Stock Option Basics

Definition:
A stock option is a contract between two parties in which the stock option buyer (holder)
purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a
predetermined price from/to the option seller (writer) within a fixed period of time.

Option Contract Specifications

The following terms are specified in an option contract.

Option Type
The two types of stock options are puts and calls. Call options confers the buyer the right
to buy the underlying stock while put options give him the rights to sell them.

Strike Price
The strike price is the price at which the underlying asset is to be bought or sold when the
option is exercised. It's relation to the market value of the underlying asset affects
the moneyness of the option and is a major determinant of the option's premium.

Premium
In exchange for the rights conferred by the option, the option buyer have to pay the option
seller a premium for carrying on the risk that comes with the obligation. The option
premium depends on the strike price, volatility of the underlying, as well as the time
remaining to expiration.

Expiration Date
Option contracts are wasting assets and all options expire after a period of time. Once the
stock option expires, the right to exercise no longer exists and the stock option becomes
worthless. The expiration month is specified for each option contract. The specific date on
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which expiration occurs depends on the type of option. For instance, stock options listed in
the United States expire on the third Friday of the expiration month.

Option Style
An option contract can be either american style or european style. The manner in which
options can be exercised also depends on the style of the option. American style options
can be exercised anytime before expiration while european style options can only be
exercise on expiration date itself. All of the stock options currently traded in the
marketplaces are american-style options.

Underlying Asset
The underlying asset is the security which the option seller has the obligation to deliver to or
purchase from the option holder in the event the option is exercised. In the case of stock
options, the underlying asset refers to the shares of a specific company. Options are also
available for other types of securities such as currencies, indices and commodities.

Contract Multiplier
The contract multiplier states the quantity of the underlying asset that needs to be delivered
in the event the option is exercised. For stock options, each contract covers 100 shares.

The Options Market

Participants in the options market buy and sell call and put options. Those who buy options
are called holders. Sellers of options are called writers. Option holders are said to have long
positions, and writers are said to have short positions.

Call Option
Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the
obligation) to buy a specified quantity of a security at a specified price (strike price) within a
fixed period of time (until its expiration).

For the writer (seller) of a call option, it represents an obligation to sell the underlying
security at the strike price if the option is exercised. The call option writer is paid
a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.

Buying Call Options

Call buying is the simplest way of trading call options. Novice traders often start off trading
options by buying calls, not only because of its simplicity but also due to the large ROI
generated from successful trades.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A call option contract with a strike
price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ
stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to
purchase a single $40 XYZ call option covering 100 shares.

Say you were spot on and the price of XYZ stock rallies to $50 after the company reported
strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in
the underlying stock price, your call buying strategy will net you a profit of $800.
Let us take a look at how we obtain this figure.

If you were to exercise your call option after the earnings report, you invoke your right to buy
100 shares of XYZ stock at $40 each and can sell them immediately in the open market for
$50 a share. This gives you a profit of $10 per share. As each call option contract covers
100 shares, the total amount you will receive from the exercise is $1000.
Since you had paid $200 to purchase the call option, your net profit for the entire trade is
$800. It is also interesting to note that in this scenario, the call buying strategy's ROI of
400% is very much higher than the 25% ROI achieved if you were to purchase the stock
itself.
This strategy of trading call options is known as the long call strategy. See our long call
strategy article for a more detailed explanation as well as formulae for calculating maximum
profit, maximum loss and breakeven points.

Selling Call Options

Instead of purchasing call options, one can also sell (write) them for a profit. Call option
writers, also known as sellers, sell call options with the hope that they expire worthless so
that they can pocket the premiums. Selling calls, or short call, involves more risk but can
also be very profitable when done properly. One can sell covered calls or naked (uncovered)
calls.

Covered Calls
The short call is covered if the call option writer owns the obligated quantity of the
underlying security. The covered call is a popular option strategy that enables the
stockowner to generate additional income from their stock holdings thru periodic selling of
call options. See our covered call strategy article for more details.

Naked (Uncovered) Calls

When the option trader write calls without owning the obligated holding of the underlying
security, he is shorting the calls naked. Naked short selling of calls is a highly risky option
strategy and is not recommended for the novice trader. See our naked call article to learn
more about this strategy.
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Call Spreads
A call spread is an options strategy in which equal number of call option contracts are
bought and sold simultaneously on the same underlying security but with different strike
prices and/or expiration dates. Call spreads limit the option trader's maximum loss at the
expense of capping his potential profit at the same time.

Put Option
Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the
obligation) to sell a specified quantity of a security at a specified price (strike price) within a
fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying
security at the strike price if the option is exercised. The put option writer is paid
a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on
particular security, he can purchase put options to profit from a slide in asset price. The
price of the asset must move significantly below the strike price of the put options before the
option expiration date for this strategy to be profitable.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A put option contract with a strike
price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ
stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to
purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported
weak earnings and lowered its earnings guidance for the next quarter. With this crash in the
underlying stock price, your put buying strategy will result in a profit of $800.
Let's take a look at how we obtain this figure.
If you were to exercise your put option after earnings, you invoke your right to sell 100
shares of XYZ stock at $40 each. Although you don't own any share of XYZ company at this
time, you can easily go to the open market to buy 100 shares at only $30 a share and sell
them immediately for $40 per share. This gives you a profit of $10 per share. Since each put
option contract covers 100 shares, the total amount you will receive from the exercise is
$1000. As you had paid $200 to purchase this put option, your net profit for the entire trade
is $800.
This strategy of trading put option is known as the long put strategy. See our long put
strategy article for a more detailed explanation as well as formulae for calculating maximum
profit, maximum loss and breakeven points.

