Futures 101

Now that you have an overview of what futures markets are, why they exist and how they work, the next step is to consider various ways in which you may be able to participate in futures trading. There are a number of alternatives and the only best alternative—if you decide to participate at all—is whichever one is best for you. Also discussed is the opening of a futures trading account, the regulatory safeguards provided participants in futures markets, and methods for resolving disputes, should they arise.

At the risk of oversimplification, choosing a method of participation is largely a matter of deciding how directly and extensively you, personally, want to be involved in making trading decisions and managing your account. Many futures traders prefer to do their own research and analysis and make their own decisions about what and when to buy and sell. That is, they manage their own futures trades in much the same way they would manage their own stock portfolios. Others choose to rely on or at least consider the recommendations of a brokerage firm or account executive. Some purchase independent trading advice. Others would rather have someone else be responsible for trading their account and therefore give trading authority to their broker. Still others purchase an interest in a commodity trading pool.

There's no formula for deciding. Your decision should, however, take into account such things as your knowledge of and any previous experience in futures trading, how much time and attention you are able to devote to trading, the amount of capital you can afford to commit to futures, and, by no means least, your individual temperament and tolerance for risk. The latter is important. Some individuals thrive on being directly involved in the fast pace of futures trading, others are unable, reluctant, or lack the time to make the immediate decisions that are frequently required. Some recognize and accept the fact that futures trading all but inevitably involves having some losing trades. Others lack the necessary disposition or discipline to acknowledge that they were wrong on this particular occasion and liquidate the position.

Many experienced traders thus suggest that, of all the things you need to know before trading in futures contracts, one of the most important is to know yourself. This can help you make the right decision about whether to participate at all and, if so, in what way.

In no event, it bears repeating, should you participate in futures trading unless the capital you would commit its risk capital. That is, capital which, in pursuit of larger profits, you can afford to lose. It should be capital over and above that needed for necessities, emergencies, savings and achieving your long-term investment objectives. You should also understand that, because of the leverage involved in futures, the profit and loss fluctuations may be wider than in most types of investment activity and you may be required to cover deficiencies due to losses over and above what you had expected to commit to futures.

This involves opening your individual trading account and—with or without the recommendations of the brokerage firm—making your own trading decisions. You will also be responsible for assuring that adequate funds are on deposit with the brokerage firm for margin purposes, or that such funds are promptly provided as needed.

Practically all of the major brokerage firms you are familiar with, and many you may not be familiar with, have departments or even separate divisions to serve clients who want to allocate some portion of their investment capital to futures trading. All brokerage firms conducting futures business with the public must be registered with the Commodity Futures Trading Commission (CFTC, the independent regulatory agency of the federal government that administers the Commodity Exchange Act) as Futures Commission Merchants or Introducing Brokers and must be Members of National Futures Association (NFA, the industry wide self-regulatory association).

Different firms offer different services. Some, for example, have extensive research departments and can provide current information and analysis concerning market developments as well as specific trading suggestions. Others tailor their services to clients who prefer to make market judgments and arrive at trading decisions on their own. Still others offer various combinations of these and other services.

An individual trading account can be opened either directly with a Futures Commission Merchant or indirectly through an Introducing Broker. Whichever course you choose, the account itself will be carried by a Futures Commission Merchant, as will your money. Introducing Brokers do not accept or handle customer funds but most offer a variety of trading-related services.

Futures Commission Merchants are required to maintain the funds and property of their customers in segregated accounts, separate from the firm's own money.

Along with the particular services a firm provides, discuss the commissions and trading costs that will be involved. And, as mentioned, clearly understand how the firm requires that any margin calls be met. If you have a question about whether a firm is properly registered with the CFTC and is a Member of NFA, you can (and should) contact NFA's Information Center toll-free at 800-621-3570 (within Illinois call 800-572-9400).

A managed account is also your individual account. The major difference is that you give someone rise—an account manager—written power of attorney to make and execute decisions about what and when to trade. He or she will have discretionary authority to buy or sell for your account or will contact you for approval to make trades he or she suggests. You, of course, remain fully responsible for any losses which may be incurred and, as necessary, for meeting margin calls, including making up any deficiencies that exceed your margin deposits.

