Colibri Trader

Advanced Trading
Knowledge
 General Introduction to Futures

A cattle owner is raising new cattle but he is afraid that the

price of the commodity may fall by the time the cattle grow
up. A meat supplier is in the business of processing meat and
selling it to his customers. He is afraid the price of cattle will
rise in the future and leave him at a loss. Both these parties are
at risk from the price of cattle going up or down. They both
wish to have a fixed price for the cattle so they can estimate
their profits for the period, so they both come together and
Forward Contracts: A brief history of agree on trading the cattle at a point in the future and at a
futures certain price. The cattle owner has now locked in his profit
and knows exactly how much money he will receive for his

 stock. The meat supplier now also knows the price at which
he will buy his next shipment of cattle. Based on this they both
can now carry on with their day to day business without
worrying about the risk associated with the rise or fall in the
price of cattle.

By
Colibri Trader
 Forward Contracts: A brief history of futures

Now if the price of cattle rises, the cattle supplier will lose out as he could have
owner will still have to sell his cattle at the purchased his supply of cattle at a cheaper
agreed price and will lose out on the price. This introduces the concept of
difference between the current price and opportunity cost. The opportunity cost of
the agreed price. The meat supplier on the these two parties entering into business is
other hand will benefit since he will pay the the chance that they make a profit or a loss
agreed price and not the current, higher from the price of the cattle in the future.
price. The cattle owners loss is exactly offset Now, if one of the parties cannot or won’t
by the meat supplier’s gain. However if the commit to their agreement, the deal would
price of cattle falls, the cattle owner will be off and the other party would be at a
benefit, since he will sell his cattle at the disadvantage. This is the risk of default that
agreed price which is higher than the both parties take, i.e. when one party
current market price, but now the meat cannot or won’t honour their agreement.
 Forward Contracts: A brief history of futures

In summary:

A forward contract is an agreement

between two parties to buy and underlying
security at a specific price in the future. This
agreement is privately negotiated and like
the term says it is a contract, therefore both
parties will make sure that all ambiguities
and terms are explained and clear. This type
of agreement does not require a clearing
firm.
 Futures contracts


A futures contract is a standardised version of the forward

❖ ❖Futures contracts, or simply futures, are exchange traded
contract, traded on a futures exchange, to buy or sell a certain derivatives. The exchange's clearinghouse acts as counter-party on
underlying instrument at a certain date in the future, at a specified all contracts, sets margin requirements, and crucially also provides
price. The future date is called the delivery date or final settlement a mechanism for settlement.
date. The pre-set price is called the futures price. The price of the ❖Essentially what this means is that a future is the same as a

underlying asset on the delivery date is called the settlement price. forward contract, but the quantity, settlement date, type of
product, quality etc. are all specified by the exchange. The clearing
house guarantees all the trades and if a party defaults, it is the
clearinghouse’s obligation to make up for the loss.

Example:
Contract specification for one Corn futures contract traded on CBOT (Chicago Board of
Trade)
A futures contract gives the holder the obligation to buy or sell. In
❖

other words, both parties of a "futures contract" must fulfil the Size - 5,000 bushels – number of bushels of corn per contract
contract on the settlement date. The seller delivers the commodity Tick Size - $0.025/bushel – minimum price increment the contract can move price
by( $12.5 per contract )
to the buyer, or, if it is a cash-settled future, then cash is transferred Daily Price Limit - $0.20/bushel – maximum change in price per day (up or down)
from the futures trader who sustained a loss to the one who made Contract Months - Dec, Mar, May, Jul, Sep – months where contracts expire(settlement
months)
a profit. To exit the commitment prior to the settlement date, the
Last Trading Day - Seventh business day proceeding the last business day of the
holder of a futures position has to offset their position by either delivery month
selling a long position or buying back a short position, effectively
closing out the futures position and its contract obligations. As can be seen from the example above, these are the terms a
❖

buyer or a seller would agree to when buying or selling one

contract of corn on the Chicago Board of Trade.
 Differences Between Futures Contracts over Forward Contracts


There are several important ❖ Futures contracts require margin to be

maintained; forward contracts do not require
differences between futures margin
contracts and forward
contracts. These differences ❖ Futures contracts are traded on exchanges ,
forward contracts are negotiated over the counter
are:
❖ A clearing house guarantees futures contract
❖ Futures contracts are standardised, whereas
performance, forward contracts are not
forward contracts are customised
guaranteed

❖ Futures contracts require daily marking to

❖ Futures Contracts do not carry counterparty
market, forward contracts do not require daily
default risk, forward contracts expose parties to
marking to market
default risk
 Advantages and disadvantages of futures contracts


Advantages of futures contracts include: Disadvantages of futures contracts

include:

❖ It is a standardised contract
❖ It is traded on an exchange and ❖ There is little or no flexibility to
therefore has a high level of availability customise the contract to meet the
and liquidity parties needs.
❖ Performance is guaranteed by the ❖ The contract has to be marked to

clearing house market, thus affecting the account

❖ Futures markets are well regulated books.
 Commodity Futures


Commodities are agreements to buy and sell virtually anything

except, for some reason, onions. The primary commodities that
are traded are oil, gold and agricultural products. Since no one
really wants to transport all those heavy materials, what is
actually traded are commodities futures contracts or options.
 
The prices of commodities can change on a daily basis. If the
price goes up, the buyer of the futures contract makes money,
because he gets the product at the lower, agreed-upon price
and can now sell it at the higher, market price. If the price goes
down, the seller makes money, because he can buy the
commodity at the lower market price, and sell it to the buyer at
the higher, agreed-upon price.
 