Protective Puts
Investors also buy put options when they wish to protect an existing long stock position. Put
options employed in this manner are also known as protective puts. Entire portfolio of stocks
can also be protected using index puts.

Selling Put Options

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Instead of purchasing put options, one can also sell (write) them for a profit. Put option
writers, also known as sellers, sell put options with the hope that they expire worthless so
that they can pocket the premiums. Selling puts, or put writing, involves more risk but can
be profitable if done properly.

Covered Puts
The written put option is covered if the put option writer is also short the obligated quantity
of the underlying security. The covered put writing strategy is employed when the investor is
bearish on the underlying.

Naked Puts
The short put is naked if the put option writer did not short the obligated quantity of the
underlying security when the put option is sold. The naked put writing strategy is used when
the investor is bullish on the underlying.
For the patient investor who is bullish on a particular company for the long haul, writing
naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads
A put spread is an options strategy in which equal number of put option contracts are
bought and sold simultaneously on the same underlying security but with different strike
prices and/or expiration dates. Put spreads limit the option trader's maximum loss at the
expense of capping his potential profit at the same time.

Strike Price
Definition:
The strike price is defined as the price at which the holder of an options can buy (in the case
of a call option) or sell (in the case of a put option) the underlying security when the option
is exercised. Hence, strike price is also known as exercise price.

Strike Price, Option Premium & Moneyness

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When selecting options to buy or sell, for options expiring on the same month, the option's
price (akapremium) and moneyness depends on the option's strike price.

Relationship between Strike Price & Call Option Price

For call options, the higher the strike price, the cheaper the option. The following table lists
option premiums typical for near term call options at various strike prices when the
underlying stock is trading at $50
Strike Price
35
40
45
50
55
60
65

Moneyness
ITM
ITM
ITM
ATM
OTM
OTM
OTM

Call Option Premium

$15.50
$11.25
$7
$4.50
$2.50
$1.50
$0.75

Intrinsic Value
$15
$10
$5
$0
$0
$0
$0

Time Value
$0.50
$1.25
$2
$4.50
$2.50
$1.50
$0.75

Relationship between Strike Price & Put Option Price

Conversely, for put options, the higher the strike price, the more expensive the option. The
following table lists option premiums typical for near term put options at various strike prices
when the underlying stock is trading at $50
Strike Price
35
40
45
50
55
60
65

Moneyness
OTM
OTM
OTM
ATM
ITM
ITM
ITM

Put Option Premium

$0.75
$1.50
$2.50
$4.50
$7
$11.25
$15.50

Intrinsic Value
$0
$0
$0
$0
$5
$10
$15

Time Value
$0.75
$1.50
$2.50
$4.50
$2
$1.25
$0.50

Strike Price Intervals

The strike price intervals vary depending on the market price and asset type of the
underlying. For lower priced stocks (usually $25 or less), intervals are at 2.5 points. Higher
priced stocks have strike price intervals of 5 point (or 10 points for very expensive stocks
priced at $200 or more). Index options typically have strike price intervals of 5 or 10 points
while futures options generally have strike intervals of around one or two points.
Next: Options Premium

Options Premium

The price paid to acquire the option. Also known simply as option price. Not to be confused
with the strike price. Market price, volatility and time remaining are the primary forces
determining the premium. There are two components to the options premium and they are
intrinsic value and time value.

Intrinsic Value
The intrinsic value is determined by the difference between the current trading price and the
strike price. Only in-the-money options have intrinsic value. Intrinsic value can be computed
for in-the-money options by taking the difference between the strike price and the current
trading price. Out-of-the-money optionshave no intrinsic value.

Time Value
An option's time value is dependent upon the length of time remaining to exercise the
option, themoneyness of the option, as well as the volatility of the underlying security's
market price.
The time value of an option decreases as its expiration date approaches and becomes
worthless after that date. This phenomenon is known as time decay. As such, options are
also wasting assets.
For in-the-money options, time value can be calculated by subtracting the intrinsic value
from the option price. Time value decreases as the option goes deeper into the money.
For out-of-the-money options, since there is zero intrinsic value, time value = option price.
Typically, higher volatility give rise to higher time value. In general, time value increases as
the uncertainty of the option's value at expiry increases.

Effect of Dividends on Time Value

Time value of call options on high cash dividend stocks can get discounted while similarly,
time value of put options can get inflated. For more details on the effect of dividends on
option pricing, read this article.

Moneyness
Moneyness is a term describing the relationship between the strike price of an option and
the current trading price of its underlying security. In options trading, terms such as in-themoney, out-of-the-moneyand at-the-money describe the moneyness of options.

In-the-Money (ITM)
A call option is in-the-money when its strike price is below the current trading price of the
underlying asset.
A put option is in-the-money when its strike price is above the current trading price of the
underlying asset.
In-the-money options are generally more expensive as their premiums consist of
significant intrinsic valueon top of their time value.