Although an account manager is likely to be managing the accounts of other persons at the same time, there is no sharing of gains or losses of other customers. Trading gains or losses in your account will result solely from trades which were made for your account.

Many Futures Commission Merchants and Introducing Brokers accept managed accounts. In most instances, the amount of money needed to open a managed account is larger than the amount required to establish an account you intend to trade yourself. Different firms and account managers, however, have different requirements and the range can be quite wide. Be certain to read and understand all of the literature and agreements you receive from the broker.

Some account managers have their own trading approaches and accept only clients to whom that approach is acceptable. Others tailor their trading to a client's objectives. In either case, obtain enough information and ask enough questions to assure yourself that your money will be managed in a way that's consistent with your goals.

Discuss fees. In addition to commissions on trades made for your account, it is not uncommon for account managers to charge a management fee, and/or there may be some arrangement for the manager to participate in the net profits that his management produces. These charges are required to be fully disclosed in advance. Make sure you know about every charge to be made to your account and what each charge is for.

While there can be no assurance that past performance will be indicative of future performance, it can be useful to inquire about the track record of an account manager you are considering. Account managers associated with a Futures Commission Merchant or Introducing Broker must generally meet certain experience requirements if the account is to be traded on a discretionary basis.

Finally, take note of whether the account management agreement includes a provision to automatically liquidate positions and close out the account if and when losses exceed a certain amount. And, of course, you should know and agree on what will be done with profits, and what, if any, restrictions apply to withdrawals from the account.

As the term implies, a Commodity Trading Advisor is an individual (or firm) that, for a fee, provides advice on commodity trading, including specific trading recommendations such as when to establish a particular long or short position and when to liquidate that position. Generally, to help you choose trading strategies that match your trading objectives, advisors offer analyses and judgments as to the prospective rewards and risks of the trades they suggest. Trading recommendations may be communicated by phone, wire or mail. Some offer the opportunity for you to phone when you have questions and some provide a frequently updated hotline you can call for a recording of current information and trading advice.

Even though you may trade on the basis of an advisor's recommendations, you will need to open your own account with, and send your margin payments directly to, a Futures Commission Merchant. Commodity Trading Advisors cannot accept or handle their customers funds unless they are also registered as Futures Commission Merchants.

Some Commodity Trading Advisors offer managed accounts. The account itself, however, must still be with a Futures Commission Merchant and in your name, with the advisor designated in writing to make and execute trading decisions on a discretionary basis.

CFTC Regulations require that Commodity Trading Advisors provide their customers, in advance, with what is called a Disclosure Document. Read it carefully and ask the Commodity Trading Advisor to explain any points you don't understand. If your money is important to you, so is the information contained in the Disclosure Document!

The prospectus-like document contains information about the advisor, his experience and, by no means least, his current (and any previous) performance records. If you use an advisor to manage your account, he must first obtain a signed acknowledgment from you that you have received and understood the Disclosure Document. As in any method of participating in futures trading, discuss and understand the advisor's fee arrangements. And if he will be managing your account, ask the same questions you would ask of any account manager you are considering.

Commodity Trading Advisors must be registered as such with the CFTC, and those that accept authority to manage customer accounts must also be Members of NFA. You can verify that these requirements have been met by calling NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400).

Another alternative method of participating in futures trading is through a commodity pool, which is similar in concept to a common stock mutual fund. It is the only method of participation in which you will not have your own individual trading account. Instead, your money will be combined with that of other pool participants and, in effect, traded as a single account. You share in the profits or losses of the pool in proportion to your investment in the pool. One potential advantage is greater diversification of risks than you might obtain if you were to establish your own trading account. Another is that your risk of loss is generally limited to your investment in the pool, because most pools are formed as limited partnerships. And you won't be subject to margin calls.

Bear in mind, however, that the risks which a pool incurs in any given futures transaction are no different than the risks incurred by an individual trader. The pool still trades in futures contracts which are highly leveraged and in markets which can be highly volatile. And like an individual trader, the pool can suffer substantial losses as well as realize substantial profits. A major consideration, therefore, is who will be managing the pool in terms of directing its trading.

