterparty Risk – Since there is no central counterparty (i.e an exchange) or collateral payment, it is vital that the creditworthiness of both counterparties is good

• Illiquidity – Since forwards are individually negotiated (i.e non-standardised), they are not tradable This makes them difficult to value since price information is not always available

Examples of OTC deals:

• Forward rate agreements (FRA’s): a forward applied to interest rates

• Swaps: a forward applied to the exchange of one series of future cash flows for another

Margin Trading

Futures contracts offer geared or leveraged market positions What does this mean in practice?

If you buy a FTSE 100 Index Future at 5922, your market exposure is £59,220 (5922 x £10), but you don't have to pay this sum to open the position Instead, you pay what's called an 'Initial Margin' - effectively a deposit - which is a fixed amount per contract based on the likely maximum overnight movement in the contract's price, known as the “scanning risk”

In addition to the initial margin, each night your position is "marked to market" This means that the daily change in contract value is credited to or debited from your account, so your total margin requirement is made up of two elements:

TOTAL MARGIN = INITIAL MARGIN + VARIATION MARGIN

Initial Margin

When you buy or sell a futures contract from a broker, in practice, the broker has an agreement with the Clearing House and you have an agreement with the broker There are pre-defined formulae for how much margin the broker is liable to pay the Clearing House, but the initial margin the broker charges you is at their discretion (over and above the Clearing House requirement) Your broker will probably want to see a sum in your account in excess of the initial margin in order to cover daily margin fluctuations

Since October 2000 the initial margin charge for the standard FTSE 100 Index Future has been £3,000 (or 300 points, as this contract is valued at £10 per full index point), and £1,500 for the FTSE 250 future This represents the maximum anticipated overnight change in the contract's price

Variation Margin

Once you've bought or sold the contract, your position is marked to market against the daily

settlement price and running profits are either added to your account or must be paid out This is called Variation Margin The settlement price on an exchange is the closing price at the end of the trading day, ignoring any prices during any extension of trading, such as after-hours trading

Variation margin is paid by the loser of an open position and received by the winner of another open position The payment is made by the next business day through a protected payment system like LCH.Clearnet's PPS

When you come to "close out" your position (by selling if you are long, or buying back if you are short) the initial margin is refunded and the net profit or loss is realised The majority of your profit or loss will probably already be in your account with the broker, as it's been adjusted on a daily basis The balance for the day should be received the following morning

Example:

• Two FTSE 100 Index contracts were bought at 5922

• We'll assume here that the initial margin charge is £3000 per futures contract, so you've got

to pay £3000 per contract to cover the risk of holding the position overnight

• At the end of the day, the futures price has risen to 5930

• Your position is "marked to market" against the settlement price and has accrued 8 points in profit (5930 - 5922), multiplied by two contracts This will be received into your account in the form of variation margin

Buy 2 futures 5922 (offer)

Receive variation margin +8 x £10 per point x 2 +£160

Let's assume that the following day, the futures price rises again, this time by 50 points to 5980 The variation margin now due to you is 50 x £10 x 2 contracts

Receive variation margin +8 x £10 per point x 2 +£160

Receive variation margin +50 x £10 per point x 2 +£1000

On the third day the price starts slipping and you decide to take profits at a futures price of 5960 Since this price is 20 points lower than the previous day’s settlement price, you are liable for 20 x £10 x 2 contracts in variation margin

Receive variation margin +8 x £10 per point x 2 +£160

Receive variation margin +50 x £10 per point x 2 +£1000

Pay out variation margin -20 x £10 per point x 2 -£400

Summing the cash flows over the holding period gives the net profit or loss on the contract, in this case +£760 Notice that you’d get the same result by simply subtracting the selling price from the buying price and multiplying by the value per point and the number of contracts (the margining system has just meant that gains/losses are received or paid out as they accrue) i.e Sold price (5960) - Bought price (5922) = 38

38 Points x £10 per point x 2 contracts = £760

Assuming commissions of £10 per contract on both the buying and selling legs, total commissions in this case would be £40, so your profit after commissions is reduced to £720, a net return of just over 12% over 3 days on your initial margin of £6000

Profit and Loss Profiles

Profit and loss profiles, called “payoffs”, show graphically the gains and losses to be made by different derivative positions To demonstrate how profit and loss profiles are constructed the illustrations below use a futures contract on wheat Note the profit and loss profile on a forward would be the same

In order for a futures trade to occur, two parties must have equal and opposite opinions as to what will happen to the price of the underlying

Long Profile Analysis

A bullish investor agrees to buy a tonne of wheat in

one month's time for £160 by taking a long futures

position

The buyer will make profit if, on expiry, the price of

wheat is more than £160 (and the higher the price

at expiry, the greater the buyer’s profit)

However, if the underlying is trading below £160 at

expiry, then the buyer is still obliged to pay £160 for

the wheat, even if it the underlying price is less than

£160 Hence the buyer will make a loss

However, the buyer can decide to sell their position at any time, realising a profit or loss depending

on the current price of the underlying (and hence the current price of the future) Summary