Out-of-the-Money (OTM)
Calls are out-of-the-money when their strike price is above the market price of the
underlying asset.
Puts are out-of-the-money when their strike price is below the market price of the underlying
asset.
Out-of-the-money options have zero intrinsic value. Their entire premium is composed of
only time value. Out-of-the-money options are cheaper than in-the-money options as they
possess greater likelihood of expiring worthless.

At-the-Money (ATM)
An at-the-money option is a call or put option that has a strike price that is equal to the
market price of the underlying asset. Like OTM options, ATM options possess no intrinsic
value and contain only time valuewhich is greatly influenced by the volatility of the
underlying security and the passage of time.
Often, it is not easy to find an option with a strike price that is exactly equal to the market
price of the underlying. Hence, close-to-the-money or near-the-money options are bought or
sold instead.
Next: Options Expiration

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Options Expiration
All options have a limited useful lifespan and every option contract is defined by an
expiration month. The option expiration date is the date on which an options contract
becomes invalid and the right to exercise it no longer exists.

When do Options Expire?

For all stock options listed in the United States, the expiration date falls on the third Friday
of the expiration month (except when that Friday is also a holiday, in which case it will be
brought forward by one day to Thursday).

Expiration Cycles
Stock options can belong to one of three expiration cycles. In the first cycle, the JAJO cycle,
the expiration months are the first month of each quarter - January, April, July, October. The
second cycle, the FMAN cycle, consists of expiration months Febuary, May, August and
November. The expiration months for the third cycle, the MJSD cycle, are March, June,
September and December.
At any given time, a minimum of four different expiration months are available for every
optionable stock. When stock options first started trading in 1973, the only expiration
months available are the months in the expiration cycle assigned to the particular stock.
Later on, as options trading became more popular, this system was modified to cater to
investors' demand to use options for shorter term hedging. The modified system ensures
that two near-month expiration months will always be available for trading. The next two
expiration months further out will still depend on the expiration cycle that was assigned to
the stock.

Determining the Expiration Cycle

As there is no set pattern as to which expiration cycle a particular optionable stock is
assigned to, the only way to find out is to deduce from the expiration months that are
currently available for trading. To do that, just look at the third available expiration month
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and see which cycle it belongs to. If the third expiration month happens to be January, then
use the fourth expiration month to check.
The reason we need to double check January is because LEAPS expire in January and if
the stock has LEAPS listed for trading, then that January expiration month is the additional
expiration month added for the LEAPS options.

Expiration Calendar
Option Exercise & Assignment
Exercise
To exercise an option is to execute the right of the holder of an option to buy (for call
options) or sell (forput options) the underlying security at the striking price.

American Style vs European Style

American style options can be exercised anytime before the expiration date. European style
options on the other hand can only be exercised on the expiration date itself. Currently, all of
the stock options traded in the marketplaces are American-Style options.
When an option is exercised by the option holder, the option writer will be assigned the
obligation to deliver the terms of the options contract.

Assignment
Assignment takes place when the written option is exercised by the options holder.
The options writer is said to be assigned the obligation to deliver the terms of the options
contract.
If a call option is assigned, the options writer will have to sell the obligated quantity of the
underlying security at the strike price.
If a put option is assigned, the options writer will have to buy the obligated quantity of the
underlying securty at the strike price.
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Once an option is sold, there exist a possibility for the option writer to be assigned to fulfil
his or her obligation to buy or sell shares of the underlying stock on any business day. One
can never tell when an assignment will take place. To ensure a fair distribution of
assignments, the Options Clearing Corporation uses a random procedure to assign exercise
notices to the accounts maintained with OCC by each Clearing Member. In turn, the
assigned firm must use an exchange approved way to allocate those notices to individual
accounts which have the short positions on those options.
Options are usually exercised when they get closer to expiration. The reason is that it does
not make much sense to exercise an option when there is still time value left. Its more
profitable to sell the option instead.
Over the years, only about 17% of options have been exercised. However, it does not mean
that only 17% of your short options will be exercised. Many of those options that were not
exercised were probably out-of-the-money to begin with and had expired worthless. In any
case, at any point in time, the deeper into-the-money the short options, the more likely they
will be exercised.
Next: Getting Started in Options Trading

Getting Started in Options Trading

To start trading options, you will need to have a trading account with an options brokerage.
Once you have setup your account, you can then place options trades with your broker who
will execute it on your behalf.

Opening a Trading Account

When opening a trading account with a brokerage firm, you will be asked whether you wish
to open a cash account or a margin account.

Cash Account vs. Margin Account

The difference between a cash account and a margin account is that a margin account
allows you to use your existing holdings (eg. stocks or long-term options) as collaterals to
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borrow funds from the brokerage to finance additional purchases. With cash accounts, you
can only use the available cash in your account to pay for all your stock and options trades.

Minimum Deposit
There is usually a minimum deposit required to open a trading account. The amount
required depends on the type of account that you are opening as well as the brokerage firm.
Little or no deposit is required to open a cash account while federal regulations require a
deposit of at least $2000 to open a margin-enabled account.