While a pool must execute all of its trades through a brokerage firm which is registered with the CFTC as a Futures Commission Merchant, it may or may not have any other affiliation with the brokerage firm. Some brokerage firms, to serve those customers who prefer to participate in commodity trading through a pool, either operate or have a relationship with one or more commodity trading pools. Other pools operate independently.

A Commodity Pool Operator cannot accept your money until it has provided you with a Disclosure Document that contains information about the pool operator, the pool's principals and any outside persons who will be providing trading advice or making trading decisions. It must also disclose the previous performance records, if any, of all persons who will be operating or advising the pool lot, if none, a statement to that effect). Disclosure Documents contain important information and should be carefully read before you invest your money. Another requirement is that the Disclosure Document advise you of the risks involved.

In the case of a new pool, there is frequently a provision that the pool will not begin trading until (and unless) a certain amount of money is raised. Normally, a time deadline is set and the Commodity Pool Operator is required to state in the Disclosure Document what that deadline is (or, if there is none, that the time period for raising, funds is indefinite). Be sure you understand the terms, including how your money will be invested in the meantime, what interest you will earn (if any), and how and when your investment will be returned in the event the pool does not commence trading.

Determine whether you will be responsible for any losses in excess of your investment in the pool. If so, this must be indicated prominently at the beginning of the pool's Disclosure Document.

Ask about fees and other costs, including what, if any, initial charges will be made against your investment for organizational or administrative expenses. Such information should be noted in the Disclosure Document. You should also determine from the Disclosure Document how the pool's operator and advisor are compensated. Understand, too, the procedure for redeeming your shares in the pool, any restrictions that may exist, and provisions for liquidating and dissolving the pool if more than a certain percentage of the capital were to be lost.

Ask about the pool operator's general trading philosophy, what types of contracts will be traded, whether they will be day-traded, etc.

With few exceptions, Commodity Pool Operators must be registered with the CFTC and be Members of NFA. You can verify that these requirements have been met by contacting NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400).

Firms and individuals that conduct futures trading business with the public are subject to regulation by the CFTC and by NFA. All futures exchanges are also regulated by the CFTC. NFA is a congressionally authorized self-regulatory organization subject to CFTC oversight. It exercises regulatory authority with the CFTC over Futures Commission Merchants, Introducing Brokers, Commodity Trading Advisors, Commodity Pool Operators and Associated Persons (salespersons) of all of the foregoing.

The NFA staff consists of more than 140 field auditors and investigators. In addition, NFA has the responsibility for registering persons and firms that are required to be registered with the CFTC. Firms and individuals that violate NFA rules of professional ethics and conduct or that fail to comply with strictly enforced financial and record-keeping requirements can, if circumstances warrant, be permanently barred from engaging in any futures-related business with the public.

The enforcement powers of the CFTC are similar to those of other major federal regulatory agencies, including the power to seek criminal prosecution by the Department of Justice where circumstances warrant such action. Futures Commission Merchants which are members of an exchange are subject to not only CFTC and NFA regulation but to regulation by the exchanges of which they are members. Exchange regulatory staffs are responsible, subject to CFTC oversight, for the business conduct and financial responsibility of their member firms. Violations of exchange rules can result in substantial fines, suspension or revocation of trading privileges, and loss of exchange membership.

Words of Caution

It is against the law for any person or firm to offer futures contracts for purchase or sale unless those contracts are traded on one of the nation's regulated futures exchanges and unless the person or firm is registered with the CFTC. Moreover, persons and firms conducting futures-related business with the public must be Members of NFA. Thus, you should be extremely cautious if approached by someone attempting to sell you a commodity-related investment unless you are able to verify that the offer or is registered with the CFTC and is a Member of NFA.

In a number of cases, sellers of illegal off-exchange futures contracts have labeled their investments by different names—such as "deferred delivery," "forward" or "partial payment" contracts—in an attempt to avoid the strict laws applicable to regulated futures trading. Many operate out of telephone boiler rooms, employ high-pressure and misleading sales tactics, and may state that they are exempt from registration and regulatory requirements. This, in itself, should be reason enough to conduct a check before you write a check. You can quickly verify whether a particular firm or person is currently registered with the CFTC and is an NFA Member by phoning NFA toll-free at 800-621-3570 (within Illinois call 800-572-9400).

