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Derivatives
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Stock Options
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Stock Warrants
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Interest Rate Swaps
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Interest Rate Caps, Floors
and Collars
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Swaptions
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Futures and Forward
Contracts
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Managed Futures
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Futures and Forward Contracts
Fortunes have been made
and lost using futures. "A famous case was in 1974 when Mrs. Hillary Clinton,
former first lady-turned U.S. senator, invested in cattle futures and turned
$1,000 into approximately $98,000 in one year." These types of gains attract
investors. Because of their high leverage, futures are in the same
investment category as options. Investors can control a large notional
dollar amount of assets for a relatively small sum. The big difference is
that with options, one’s loss is limited to the cost of the option, which is
paid up front. With futures contracts, one is exposed for the entire
notional amount of the contract. Understand the nuances; with options, one
purchases the RIGHT to buy an asset; with futures one is actually PURCHASING
the assets with a deferred closing date. Investors in futures contracts are
responsible for the entire purchase price, not just the initial margin
deposit.
Futures and forwards are
contracts to commit to the future delivery of a commodity at a specific
price, quantity, quality, date, and delivery location. The goal is simple:
for long positions, the holder is betting that the spot (market) price at
the contract’s settlement date exceeds today’s future price, resulting in a
gain. Long investors are betting that the price will increase. With short
positions, one is selling a futures contract and agrees to deliver the
commodity at a specified time and location. Short sellers are betting that
the spot price at the delivery date will be less than today’s price; in
effect, trying to sell high, and then buy low.
The profit
potential with futures and forward contracts can be enormous! The risk,
however, is unlimited; you can lose more than your margin deposit in your
brokerage account. If a trade goes against you, you are still obligated to
fulfill the contract until a reverse order is executed. The brokerage firms
allow you to buy on margin, with 5% to 10% normally the down payment
requirement; that translates into approximately a 20 to 1 leverage ratio. A
small change in price can wipe out the margin deposit, resulting in a margin
call to adhere to the broker’s maintenance margin requirements. Losses can
exceed your initial deposit.
Forwards versus
Futures
Forward contracts
are more informal, individually tailored, deferred delivery agreements
between two parties. These agreements are not regulated by the Commodities
Futures Trading Commission and are not executed through a clearinghouse.
Payments are made on the settlement date. Like futures contracts, delivery
of the commodity is normally not taken; it is more cost efficient to
liquidate one’s position by reversing the trade before maturity than to take
actual delivery. Very few contracts actually take physical delivery of the
commodity; settling in cash is more cost beneficial.
Futures contracts
are standardized, deferred delivery contracts that trade on the exchanges
and are regulated by the Commodities Futures Trading Commission, a federal
agency. Standardized futures contracts became popular because they were
flexible. If events disrupted the supply chain, adjustments could easily be
made without renegotiating the original contract. Additionally, the
clearinghouse made trading simple by guaranteeing that the other side of a
transaction would be fulfilled. This provided security and liquidity to the
market place, making it attractive to both hedgers and financial traders.
Unlike forward contracts, futures contacts are “marked to market” and
settled daily, usually at the end of the day. Marking to market ensures that
all participants fulfill their financial obligations.
Taxes
Because futures are
marked-to-market daily and settled with cash, taxable income or loss is
realized immediately, regardless of whether a position is closed out or not.
It’s not like common stock, where you have some flexibility as to when sales
take place, and can move gains or losses to a different tax year.
Hedgers and
Speculators
Hedgers have a business
purpose to trade futures contracts, while speculators have no business use
for the commodity; they are merely trying to profit from price fluctuations.
Financial traders are speculators.
Examples:
Text book example:
"Assume you are a wheat farmer and you want to lock in your profits as soon
as your crop is planted. Selling a futures contract on the exchanges, for
the quantity equivalent of your expected crop, hedges your position by
fixing your selling price. The contract is with the commodity exchange,
usually the Chicago Board of Trade (CBOT). The counter party would be the
miller, who purchases the wheat for his processing, and is interested in
locking in his cost structure. Both parties have a vested interest in
hedging their positions. Normally, one closes out his position before the
contract terminates and settles in cash; delivery is then handled through
the normal channels."
Recent real world
example: September 2005 –with oil prices at record levels and jet fuel
selling at $92 a barrel, many airlines were struggling to survive; yet
Southwest Airlines was being recommended and on the buy list of many stock
analysts. Southwest realized that their main cost was jet fuel, and
purchased futures oil contracts for their expected usage, locking in their
cost structure for a few years going out. They were hedged at $26 a barrel
of crude, while the spot oil prices approached triple digits. Hedging
correctly gave Southwest Airlines a major cost advantage over their
competitors. Futures can result in life or death situations for businesses.
Fundamental and
Technical Analysis
Similar to stock market
investors, there are two types of investment styles:
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Fundamental investors research
supply and demand trends and base their trading decisions on them.
·
Technical
investors base their trading decisions on price movements and chart
patterns.
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