Online Brokerage vs. Offline Brokerage

To trade options effectively, I find it necessary to trade via an online brokerage account as
there are simply too many variables in a typical options trade, as compared to a stock trade.
Having to communicate too many details in one trade to your broker over the phone also
increases the chance of miscommunication which can prove very costly.
With technology so advanced these days, online brokerages for options now offer highly
intuitive user interfaces where it is far easier to place option trades online than having to do
it over the phone. Moreover, while a human broker can only handle one client at a time,
online brokerages can handle thousands of orders simultaneously. Thus, it is no
coincidence that the rise of option trading also coincide with the rapid advancement of
internet technologies.

Finding the Best Options Broker Online

When opening an option brokerage account, don't just go with the cheapest broker. You will
find it worthwhile to spend some time evaluating their quality of service first. Read on for tips
on how to find the best online options brokerage for your trading needs.

Full-Service Broker vs. Discount Broker

There are two main types of options brokerage firms in the market - the full service
brokerage and the self-directed discount brokerage.
Full service or traditional brokerages provide a wide range of services at extra charges.
Their services include advice to their clients on where to place their investment money.
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Discount brokers are geared towards the self-directed trader. They do not provide any
investment advice, leaving their clients to make their own financial decisions. Discount
brokerages merely execute your orders and consequently their charges are much less than
their full-service counterparts.
There are also brokerage companies that offer both services to their customers, letting them
to choose the level of service they require.
Most option traders that I know opt to go with the discount brokerages since anyone who is
confident enough to trade complex instruments such as options are usually financially savvy
enough not to require trading advice from their brokers, especially when the broker's
renumeration is based upon the frequency of trades rather than the quality of their
recommendations.

Quality of Service
When determining which is the best options brokerage, commission charges should not be
the only consideration. When it comes to online brokers, site availability, speed of execution
and ease of use are just as important, if not more so, than price.

Availability & Speed of Execution

Site availability and responsiveness are perhaps the most crucial aspects to look out for
when selecting an online brokerage. No matter how low the commission charges, if the
trade does not get through because the brokerage site is overwhelmed by ultra high load
and becomes unavailable, the amount of transaction fees you save is not going to be worth
it.
Responsiveness of the site affects the timeliness of the real-time price quotes you get.
Remember, we are living in the information age. News travel fast, round the globe, 24 hours
a day. Markets react to breaking news events faster than ever before. You don't want to be
lagging, even if its just seconds behind, especially when the trading action is fast and
furious.
Note: Your own internet connection should also be up to speed. You should upgrade to a
broadband connection if you are still using dial-up. If you are using wireless, check that your
connectivity is good before connecting to the brokerage site.

Quality of Execution

15

The National Best Bid or Offer (NBBO) is an SEC requirement that brokers must guarantee
customers the best available ask price when they buy securities and the best available bid
price when they sell securities. Look for brokers that guarantee trade execution prices that
meet or exceed the NBBO.

Ease of Use
With option trades already complicated enough on their own, it sure doesn't help when you
still have to puzzle over how to use the order placement form. An easy to understand user
interface helps minimize errors, which can be extremely costly when thousands of dollars
are changing hands every trade. Look for option trading brokerages that offer single-screen
order entry forms for covered calls, condors, butterflies and other multi-legged option
strategies.

Commissions and Fees

To differentiate themselves from their competition, options trading brokerages are very
creative when charging commissions. For options trades, if you take a look at their
commission and fees page, you should see two charges: 1) a per trade fee and 2) a per
contract fee.
Per Trade Fee (or Ticket Charge) - There is usually a minimum fee per transaction,
regardless of how many (or rather, how few) contracts are involved in each trade.
Per Contract Fee - This fee is charged for every option contract involved in each trade.
It is important to know how they are used to calculate the total commission costs per
transaction. Usually, the following method is used:
Total Commission = $X per Trade + $Y Per Contract
But some brokerages use the following formula:
Total Commission = $X per Trade or $Y per Contract, whichever is higher

Market or Limit Order

Some companies charges different brokerage fees for different types of orders. You should
note the fee for limit orders since you almost never place market orders.

Internet or Broker-assisted Trade

16

Broker assisted trades can cost as much as several times more than internet trades. The
only reason to place a broker-assisted trade is when you are cut off from the internet and a
very good trading opportunity happen to arise.

Volume Discount
There are options brokerage houses which charge a lower rate if your trading frequency
exceeds a certain threshold. So, if you are an active trader making dozens of trades a
month, it makes sense to look out for a brokerage firm that offers such a discount scheme.

Hidden Fees
To offset their low commission charges, some discount brokerage firms charges a slew of
hidden fees. So if an option brokerage charges an unusually low fee compared to the
industry norms, make sure you find out whether there are other fees that you should be
aware of. Some common hidden fees include:

Account Inactivity Fee - Some brokerages charges a fee if you did not make any
trade after a certain period of time.

Annual Maintenance Fee - This is a fee levied every year as long as you have an
account with the brokerage firm, whether or not you have made any trade.

Minimum Balance Fee - This is a fee that is levied peroidically (say monthly or
quarterly) when your account balance is below a certain threshold.

Commissions can have a significant impact to an option trader's overall profit or loss,
especially if your trading capital limits you to prudently buy/sell only 1 or 2 contracts per
trade or if you are just starting out and your win/loss ratio is 6:4 or lower. Finding a lowcommissions options broker can boost trading profits by as much as 50%.