At the time you apply to establish a futures trading account, you can expect to be asked for certain information beyond simply your name, address and phone number. The requested information will generally include (but not necessarily be limited to) your income, net worth, what previous investment or futures trading experience you have had, and any other information needed in order to advise you of the risks involved in trading futures contracts. At a minimum, the person or firm who will handle your account is required to provide you with risk disclosure documents or statements specified by the CFTC and obtain written acknowledgment that you have received and understood them.

Opening a futures account is a serious decision—no less so than making any major financial investment—and should obviously be approached as such. Just as you wouldn't consider buying a car or a house without carefully reading and understanding the terms of the contract, neither should you establish a trading account without first reading and understanding the Account Agreement and all other documents supplied by your broker. It is in your interest and the firm's interest that you dearly know your rights and obligations as well as the rights and obligations of the firm with which you are dealing before you enter into any futures transaction.

If you have questions about exactly what any provisions of the Agreement mean, don't hesitate to ask. A good and continuing relationship can exist only if both parties have, from the outset, a clear understanding of the relationship. Nor should you be hesitant to ask, in advance, what services you will be getting for the trading commissions the firm charges.

As indicated earlier, not all firms offer identical services. And not all clients have identical needs. If it is important to you, for example, you might inquire about the firm's research capability, and whatever reports it makes available to clients. Other subjects of inquiry could be how transaction and statement information will be provided, and how your orders will be handled and executed.

All but a small percentage of transactions involving regulated futures contracts take place without problems or misunderstandings. However, in any business in which some 150 million or more contracts are traded each year, occasional disagreements are inevitable. Obviously, the best way to resolve a disagreement is through direct discussions by the parties involved. Failing this, however, participants in futures markets have several alternatives (unless some particular method has been agreed to in advance). Under certain circumstances, it may be possible to seek resolution through the exchange where the futures contracts were traded. Or a claim for reparations may be filed with the CFTC. However, a newer, generally faster and less expensive alternative is to apply to resolve the disagreement through the arbitration program conducted by National Futures Association. There are several advantages:

• You can elect, if you prefer, to have arbitrators who have no connection with the futures industry.
• You do not have to allege or prove that any law or rule was broken only that you were dealt with improperly or unfairly.
• In some cases, it may be possible to conduct arbitration entirely through written submissions. If a hearing is required, it can generally be scheduled at a time and place convenient for both parties.
• Unless you wish to do so, you do not have to employ an attorney.

Whatever type of investment you are considering—including but not limited to futures contracts—it makes sense to begin by obtaining as much information as possible about that particular investment. The more you know in advance, the less likely there will be surprises later on. Moreover, even among futures contracts, there are important differences which—because they can affect your investment results—should be taken into account in making your investment decisions.

Delivery-type futures contracts stipulate the specifications of the commodity to be delivered (such as 5,000 bushels of grain, 40,000 pounds of livestock, or 100 troy ounces of gold). Foreign currency futures provide for delivery of a specified number of marks, francs, yen, pounds or pesos. U.S. Treasury obligation futures are in terms of instruments having a stated face value (such as $100,000 or $1 million) at maturity. Futures contracts that call for cash settlement rather than delivery are based on a given index number times a specified dollar multiple. This is the case, for example, with stock index futures. Whatever the yardstick, it's important to know precisely what it is you would be buying or selling, and the quantity you would be buying or selling.

Futures prices are usually quoted the same way prices are quoted in the cash market (where a cash market exists). That is, in dollars, cents, and sometimes fractions of a cent, per bushel, pound or ounce; also in dollars, cents and increments of a cent for foreign currencies; and in points and percentages of a point for financial instruments. Cash settlement contract prices are quoted in terms of an index number, usually stated to two decimal points. Be certain you understand the price quotation system for the particular futures contract you are considering.

