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Commodities and Financial Futures

12/21/2016

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We are publishing today an article on commodities and financial futures. We focus at the Traders' Lounge mostly on the currency markets by looking at charts through the lens of a methodology revolving around median lines. Using a consistent framework allows one to develop an edge. However without the ability to capture this edge traders and investors are missing one key piece of the puzzle needed to achieve consistency. This last piece of the puzzle can only be mastered individually by trial and error and self observation. By exploring other markets and vehicles one might discover something better suited to capture their edge in its broadest sense: (i) trading strategy, (ii) risk tolerance, (iii) risk profile which can vary for reasons like the size of the account, skill development, maturity, etc.
So If you ever wanted to explore other trading opportunities besides spot FX but didn't know where to start, today we'll delve into the world of commodities and financial futures and cover the basics relating to futures trading, commodities futures, financial futures and options on futures.

This article is meant to be a practical guide to get you started and should give you enough information to build on to make further research.

Introduction

What is a Futures Contract?
Futures are traded on exchanges - Exchanges are SROs (Self Regulatory Organizations) and are registered. Each exchange has its own rules.

Trading futures on exchanges means you will have to be aware of price limits, position limits and clearinghouses.
​
Price limits = the max. daily price increase/decrease that the exchange allows. Price will be frozen but no trading. The idea behind is to limit price volatility. Not all exchange have price limits. Limits can be adjusted as a consequence of price volatility. One more thing, these limits do not guarantee you the ability to close a position within the range of the limit.

Price Limits
The Clearinghouses (i) match buy & sell trades, (ii) collect margins and (iii) report trading volume. The Clearinghouses guarantee futures trades. They are the counterparty on all trades.
Almost all futures positions will be liquidated before the delivery date. If a future is held to its delivery date then delivery of the commodity is mandatory.

In spot FX the minimum price change is mostly known as a pip. In futures the term tick is used (perfectly appropriate for Spot FX also). The tick value changes from contract to contract and is set by the exchanges. Again, you can draw some parallels with Spot FX: think of the different pip value when you go long/short 1 lot of EUR/USD with 1 lot of EUR/GBP.

Currency and interest futures are traded on the IMM - International Monetary Market.
​
​Minimum Price Fluctuation (Tick)

Most of the order types will probably already be familiar to you. The most important ones being: Market Orders, Limit Orders, Stop Orders, Day Orders, GTC Orders (Good til Cancelled), Stop Limit Orders, MIF Orders (Market if Touched), FOK Orders (Fill or Kill), IOC Orders (Immediate or Cancel) and AON Orders (All or None).

One brief word regarding regulation. The Commodity Exchange Act (1936) set the start of the regulatory framework governing futures trading on exchanges. The futures markets are regulated by the CFTC (The Commodity Futures Trading Commission), the NFA (National Futures Association) and the futures exchanges.
​
  • CFTC
  • NFA
  • Futures Exhanges
<
>
Futures contracts are legally binding contracts to buy or sell an underlying for delivery at a future date. The clearinghouse associated with the exchange is the guarantor on the trades once a trade is executed on that exchange. All futures contracts are standardized. This means that futures contracts all have specifications like:
  • contract size
  • tick size
  • delivery month
  • settlement
  • last trading date
  • underlying
  • delivery process
  • ticker symbol
  • trading hours
  • CUSIP number which stands for Committee on Uniform Securities Identification Procedures that helps to identify securities.
The only property not standardized is margin requirements. Futures traders need to know and monitor initial margin levels as well as maintenance margin levels.
​
Margin

Futures Months

JAN
F
FEB
G
MAR
H
APR
J
MAY
K
JUN
M
JUL
N
AUG
Q
SEP
U
OCT
V
NOV
X
DEC
Z
Contract Codes
FX Final Settlement And Delivery
If you deal with futures you will also need about the Basis - specifically in commodities futures. The Basis is simply the difference between the cash price of the commodity and its future price.
Basis = Cash - Futures
A normal market will have a Negative Basis i.e. the future price of the commodity higher than the cash price. A Negative Basis is also being refered as the basis being under. Granted, this is more relevant to you if you are in the business of hedging or are a spreader.

Other terminolgy you might relate to is when describing markets as being in Contango or in Backwardation (sometimes also Backwardization).
  • A Normal market is a Contago market = cash price lower than futures price. 
  • An Inverted market or Backwardation market = cash price higher than futures price.

Why a Normal market? because the difference between cash and futures is the result of the carrying charges (insurrance, storage, etc..) and the underlying change in value.