Recommended Options Brokerage

If you are new to option trading, we recommend you sign up with OptionsHouse. They
provide quality trade execution, intuitive, user-friendly interface while maintaining low
commission charges. optionshouse also provides a Virtual Trading Tool where beginners
can try out options trading in real market conditions without risking real money.

Option Strategy Finder

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A large number of options trading strategies are available to the options trader. Use the
search facility below to quickly locate the best options strategies based upon your view of
the underlying and desired risk/reward characteristics.
Outlook on Underlying:
Bullish

Profit Potential:

Loss Potential:

Credit/Debit:

No. Legs:

Find Strategies

Click on the profit graph for a detailed explanation of each individual options
strategy.
Bull Call Spread

18

Bull Put Spread

Buying Index Calls

Call Backspread

19

Costless Collar (Zero-Cost Collar)

Covered Calls

Covered Combination

20

Covered Straddle

In-The-Money Covered Call

Long Call

21

Married Put

Protective Put

Selling Index Puts

22

Stock Repair Strategy

Synthetic Long Call

Synthetic Long Stock

23

Synthetic Long Stock (Split Strikes)

Synthetic Short Put

The Collar Strategy

24

Uncovered Put Write

Futures Trading Basics

A futures contract is a standardized contract that calls for the delivery of a specific quantity
of a specific product at some time in the future at a predetermined price. Futures contracts
are derivative instrumentsvery similar to forward contracts but they differ in some aspects.
Futures contracts are traded in futures exchanges worldwide and covers a wide range
of commodities such as agriculture produce, livestock, energy, metals and financial products
such as market indices, interest rates and currencies.

Why Trade Futures?

25

The primary purpose of the futures market is to allow those who wish to manage price risk
(the hedgers) to transfer that risk to those who are willing to take that risk (the speculators)
in return for an opportunity to profit.

Hedging
Producers and manufacturers can make use of the futures market to hedge the price risk of
commodities that they need to purchase or sell in order to protect their profit margins.
Businesses employ a long hedgeto lock in the price of a raw material that they wish to
purchase some time in the future. To lock in a selling price for a product to be sold in the
future, a short hedge is used.

Speculation
Speculators assume the price risk that hedgers try to avoid in return for a possibility of
profits. They have no commercial interest in the underlying commodities and are motivated
purely by the potential for profits. Although this makes them appear to be mere gamblers,
speculators do play an important role in the futures market. Without speculators bridging the
gap between buyers and sellers with a commercial interest, the market will be less fluid, less
efficient and more volatile.
Futures speculators take up a long futures position when they believe that the price of the
underlying will rise. They take up a short futures position when they believe that the price of
the underlying will fall.

Example of a Futures Trade

In March, a speculator bullish on soybeans purchased one May Soybeans futures at $9.60
per bushel. Each Soybeans futures contract represents 5000 bushels and requires an initial
margin of $3500. To open the futures position, $3500 is debited from his trading account
and held by the exchange clearinghouse.
Come May, the price of soybeans has gone up to $10 per bushel. Since the price has gone
up by $0.40 per bushel, the speculator can exit his futures position with a profit of $0.40 x
5000 bushels = $2000.
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Futures Contract Details

Every futures contract is an agreement that represents a specific quantity of the
underlying commodity to be delivered some time in the future for a pre-agreed price.
Unlike options, buyers and sellers of futures contracts are obligated to take or make delivery
of the underlying asset on settlement date.

Futures Contract Specifications

The Underlying
Each futures contract represents a specific underlying asset to be delivered on the delivery
date. Besides commodities, other instruments such as interest rates, currencies and stock
indices are also traded in the futures exchanges.

Exchange
The futures exchange where the futures contract is traded. Some of the world's largest
futures exchanges include:

Chicago Mercantile Exchange (CME)

New York Mercantile Exchange (NYMEX)

Tokyo Commodity Exchange (TOCOM)

Multi-Commodity Exchange (MCX)

Symbol
Each futures contract traded in a futures exchange is identified by a unique ticker symbol.

Contract Size (or Trading Unit)

The contract size states the amount and unit of the underlying commodity represented by
each futures contract (E.g. 1000 barrels of crude oil or 50 troy ounces of platinum).

Price Quotation
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The quoted price of a futures contract is the agreed price (per unit) of the underlying asset
that the buyer has to pay to the seller in order to take delivery of the goods.
Correspondingly, it is also the price at which the seller must sell the underlying asset to the
buyer. Depending on the type of futures contract, the price can be quoted in cents, dollars or
even in a foreign currency.

Grade of Deliverable
The grade not only specifies the quality of the underlying but also the manner and the exact
place(s) of delivery.

Delivery Date
Each futures contract has a specific delivery date where the seller of the futures contract is
required to make delivery of the underlying product being traded and the buyer of the
futures contract is required to take delivery.

Last Trading Day

Trading shuts down some time before the delivery date to give the futures contract seller
sufficient time to prepare the underlying products for delivery. Futures positions which have
not been closed out (offset) before end of the last trading day will have to be settled by
making or taking delivery of the underlying product.

Delivery Months
Every futures contract has standardized months at which the underlying can be traded for
delivery.