• Maximum gain – unlimited

• Maximum loss - the price of the future itself

Short Profile Analysis

A bearish investor agrees to sell a tonne of Wheat in

one month's time for £160 by taking a short futures

position

The p&l profile for the short position is the mirror

image of the long position

The seller will make profit if the price of wheat at

expiry is less than £160 (and the lower the price of

the underlying at expiry, the greater the seller’s

profit) If the price is above £160 at expiry, then the

seller makes a loss

We assume here that the short position does not already own the cocoa (i.e an uncovered futures position) This means that, on expiry, the seller must cover their short position by buying cocoa in the cash market at the prevailing market price

This may sound strange, but one of the features of futures trading is the ability for an investor to agree

to sell something they do not yet own Also note, however, that the seller may decide to cover their position at any time, realising a profit or loss depending on the current price of the underlying (and hence the current price of the future)

Summary

• Maximum gain – the price of the future itself

• Maximum loss – unlimited

Profit and Loss Profiles Summary

Long futures Unlimited Limited to the price of the future

Short futures Limited to the price of the future Unlimited

Long & short positions are mirror images of each other Whatever amount the long position gains, the short position loses (& vice versa) This is why futures contracts are sometimes called a “zero sum game”

Closing Out

An investor with an open futures position, either long or short, has two choices:

• To hold the future to expiry and then take (or make) delivery of the underlying (or cash in the case of a CFD)

• To sell (or buy) the future before the expiry date This is known as CLOSING OUT Closing out

is done by entering into an equal and opposite contract in order to offset the terms of the first

The price of gold rises, pushing up the future's price to $1690

Trader A has two options:

a Keep his position open and run the risk of the price falling back down again, or

b Cash in on his profits by closing out his position

Trader A decides he wants to take profit and sells a gold future to Trader C for $1690

Trader A is now “square” since he has agreed to buy from B at $1675 and sell to C at $1690, so he’s locked in a profit of $15 per ounce and in 3 months' time B will deliver the gold directly to C

Trader A is now square, Trader B is still short at $1675 and Trader C is long at $1690

Step 3:

The price of gold rises further and the gold future's price increases to $1700

Trader B is losing money - $25 per ounce ($1675 − $1700) – and wants to take his loss now, rather than risk any further price movements against him

Trader C now has a potential profit of $10 per ounce and decides to sell i.e

Both B & C want to close out their positions

Trader B is short gold futures, so he must buy gold futures (at $1700) to close out (square / offset) his position, while Trader C is long gold futures, so he must sell at $1700 to close out his position

If we assume for a moment that that there are only three Traders in the whole market, both Trader B and Trader C close out their positions with each another Once this is done, there are no open positions left in the market (i.e “Open Interest” is zero)

Trader A has realized $15 profit

Trader B has realized $25 loss

Trader C has realized $10 profit

Why Trade Futures?

There are three main uses of futures contracts:

to trade contracts before their expiry date

• Positions can be highly leveraged Traders can buy long or sell short

• There’s no counterparty risk

• Standardised contract size and maturity

• Limited number of currency pairs

• Limited and fixed settlement dates

These factors contribute to the liquidity of futures contracts and make them better for speculation

Example

A news report suggests a potential shortage of wheat in months to come, so a trader decides to buy a wheat future at £100 per tonne He is said to be “bullish” as he expects the price to rise The next day the price of wheat (in the cash market) has risen This increases the price of wheat futures to £120 per tonne The Trader can:

a Keep his position open in the hope the price will rise even further, or

b Close out his position by selling wheat futures at £120 (a profit of £20 per tonne)

Had the news been potentially bad for the wheat price (e.g greater supply or lower demand), then the Trader would be “bearish” (thinking prices would fall) & he would have sold short the future, making profits as prices fell

Features of speculation

• Speculation is done by traders who have no real interest in the underlying asset

• Speculators take positions on the price of an underlying asset in the expectation that the price will rise or fall, hoping to be proved correct

Cash-settled futures

Some futures contracts are not physically delivered (i.e The underlying is not actually bought or sold) These futures are known as Contracts For Difference (CFD’s) and are settled by a cash amount representing the difference between the underlying asset at delivery and the futures price

Hedging

Unlike speculation, hedging is not a money-making exercise Hedging is used by people who have a genuine interest in the underlying asset but want to remove the risk (uncertainty) of potential price movements In FX markets, futures are seldom used for hedging due to their inflexible (fixed) maturity dates FX forwards are most commonly used for hedging FX exposures

Short Hedge

A short hedge is used to remove the uncertainty of owning an asset, (i.e being long the underlying) The risk associated with owning an asset is that by the time you want to sell it the price will have fallen