An Inverted market points towards a tight market supply.
​
​
Equity Index Basis

Commodities

Commodities are traded in the cash / spot market.
The cash / spot market = real word where people by and sell physical commodities
Commodities are the underlying assets for many futures contracts. Here are some of the most common ones:
  • Agricultural commodities: wheat, corn, oats, soybeans, cocoa, sugar, coffee
  • Livestock: live cattle, feeder cattle, hogs, pork belies
  • Energy: crude oil, heating oil, natural gas
  • Precious metals: gold, silver, copper, platanium

Grains: Corn (/ZC), Wheat (/ZW), Soybeans (/ZS), Oats (/ZO)
Contract size: 5000 bushels
The contract value is thus  5000 x price per unit. So if  corn is quoted at 210.40 cents that translates into  $2.1040 x 5000 bushels = $10'520

Soft commodities: Orange juice (/OJ), Coffee (/KC), Sugar (/SB), Cocoa (/CJ)
  • Orange juice contract size: 15'000 lbs
  • Coffee contract size: 37'500 lbs
  • Sugar contract size: 112'000 lbs
The contract value is thus  contract size x price per unit. So if sugar is quoted at 124.80 that translates into  $1.2480 x 112'000 = $139'776
​


Livestock: Pork bellies (/PB), Lean hogs (/HE), Live cattle (/LE), Feeder cattle (/GF)
  • Pork bellies, Lean hogs and Live cattle contract size: 40'000 lbs
  • Feed cattle contract size: 50'000 lbs 
The contract value is thus  contract size x price per unit. So if Live cattle is quoted at $58.50 that translates into  $0.5850 x 40'000 = $23'400
​

Energy: Crude Oil (/CL), Heating Oil (/HO) and Gasoline (/RB)
  • Crude Oil contract size: 1'000 barrels
  • Heating Oil and Gasoline contract size: 42'000 gallons
The contract value is thus  contract size x price per unit. So if Crude Oil is quoted at $55.20 that translates into $55.20 x 1'000 = $55'200
​

If you trade FX you'll probably be acquainted with gold and silver. However be aware that your broker can offer you access to PMs through the Futures Market (GC and SI contracts on the COMEX) or through spot (e.g XAU/USD) and/or through CFDs if you reside outside of the U.S.
​

Metals: Gold (/GC), Silver (/SI), Copper (/HG)
  • Gold contract size: 100 troy oz.
  • Silver contract size: 5'000 troy oz.
  • Copper contract size: 25'000 lbs
​
The contract value is thus  contract size x price per unit. So if ​ Gold is quoted at $1350 that translates into  $1350 x 100 = $135'000
​


Contract Unit and Notional Value

Financial Futures

What about financial futures? Essentially, there are three main underlying asset in financial futures:
  • debt securities
  • equity securities
  • foreign currencies
There are multiple financial product available for the same underlying. For example: trading indices like the Dow Jones Industrial Average, S&P500 Composite Index or the Nasdaq 100 Index can be done through futures, CFDs or ETPs to name the most commons.

Note: if you trader through futures, know that stock index futures are settled in cash at the close of business on the (contract) specified final settlement date.
​
In the case of stock index futures, basis refers to the difference between the stock index value and the price of the stock index futures contract.
​
Trading Options on Futures VS ETFs

Equitiy Indices

Product
E-Mini
Nasdaq
Dow Jones
Nikkei 225
Symbol
/ES
/NQ
/YM
/NKD
1 point $ value
$50
$20
$5
$500
min. tick
$0.25
$0.25
$1
$5

What are other Financial Futures worth mentioning:
  • Treasury Bills / T-Bills
  • Treasury Bonds (/ZB)
  • Treasury Notes (/ZT)
  • Eurodollar futures (/GE)
  • Index futures (/ES, /NQ, /YM...)
  • Currency futures (/6E, /6B, /6J...)
Each instruments have their own specifications. 
  • T-Bills are traded on the CBOT - contract size is $1'000'000
  • Treasury Bonds, Treasury Notes and GNMAs - contract size $100'000
  • Eurodollar - contract size $1'000'000
From the CME (pdf): Understanding Treasury Futures
​

  • 10 Year
  • 30 Year​
  • Libor
<
>
Credio | Graphiq
Credio | Graphiq
FindTheData | Graphiq

​The Eurodollar market should be worthy of your attention.  Not to be confused with the Euro/Dollar i.e the EUR/USD FX pair, the Eurodollar is basically the interest rate on U.S. Dollars held outside of the USA. Note below the liquidity of eurodollar contract

To put trading volumes numbers into perspective:
  • Euro FX Futures: 500-700k contracts traded per day
  • Euro FX Options: 20k-30k contracts traded per day
  • Crude Oil Futures: in the 1.2- 1.5 million contracts traded per day
  • Crude Oil Options: 250k-300k contracts per day    
  • Gold Futures: 270k-320k contracts per day
  • Gold Options: 60k-100k contracts per day
  • Eurodollar Futures: 7.4-7.7 million contracts traded per day
  • Eurodollar Options: 1.4-1.7 million contracts traded per day

From the CME (pdf): Understanding Eurodollar Futures
From Quandl: CME Eurodollar Futures (ED)
Eurodollar

Options on Futures

As the name implies, futures are the underlying of Options on Futures. 
Futures Options vs Equity Options
  • Options on Stocks -> stocks underlying
  • Options in Futures -> futures underling

You will have to familiarize yourself with expiration cycles: some futures expire to cash other expire to the underlying futures contract.