Exchanges establish the minimum amount that the price can fluctuate upward or downward. This is known as the "tick" For example, each tick for grain is 0.25 cents per bushel. On a 5,000 bushel futures contract, that's $12.50. On a gold futures contract, the tick is 10 cents per ounce, which on a 100 ounce contract is $10. You'll want to familiarize yourself with the minimum price fluctuation—the tick size—for whatever futures contracts you plan to trade. And, of course, you'll need to know how a price change of any given amount will affect the value of the contract.

Exchanges establish daily price limits for trading in futures contracts. The limits are stated in terms of the previous day's closing price plus and minus so many cents or dollars per trading unit. Once a futures price has increased by its daily limit, there can be no trading at any higher price until the next day of trading. Conversely, once a futures price has declined by its daily limit, there can be no trading at any lower price until the next day of trading. Thus, if the daily limit for a particular grain is currently 10 cents a bushel and the previous day's settlement price was $3.00, there can not be trading during the current day at any price below $2.90 or above $3.10. The price is allowed to increase or decrease by the limit amount each day. For some contracts, daily price limits are eliminated during the month in which the contract expires. Because prices can become particularly volatile during the expiration month (also called the "delivery" or "spot" month), persons lacking experience in futures trading may wish to liquidate their positions prior to that time. Or, at the very least, trade cautiously and with an understanding of the risks which may be involved. Daily price limits set by the exchanges are subject to change. They can, for example, be increased once the market price has increased or decreased by the existing limit for a given number of successive days. Because of daily price limits, there may be occasions when it is not possible to liquidate an existing futures position at will. In this event, possible alternative strategies should be discussed with a broker.

Although the average trader is unlikely to ever approach them, exchanges and the CFTC establish limits on the maximum speculative position that any one person can have at one time in any one futures contract. The purpose is to prevent one buyer or seller from being able to exert undue influence on the price in either the establishment or liquidation of positions. Position limits are stated in number of contracts or total units of the commodity. The easiest way to obtain the types of information just discussed is to ask your broker or other advisor to provide you with a copy of the contract specifications for the specific futures contracts you are thinking about trading. Or you can obtain the information from the exchange where the contract is trade.

Anyone buying or selling futures contracts should clearly understand that the Risks of any given transaction may result in a Futures Trading loss. The loss may exceed not only the amount of the initial margin but also the entire amount deposited in the account or more. Moreover, while there are a number of steps which can be taken in an effort to limit the size of possible losses, there can be no guarantees that these steps will prove effective. Well-informed futures traders should, nonetheless, be familiar with available risk management possibilities.

Just as different common stocks or different bonds may involve different degrees of probable risk. and reward at a particular time, so may different futures contracts. The market for one commodity may, at present, be highly volatile, perhaps because of supply-demand uncertainties which—depending on future developments—could suddenly propel prices sharply higher or sharply lower. The market for some other commodity may currently be less volatile, with greater likelihood that prices will fluctuate in a narrower range. You should be able to evaluate and choose the futures contracts that appear—based on present information—most likely to meet your objectives and willingness to accept risk. Keep in mind, however, that neither past nor even present price behavior provides assurance of what will occur in the future. Prices that have been relatively stable may become highly volatile (which is why many individuals and firms choose to hedge against unforeseeable price changes).

There can be no ironclad assurance that, at all times, a liquid market will exist for offsetting a futures contract that you have previously bought or sold. This could be the case if, for example, a futures price has increased or decreased by the maximum allowable daily limit and there is no one presently willing to buy the futures contract you want to sell or sell the futures contract you want to buy. Even on a day-to-day basis, some contracts and some delivery months tend to be more actively traded and liquid than others. Two useful indicators of liquidity are the volume of trading and the open interest (the number of open futures positions still remaining to be liquidated by an offsetting trade or satisfied by delivery). These figures are usually reported in newspapers that carry futures quotations. The information is also available from your broker or advisor and from the exchange where the contract is traded.

In futures trading, being right about the direction of prices isn't enough. It is also necessary to anticipate the timing of price changes. The reason, of course, is that an adverse price change may, in the short run, result in a greater loss than you are willing to accept in the hope of eventually being proven right in the long run.