Futures Trading
One can trade futures contracts via a regulated futures exchange.

Futures Exchanges
A futures exchange is a financial exchange where futures contracts are traded. Futures
exchanges are usually commodity exchanges. This is because all derivatives, including
financial derivatives, are often traded at commodity exchanges. The reason for this has to
do with the history of the development of these exchanges.
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In the 19th century, the first exchanges were opened in Chicago to trade forward
contracts on commodities. Exchange traded forward contracts are called futures contracts.
Thus, futures trading was synonymous with commodity trading and it has been the case for
around a hundred years.
In the 1970s, these commodity exchanges started offering future contracts on other
products, such as stocks, options contracts and interest rates. Products such as these are
called financial futures. Trading in this new class of futures contracts quickly outgrown the
traditional commodities markets. In recognition of this development, commodity exchanges
are now generally known as futures exchanges.

Major Global Exchanges

Today, global exchanges can be found all over the world in both developed and developing
countries. The following table lists some of the largest futures exchanges in the world and
the principle commodities that are traded at each of these exchanges.
Exchange

Headquarter

Principle Commodities

Chicago Board of Trade (CBOT)

Chicago, USA

Grains, Energy

Chicago Mercantile Exchange (CME)

Chicago, USA

Livestock

New York Mercantile Exchange (NYMEX)

New York, USA Softs, Base Metals, Energy, Precious Metals

London Metal Exchange (LME)

London, UK

Base Metals

NYSE Euronext (Euronext)

Paris, France

Grains, Softs

Tokyo Commodity Exchange (TOCOM)

Tokyo, Japan

Softs, Base Metals, Energy, Precious Metals

Tokyo Grain Exchange (TGE)

Tokyo, Japan

Grains, Softs

Margin Requirements
To ensure the smooth running of the futures market, participants in a futures contract are
required to post a performance bond of sorts as a form of guarantee. This is known as the
margin. The amount of margin required can vary depending on the perceived volatility of the
underlying asset.

Futures Margins
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Participants in a futures contract are required to post performance bond margins in order to
open and maintain a futures position.
Futures margin requirements are set by the exchanges and are typically only 2 to 10 percent
of the full value of the futures contract.
Margins are financial guarantees required of both buyers and sellers of futures contracts to
ensure that they fulfill their futures contract obligations.

Initial Margin
Before a futures position can be opened, there must be enough available balance in the
futures trader's margin account to meet the initial margin requirement. Upon opening the
futures position, an amount equal to the initial margin requirement will be deducted from the
trader's margin account and transferred to the exchange's clearing firm. This money is held
by the exchange clearinghouse as long as the futures position remains open.

Maintenance Margin
The maintenance margin is the minimum amount a futures trader is required to maintain in
his margin account in order to hold a futures position. The maintenance margin level is
usually slightly below the initial margin.
If the balance in the futures trader's margin account falls below the maintenance margin
level, he or she will receive a margin call to top up his margin account so as to meet the
initial margin requirement.

Example
Let's assume we have a speculator who has $10000 in his trading account. He decides to
buy August Crude Oil at $40 per barrel. Each Crude Oil futures contract represents 1000
barrels and requires an initial margin of $9000 and has a maintenance margin level set at
$6500.

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Since his account is $10000, which is more than the initial margin requirement, he can
therefore open up one August Crude Oil futures position.
One day later, the price of August Crude Oil drops to $38 a barrel. Our speculator has
suffered an open position loss of $2000 ($2 x 1000 barrels) and thus his account balance
drops to $8000.
Although his balance is now lower than the initial margin requirement, he did not get the
margin call as it is still above the maintenance level of $6500.
Unfortunately, on the very next day, the price of August Crude Oil crashed further to $35,
leading to an additional $3000 loss on his open Crude Oil position. With only $5000 left in
his trading account, which is below the maintenance level of $6500, he received a call from
his broker asking him to top up his trading account back to the initial level of $9000 in order
to maintain his open Crude Oil position.
This means that if the speculator wishes to stay in the position, he will need to deposit an
additional $4000 into his trading account.
Otherwise, if he decides to quit the position, the remaining $5000 in his account will be
available to use for trading once again.

Long Futures Position

The long futures position is an unlimited profit, unlimited risk position that can be entered by
the futures speculator to profit from a rise in the price of the underlying.
The long futures position is also used when a manufacturer wishes to lock in the price of a
raw material that he will require sometime in the future. See long hedge.
Long Futures Position Construction

Buy 1 Futures Contract

To construct a long futures position, the trader must have enough balance in his account to
meet the initial margin requirement for each futures contract he wishes to purchase.

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Unlimited Profit Potential

There is no maximum profit for the long futures position. The futures trader stands to profit
as long as the underlying futures price goes up.
The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Market Price of Futures > Purchase Price of Futures

Profit = (Market Price of Futures - Purchase Price of Futures) x Contract Size

Unlimited Risk
Large losses can occur for the long futures position if the underlying futures price falls
dramatically.
The formula for calculating loss is given below:

Maximum Loss = Unlimited

Loss Occurs When Market Price of Futures < Purchase Price of Futures

Loss = (Purchase Price of Futures - Market Price of Futures) x Contract Size +

Commissions Paid

Breakeven Point(s)

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The underlier price at which break-even is achieved for the long futures position position can
be calculated using the following formula.