What happens at the set exercise with Options on futures?
  • If you are a call buyer you will be assigned a long future
  • If you are a call seller you will be assigned a short future
  • If you are a put buyer you will be assigned a short future
  • If you are a put seller you will be assigned a long future

Everything else you know about options applies of course to options on futures like the premium (determined by intrinsic value, time value, volatility, interest rates)

As with all options the risk profiles differs significantly depending if you buy or write an option i.e. an option buyer loss is limited to option premium; an option seller can generate income by cashing the premium but is exposed to potentially unlimited limited risk.

​Options on Futures can be great vehicles, however one aspect you want to consider / keep an eye on when dealing with Options on Futures is liquidity. The liquidity profile between Options on Futures vs the underlying can differ substantially. Observe and study.

If you come from the Spot FX space, you might want to consider Options on currency futures which can be a great tool if you want to hold positions over the weekend-end without worrying about market risk like you would be subject to with Spot / Futures / CFDs positions. Clearly a question of overall position leverage.

You might run into terms like Synthetic positions which you might already have encountered in Spot FX. You could build for instance a synthetic long GBP/JPY position: This would be done by going long GBP/USD (1st leg) and long USD/JPY (2nd leg).
​
Synthetic Options positions:
Synthetic Long Put  ->  Equivalent = Short futures / long call
Synthetic Long Call  ->  Equivalent = Long futures / long put
Synthetic Futures positions:
​Synthetic Long Future  ->  Equivalent  = Long Call & Short Put (same strike & exp. date)
Synthetic Short Future  ->  Equivalent  = Long Put and Short Call (same strike & exp. date)

Common option strategies include:
  • Vanilla: just buying puts or buying calls
  • Spreads: a basic spread position is a long and short position (call or put) on the same underlying 
  • Straddles: a position with an equal number of puts and calls

There are plenty of options' strategies articles out there going into much furter detail. For now remember the following:
  • Spreads: Bull spreads make money form a rise in the underlying; Bear spread from a decline in the underlying. Spreads enable limitation of risk. Risk is capped, so ismax. profit potential.  A speculator will put on a spread if he has a directional bias. Spreads are not expected to be exercised.
  • Long straddle: speculator expects a big move but unsure of the direction. Risk is limited to the paid up premiums
  • Short straddle: speculator expects future price to remain neutral; makes money from the premium received. Risk unlimited

Other Spread strategies include: Bull Spread, Bear Spread, Calendar Spread, Vertical Spread, Vertical Bull/Bear Call/Bear Spread, Diagonal Spread and Butterfly Spread.
​

Options on Futures: Understanding the Underlying Futures Contract of an Option
Options on Futures: Contract Details
Options on Futures: Theoretical Pricing Models

Futures Margin


The margin you post with your broker that you will use for leverage trading/speculation is actually not a loan from the broker but  a performance bond. Understand that the deposited margin represents the amount to insure performance of the contract. This performance bond covers the default risk. It is not a downpayment. When you trade a contract, you  (i.e. the buyer or the seller) becomes liable for the full cash market value of the traded contract.
There are two types of margin deposits: clearing margins and customer margins.
  • Clearing margins are deposits your Futures Commission Merchants makes the clearinghouse in order to ensure performance of their clients' positions. Initial margin is set by the clearinghouses. Variation margin can result from market fluctuations and is due within one hour.
  • Customer margins are what your FCM requires you to deposit with the firm to buy or sell contracts.
​
Margins are different from contract to contract. The requirements are usually the same whether you go long or short. ​​Both initial margin and the maintenance margin requirements are set by the board of directors of the futures exchanges.
A maintenance margin is the minimum margin required per outstanding contract to be available on the trading account (usually about 75% of the initial margin).
Regarding margin calls: The margin due is based on the settlement price. (*)Settlement price is always the price of the last trade of a trading day. The position may be partly or entirely closed out by the FCM if a customer does not meet a call for additional margin within a certain timeframe.
​(*) Settlement refers to the Clearinghouse's marking to market calculations i.e. adjusting futures accounts for daily gains and losses
Mark to Market

That covers our introduction to commodities and financial futures. We hope that this overview was helpful to you and that it genereated some ideas for you to research further.

***This article was updated on October 16, 2017 with video content made publicly available by the CME GROUP***

Hashtags: #Futures, #Commodities, #FinancialFutures, #CommiditiesFutures, #Clearinghouses, #OrderTypes, #IMM, #FuturesMonths, #InvertedMarket, #NormalMarket, #CarryingCharges, #Backwardation, #Backwardization, #Contango, #Basis, #PreciousMetals, #Grains, #SoftCommodities, #Livestock, #Energy, #EquitySecurities, #DebtSecurities, #LiborFutures, #CurrencyFutures, #IndexFutures, #GNMAs, #Eurodollar, #TreasuryNotes, #TBills, #TreasuryBonds, #SyntheticFutures, #SuntheticOptions, #Spreads, #Straddles, #Vanilla, #OptionsOnFutures, #Options, #Margin, #MarginTrading, #CME, #CMEGROUP, @CMEGroup

​
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