Example: In January, you deposit initial margin of $1,500 to buy a May wheat futures contract at $3.30—anticipating that, by spring, the price will climb to $3.50 or higher No sooner than you buy the contract, the price drops to $3.15, a loss of $750. To avoid the risk of a further loss, you have your broker liquidate the position. The possibility that the price may now recover—and even climb to $3.50 or above—is of no consolation.

The lesson to be learned is that deciding when to buy or sell a futures contract can be as important as deciding what futures contract to buy or sell. In fact, it can be argued that timing is the key to successful futures trading.

A stop order is an order, placed with your broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. Stop orders are often used by futures traders in an effort to limit the amount they. might lose if the futures price moves against their position.

For example, were you to purchase a crude oil futures contract at $21.00 a barrel and wished to limit your loss to $1.00 a barrel, you might place a stop order to sell an off-setting contract if the price should fall to, say, $20.00 a barrel. If and when the market reaches whatever price you specify, a stop order becomes an order to execute the desired trade at the best price immediately obtainable.

There can be no guarantee, however, that it will be possible under all market conditions to execute the order at the price specified. In an active, volatile market, the market price may be declining (or rising) so rapidly that there is no opportunity to liquidate your position at the stop price you have designated. Under these circumstances, the broker's only obligation is to execute your order at the best price that is available. In the event that prices have risen or fallen by the maximum daily limit, and there is presently no trading in the contract (known as a "lock limit" market), it may not be possible to execute your order at any price.

In addition, although it happens infrequently, it is possible that markets may be lock limit for more than one day, resulting in substantial losses to futures traders who may find it impossible to liquidate losing futures positions. Subject to the kinds of limitations just discussed, stop orders can nonetheless provide a useful tool for the futures trader who seeks to limit his losses. Far more often than not, it will be possible for the broker to execute a stop order at or near the specified price.

In addition to providing a way to limit losses, stop orders can also be employed to protect profits. For instance, if you have bought crude oil futures at $21.00 a barrel and the price is now at $24.00 a barrel, you might wish to place a stop order to sell if and when the price declines to $23.00. This (again subject to the described limitations of stop orders) could protect $2.00 of your existing $3.00 profit while still allowing you to benefit from any continued increase in price.

Spreads involve the purchase of one futures contract and the sale of a different futures contract in the hope of profiting from a widening or narrowing of the price difference. Because gains and losses occur only as the result of a change in the price difference—rather than as a result of a change in the overall level of futures prices—spreads are often considered more conservative and less risky than having an outright long or short futures position. In general, this may be the case.

It should be recognized, though, that the loss from a spread can be as great as—or even greater than—that which might be incurred in having an outright futures position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures prices, and it is possible to experience losses on both of the futures contracts involved (that is, on both legs of the spread).

What are known as put and call options are being traded on a growing number of futures contracts. The principal attraction of buying options is that they make it possible to speculate on increasing or decreasing futures prices with a known and limited risk. The most that the buyer of an option can lose is the cost of purchasing the option (known as the option "premium") plus transaction costs.

Options can be most easily understood when call options and put options are considered separately, since, in fact, they are totally separate and distinct. Buying or selling a call in no way involves a put, and buying or selling a put in no way involves a call.

The buyer of a call option acquires the right but not the obligation to purchase (go long) a particular futures contract at a specified price at any time during the life of the option. Each option specifies the futures contract which may be purchased (known as the "underlying" futures contract) and the price at which it can be purchased (known as the "exercise" or "strike" price).

A March Treasury bond 84 call option would convey the right to buy one March U.S. Treasury bond futures contract at a price of $84,000 at any time during the life of the option.

One reason for buying call options is to profit from an anticipated increase in the underlying futures price. A call option buyer will realize a net profit if, upon exercise, the underlying futures price is above the option exercise price by more than the premium paid for the option. Or a profit can be realized it, prior to expiration, the option rights can be sold for more than they cost.

Example: You expect lower interest rates to result in higher bond prices (interest rates and bond prices move inversely). To profit if you are right, you buy a June T-bond 82 call. Assume the premium you pay is $2,000. If, at the expiration of the option (in May) the June T-bond futures price is 88, you can realize a gain of 6 (that's $6,000) by exercising or selling the option that was purchased at 82. Since you paid $2,000 for the option, your net profit is $4,000 less transaction costs.