Breakeven Point = Purchase Price of Futures Contract

Example
Suppose June Crude Oil futures is trading at $40 and each futures contract covers 1000
barrels of Crude Oil. A futures trader enters a long futures position by buying 1 contract of
June Crude Oil futures at $40 a barrel.

Scenario #1: June Crude Oil futures rises to $50

If June Crude Oil futures instead rallies to $50 on delivery date, then the long futures
position will gain $10 per barrel. Since the contract size for Crude Oil futures is 1000
barrels, the trader will achieve a profit of $10 x 1000 = $10000.

Scenario #2: June Crude Oil futures drops to $30

If June Crude Oil futures is trading at $30 on delivery date, then the long futures position will
suffer a loss of $10 x 1000 barrel = $10000 in value.

Daily Mark-to-Market & Margin Requirement

The value of a long futures position is marked-to-market daily. Gains are credited and losses
are debited from the future trader's account at the end of each trading day.
If the losses result in margin account balance falling below the required maintenance level,
a margin call will be issued by the broker to the futures trader to top up his or her account in
order for the futures position to remain open.

Synthetic Long Futures

An equivalent position known as a synthetic long futures position can be constructed using
only options.

Short Futures Position

The short futures position is an unlimited profit, unlimited risk position that can be entered
by the futures speculator to profit from a fall in the price of the underlying.
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The short futures position is also used by a producer to lock in a price of a commodity that
he is going to sell in the future. See short hedge.
Short Futures Position Construction

Sell 1 Futures Contract

To create a short futures position, the trader must have enough balance in his account to
meet the initial margin requirement for each futures contract he wishes to sell.

Unlimited Profit Potential

There is no maximum profit for the short futures position. The futures trader stands to profit
as long as the underlying asset price goes down.
The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Market Price of Futures < Selling Price of Futures

Profit = (Selling Price of Futures - Market Price of Futures) x Contract Size

Unlimited Risk
Heavy losses can occur for the short futures position if the underlying asset price rises
dramatically.
The formula for calculating loss is given below:

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Maximum Loss = Unlimited

Loss Occurs When Market Price of Futures > Selling Price of Futures

Loss = (Market Price of Futures - Selling Price of Futures) x Contract Size +

Commissions Paid

Breakeven Point(s)
The underlier price at which break-even is achieved for the short futures position position
can be calculated using the following formula.

Breakeven Point = Selling Price of Futures Contract

Example
Suppose June Crude Oil futures is trading at $40 and each futures contract covers 1000
barrels of Crude Oil. A futures trader enters a short futures position by selling 1 contract of
June Crude Oil futures at $40 a barrel.

Scenario #1: June Crude Oil futures drops to $30

If June Crude Oil futures is trading at $30 on delivery date, then the short futures position
will gain $10 per barrel. Since the contract size for Crude Oil futures is 1000 barrels, the
trader will net a profit of $10 x 1000 = $10000.

Scenario #2: June Crude Oil futures rises to $50

If June Crude Oil futures instead rallies to $50 on delivery date, then the short futures
position will suffer a loss of $10 x 1000 barrel = $10000 in value.

Daily Mark-to-Market & Margin Requirement

The value of a short futures position is marked-to-market daily. Gains are credited and
losses are debited from the future trader's account at the end of each trading day.
If the losses result in margin account balance falling below the required maintenance level,
a margin call will be issued by the broker to the futures trader to top up his or her account in
order for the futures position to remain open.

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Synthetic Short Futures

An equivalent position known as a synthetic short futures position can be constructed using
only options.

Long Hedge
The long hedge is a hedging strategy used by manufacturers and producers to lock in the
price of a product or commodity to be purchased some time in the future. Hence, the long
hedge is also known as input hedge.
The long hedge involves taking up a long futures position. Should the underlying commodity
price rise, the gain in the value of the long futures position will be able to offset the increase
in purchasing costs.

Long Hedge Example

In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in
September. Let's assume that the total amount of wheat needed to produce the flour is
50000 bushels. Based on the agreed selling price for the flour, the flour maker calculated
that he must purchase wheat at $7.00/bu or less in order to breakeven.
At that time, wheat is going for $6.60 per bushel at the local elevator while September
Wheat futures are trading at $6.70 per bushel, and the flour maker wishes to lock in this
purchase price. To do this, he enters a long hedge by buying some September Wheat
futures.
With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures
contracts to hedge his projected 50000 bushels requirement.
In August, the manufacturing process begins and the flour maker need to purchase his
wheat supply from the local elevator. However, the price of wheat have since gone up and at
the local elevator, the price has risen to $7.20 per bushel. Correspondingly, prices of
September Wheat futures have also risen and are now trading at $7.27 per bushel.

Loss in Cash Market...

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Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose
$0.20/bu. At 50000 bushels, he will lose $10000 in the cash market.
So for all his efforts, the flour maker might have ended up with a loss of $10000.

... is Offset by Gain in Futures Market.

Fortunately, he had hedge his input with a long position in September Wheat futures which
have since gained in value.
Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts
= $335000
Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts =
$363500
Net Gain in Futures Market = $363500 - $335000 = $28500
Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500
Hence, with the long hedge in place, the flour maker can still manage to make a profit of
$18500 despite rising Wheat prices.