Example 1: Imagine an investor is holding a £110,000 mixed portfolio of shares, which closely mirrors

the FTSE 100 Index However, the investor is worried about the outlook for the UK stock market - in fact, he's positively bearish How can he protect himself against a stock market fall without selling all

or part of his portfolio?

i.e Value of exposure / (Spot index level x Index point value)

Therefore, Hedge ratio = £110,000 / (5300 x £10) = 2.075 = 2 contracts (rounded)

So, the investor sells 2 FTSE 100 Index Future contracts at 5310 and holds his position until maturity

As the last trading day approaches the futures price will converge with the actual FTSE 100 index level This final closing price is known as the Exchange Delivery Settlement Price (EDSP) Let's assume that

at expiry the EDSP (Exchange Delivery Settlement Price) is 5061 - a fall in value of roughly 4.5% What's the outcome?

Example 2: A farmer produces barley at

a cost of £60 per tonne By the time he

comes to sell it the market price of barley

may have decreased (or increased), so he

is running a risk He can hedge against

the risk of falling barley prices by taking

an opposite position in the futures

market, (i.e short barley futures)

So, if the farmer sells barley futures (on

NYSE.liffe) at, say, £75 per tonne, any

losses made on the cash barley (should

the price fall) will be offset by profits

made on the short futures position

Having produced barley at £60 per tonne

& sold barley futures at £75 per tonne, the farmer has locked in a profit of £15 per tonne

• Regardless of the price of barley when the farmer comes to sell it, he will make a profit of £15 per tonne

• Examples:

o If the price of barley was £60 on sale day, £0 is made on the underlying but £15 is made on the short future position

o If the price of barley was £70 on sale day, £10 profit is made on the cash asset and £5

on the short future (total £15)

o If the price of barley was £80 on sale day, £20 profit is made on the cash asset, but a

£5 loss is made on the future Summary

• Someone is long the underlying & is concerned about prices falling

• Selling futures on the underlying asset protects against falling prices (but would penalise on rising prices)

• Long underlying/short futures = short hedge (note that the hedge takes its name “short” from the futures position)

Long hedges

A long hedge is used to remove the uncertainty of not owning an asset, i.e being short the underlying For example, a chocolate manufacturer might want to buy a large consignment of cocoa in three months but is concerned that the price of cocoa will increase, i.e the manufacturer is short the underlying

To protect against this eventuality, the manufacturer will affect a long hedge, i.e short the underlying, long future The principles of a long hedge are the mirror image of those of a short hedge

A long futures position will make money in a rising market Therefore, any increase in the price of the underlying will be offset by the profit made on the futures position

Thus a long hedge allows someone to fix the price they end up paying for the underlying, as, even if the price of the underlying does increase, the profit on the long future will compensate for this extra cost

Hedging Strategy Short hedge (i.e sell futures) Long hedge (i.e buy futures)

Real hedges

In reality, hedging does not eliminate ALL the risk of potential price movements because the gap between future price and cash price (basis) cannot be assumed to remain constant This results in what is known as “Basis Risk”

Arbitrage

Arbitrage is the process whereby an investor (usually a market professional) makes a risk-free profit

by exploiting anomalies and inconsistencies in the prices between two related but different markets For example, as cars are (allegedly) cheaper in the rest of Europe than in the UK, someone can buy a car in France and sell it immediately in the UK for a profit By exploiting the inconsistencies between motor car prices in different markets a quick profit can be made The same principle is used when arbitraging between a cash asset and its derivative Of course, when arbitraging financial instruments, only the fastest will be able to exploit the arbitrage opportunity It does not take long for everyone in the market to spot the arbitrage opportunity and the two prices are very quickly brought back into line with one another again

Relative Value Trading

Futures can also allow you to take a position in the relative performance of two shares, a practice known as “Spread Trading” or “Pairs Trading” Rather than speculating on the specific price direction

of a share, you're simply looking for one share to do better than another (whether both prices rise, both fall or one rises and one falls) You can achieve this by buying futures on one share and selling futures on another The overall gain or loss depends on the relative performance of the two shares You could also take a position in the relative performance of an individual share against a market index, say, by buying futures on an individual stock and selling index futures (or vice versa)

Example: You think that share A will outperform share B over the next few months Here are the

current prices of both the shares and the Universal Stock Futures (USF, for 1000 shares):

You buy 2 futures on share A and sell 3 futures on share B The different number of contracts traded ensures that each position represents approximately the same value of share

Buy 2 futures contracts on share A = £12,000 worth of share (2 x 1000 x £6) Sell

3 futures contracts on share B = £12,000 worth of share (3 x 1000 x £4)

A few weeks later the market prices are as follows:

Both shares have fallen, but share B has fallen by greater proportion of its original value i.e

Share A has 'outperformed' share B, as you had hoped

Share A futures loss: (£5.46 - £6.75) x 2 x 1000 = (£2,580) Share

B futures gain: (£4.50 - £3.44) x 3 x 1000 = £3,180

So net profit = £600