As mentioned, the most that an option buyer can lose is the option premium plus transaction costs. Thus, in the preceding example, the most you could have lost—no matter how wrong you might have been about the direction and timing of interest rates and bond prices—would have been the $2,000 premium you paid for the option plus transaction costs. In contrast if you had an outright long position in the underlying futures contract, your potential loss would be unlimited.

It should be pointed out, however, that while an option buyer has a limited risk (the loss of the option premium), his profit potential is reduced by the amount of the premium. In the example, the option buyer realized a net profit of $4,000. For someone with an outright long position in the June T-bond futures contract, an increase in the futures price from 82 to 88 would have yielded a net profit of $6,000 less transaction costs. Although an option buyer cannot lose more than the premium paid for the option, he can lose the entire amount of the premium. This will be the case if an option held until expiration is not worthwhile to exercise.

Whereas a call option conveys the right to purchase (go long) a particular futures contract at a specified price, a put option conveys the right to sell (go short) a particular futures contract at a specified price. Put options can be purchased to profit from an anticipated price decrease. As in the case of call options, the most that a put option buyer can lose, if he is wrong about the direction or timing of the price change, is the option premium plus transaction costs.

Example: Expecting a decline in the price of gold, you pay a premium of $1,000 to purchase an October 320 gold put option. The option gives you the right to sell a 100 ounce gold futures contract for $320 an ounce.

Assume that, at expiration, the October futures price has—as you expected-declined to $290 an ounce. The option giving you the right to sell at $320 can thus be sold or exercised at a gain of $30 an ounce. On 100 ounces, that's $3,000. After subtracting $1,000 paid for the option, your net profit comes to $2,000. Had you been wrong about the direction or timing of a change in the gold futures price, the most you could have lost would have been the $1,000 premium paid for the option plus transaction costs. However, you could have lost the entire premium.

Option premiums are determined the same way futures prices are determined, through active competition between buyers and sellers. Three major variables influence the premium for a given option:

• The option's exercise price, or, more specifically, the relationship between the exercise price and the current price of the underlying futures contract. All else being equal, an option that is already worthwhile to exercise (known as an "in-the-money" option) commands a higher premium than an option that is not yet worthwhile to exercise (an "out-of-the-money" option). For example, if a gold contract is currently selling at $295 an ounce, a put option conveying the right to sell gold at $320 an ounce is more valuable than a put option that conveys the right to sell gold at only $300 an ounce.
• The length of time remaining until expiration. All else being equal, an option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration because it has more time in which to become profitable. Said another way, an option is an eroding asset. Its time value declines as it approaches expiration.
• The volatility of the underlying futures contract. All rise being equal, the greater the volatility the higher the option premium. In a volatile market, the option stands a greater chance of becoming profitable to exercise.

At this point, you might well ask, who sells the options that option buyers purchase? The answer is that options are sold by other market participants known as option writers, or grantors. Their sole reason for writing options is to earn the premium paid by the option buyer. If the option expires without being exercised (which is what the option writer hopes will happen), the writer retains the full amount of the premium. If the option buyer exercises the option, however, the writer must pay the difference between the market value and the exercise price.

It should be emphasized and clearly recognized that unlike an option buyer who has a limited risk (the loss of the option premium), the writer of an option has unlimited risk. This is because any gain realized by the option buyer if and when he exercises the option will become a loss for the option writer.

The foregoing is, at most, a brief and incomplete discussion of a complex topic. Options trading has its own vocabulary and its own arithmetic. If you wish to consider trading in options on futures contracts, you should discuss the possibility with your broker and read and thoroughly understand the Options Disclosure Document which he is required to provide. In addition, have your broker provide you with educational and other literature prepared by the exchanges on which options are traded. Or contact the exchange directly. A number of excellent publications are available. In no way, it should be emphasized, should anything discussed herein be considered trading advice or recommendations. That should be provided by your broker or advisor. Similarly, your broker or advisor—as well as the exchanges where futures contracts are traded—are your best sources for additional, more detailed information about futures trading.

Source: National Futures Association