Of course, if commodities traders had to actually deliver the
product, very few people would do it. Instead, they can fulfill
the contract by delivering proof that the product is at the
warehouse, by paying the cash difference, or by providing
another contract at the market price.
 
The important things to know
Commodity futures, since they are traded on an open market,
do a great job of accurately assessing the price of each
commodity
Since they are futures contracts, they also forecast the value of
the commodity into the future
The most commonly reviewed commodities are oil and gold.
Many other agricultural products such as pork bellies and
wheat are traded
 Currency Futures


❖ A currency future, also FX future or foreign exchange

future, is a futures contract to exchange one currency for
another at a specified date in the future at a price
(exchange rate) that is fixed on the purchase date.
Typically, one of the currencies is the US dollar. The price
of a future is then in terms of US dollars per unit of other
currency. This can be different from the standard way of
quoting in the spot foreign exchange markets. The trade
unit of each contract is then a certain amount of other
currency, for instance €125,000. Most contracts have
physical delivery, so for those held at the end of the last
trading day, actual payments are made in each currency.
However, most contracts are closed out before that.
Investors can close out the contract at any time prior to
the contract's delivery date.
 Options 


❖ Options are financial instruments that convey the

right, but not the obligation, to engage in a future
❖ Whether the option holder has the right to buy (a
transaction on some underlying security, or in a
call option) or the right to sell (a put option)
futures contract. In other words, the holder does
not have to exercise this right, unlike a forward or ❖ The quantity and class of the underlying asset(s)
future. For example, buying a call option provides
(e.g. 100 shares of XYZ Co. B stock)
the right to buy a specified quantity of a security at
a set strike price at some time on or before ❖ The strike price, also known as the exercise price,
expiration, while buying a put option provides the which is the price at which the underlying
right to sell. Upon the option holder's choice to transaction will occur upon exercise
exercise the option, the party who sold, or wrote,
the option must fulfill the terms of the contract. ❖ The expiration date, or expiry, which is the last
date the option can be exercised
❖ Option contract specifications
❖ The settlement terms, for instance whether the
❖ Every financial option is a contract between the
writer must deliver the actual asset on exercise, or
two counter-parties. Option contracts may be quite
may simply tender the equivalent cash amount
complicated; however, at minimum, they usually
contain the following specifications:
 Evolution of Derivatives

You can come up with a hundreds of formulae for derivatives, use

them within numerous applications, but in its pure form, derivatives
are merely pieces of paper, or in more modern day view, electronic
contracts which give you a right or an obligation, or a combination of
the two to receive or give something in the future. This can be a stock
of a company, a foreign currency, wheat, oil, or to take it to its extreme,
an agreement with your neighbour for 2 bags of sugar next week.
 
A derivative is essentially a contract, which has its value derived as a
function of some underlying variables. For a stock, the underlying
variable is the stock price, for wheat, the underlying is the price of
wheat at a certain time, and for the 2 bags of sugar, it could be the
difference between the two sugar prices. The aim of a derivatives
practitioner is to understand the dynamics behind the underlying
variable and the factors which might influence the value of it in the
future.
 
 Key Usage of Derivatives


❖ Hedging

❖ Hedging using derivatives is commonly used by parties who seek to

offset their existing risks by entering into a derivatives transaction. The
existing risks could be an investment portfolio, price changes in oil for a
petroleum mining company or perhaps investments in a foreign
country. 
❖ Arbitrage

❖ Speculating
❖ Opportunities to arbitrage take place throughout the world markets,
and derivatives are sometimes used to exploit these. Practitioners
❖ Speculation is more commonly used by hedge funds or traders who aim working within risk finance or quantitative finance often develop
to generate profits with only a marginal investment, essentially placing a models to price various assets being traded across the markets, and
bet on the movement of an asset. Although speculation can produce a upon finding price discrepancies, one can make use of a specific
high return on investment, the downside risks are equally as prominent combination of derivatives in order make a riskless profit.
as demonstrated by the collapse of Long Term Capital Management in
September of 1998. Because of the high degree of leverage one can take
in speculative contracts, an adverse change in prices could result in
rapidly increasing debt and a portfolio worth millions could fall to
almost zero with the space of a few hours.
 Dangers of Derivatives

❖ It is a commonly said fact that derivatives contribute to the 'completeness'

of the global markets, and without them, loopholes within the financial
industry would exist. At this point, it may be worthy to note that even
through numerous financial disasters ala Amaranth, Barings, LTCM, Enron
and others related to the mismanagement of derivatives, it is key to
consider that it has not been the use of derivatives as a tool which has led
to the downfall of these companies - but rather, the misuse and
compromise of such instruments.

❖ Are derivatives dangerous? That's almost like asking if water is dangerous.

Derivatives can be dangerous if used incorrectly - as several large
companies and individuals have found out in recent history. This in turn,
has led to the advancement of risk management; a profession which deals
specifically with managing the risks involved with taking positions in
❖ Looking back in time we have seen the evolution of derivatives even way
these tools. Derivatives are essential to the efficiency of the markets.
before the invention of the car. Over 2000 years ago, contracts for delivery
in the future was commonly used with Greek olive farmers, in the 1600s,
Tulip derivatives were used by the Dutch and it was more or less only as
Louis Bachelier in 1900 formally introduced futures pricing when people
began to take derivatives at more than just face value.
 Coming Soon

THE PROFESSIONAL PROP TRADING COURSE- THE WAY I TRADE