Basis Risk
The long hedge is not perfect. In the above example, while cash prices have risen by
$0.60/bu, futures prices have only gone up by $0.57/bu and so the long futures position
have only managed to offset 95% of the rise in price. This is due to the strengthening of the
basis.
Cash

September Futures

Basis

May

$6.60

$6.70

-$0.10

August

$7.20

$7.27

-$0.07

Net

-$0.60/bu

+$0.57/bu

+$0.03 (Stengthened by $0.03)

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The basis tracks the relationship between the cash market and the futures market. Hedgers
should pay attention to the basis when deciding when to enter the hedge as they are said to
have taken up a position in the basis once a hedge is in place. See basis.

Short Hedge
The short hedge is a hedging strategy used by manufacturers and producers to lock in the
price of a product or commodity to be delivered some time in the future. Hence, the short
hedge is also known as output hedge.
The short hedge involves taking up a short futures position while owning the underlying
product or commodity to be delivered. Should the underlying commodity price fall, the gain
in the value of the short futures position will be able to offset the drop in revenue from the
sale of the underlying.

Short Hedge Example

In March, a wheat farmer is planning to plant 100000 bushels of wheat, which will be ready
for harvesting by late August and delivery in September. The farmer knows from past years
that the total cost of planting and harvesting the crops is about $6.30 per bushel.
At that time, September Wheat futures are trading at $6.70 per bushel, and the wheat
farmer wishes to lock in this selling price. To do this, he enters a short hedge by selling
some September Wheat futures.
With each Wheat futures contract covering 5000 bushels, he will need to sell 20 futures
contracts to hedge his projected 100000 bushels production.
By mid-August, his wheat crops are ready for harvesting. However, the price of wheat have
since fallen and at the local elevator, the price has dropped to $6.20 per bushel.
Correspondingly, prices of September Wheat futures have also fallen and are now trading at
$6.33 per bushel.

Loss in Cash Market...

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Selling his harvest of 100000 bushels of wheat at the local elevator yields $6.20/bu x
100000 bushels = $620000.
But the cost of growing the crops is $6.30/bu x 100000 bushels = $630000
Hence, his net profit from the farming business = Revenue Yield - Cost of Growing Crops =
$620000 - $630000 = -$10000
For all his efforts, the wheat farmer might have ended up with a loss of $10000.

... is Offset by Gain in Futures Market.

Fortunately, he had hedge his output with a short position in September Wheat futures
which have since gained in value.
Value of Wheat futures Sold in March = $6.70 x 20 contracts x 5000 bushels = $670000
Value of Wheat futures Purchased in August = $6.33 x 20 contracts x 5000 bushels =
$633000
Net Gain in Futures Market = $670000 - $633000 = $37000
Overall profit = Gain in Futures Market - Loss in Cash Market = $37000 - $10000 = $27000
Hence, with the short hedge in place, the farmer can still manage to make a profit of $27000
despite falling Wheat prices.

Basis Risk
The short hedge is not perfect. In the above example, while cash prices have fallen by
$0.40/bu, futures prices have only dropped by $0.37/bu and so the short futures position
have only managed to offset 92.5% of the drop in price. This is due to the weakening of the
basis.
Cash

September Futures

Basis

March

$6.60

$6.70

-$0.10

August

$6.20

$6.33

-$0.13

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Net

-$0.40/bu

+$0.37/bu

-$0.03 (Weakened by $0.03)

The basis tracks the relationship between the cash market and the futures market. Hedgers
should pay attention to the basis when deciding when to enter the hedge as they are said to
have taken up a position in the basis once a hedge is in place. See basis.
Next: Futures Basis

Futures Basis
The basis reflects the relationship between cash price and futures price. (In futures trading,
the term "cash" refers to the underlying product). The basis is obtained by subtracting the
futures price from the cash price.
The basis can be a positive or negative number. A positive basis is said to be "over" as the
cash price is higher than the futures price. A negative basis is said to be "under" as the cash
price is lower than the futures price.

Basis Calculation Example

Spot (Cash) Price

$42

August Futures Price

$47

Basis

-5 (In market lingo, the basis is "$5 under August".)

Strong or Weak Basis

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The basis changes from time to time. If the basis gains in value (say from -4 to -1), we say
the basis has strengthened. On the other hand, if basis drops in value (say from 8 to 2), we
say the basis has weakened.
Short term demand and supply situations are generally the main factors responsible for the
change in the basis. If demand is strong and the available supply small, cash prices could
rise relative to futures price, causing the basis to strengthen. On the other hand, if the
demand is weak and a large supply is available, cash prices could fall relative to the futures
price, causing the basis to weaken.
However, although the basis can and does fluctuate, it is still generally less volatile than
either the cash or futures price.

Basis Risk
Basis risk is the chance that the basis will have strengthened or weakened from the time the
hedge is implemented to the time when the hedge is removed. Hedgers are exposed to
basis risk and are said to have a position in the basis.

Long Basis Position

A long basis position stand to gain from a strengthening basis. Short hedges have a long
basis position.

Short Basis Position

A short basis position stand to gain from a weakening basis. Long hedges have a short
basis position.

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