Introduction to
Futures and Options Contracts
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Outline
Futures Contracts
•Basic Concepts
•Characteristics of Market Participants
Futures Exchanges
•Open-Outcry vs Electronic Trading
•The Trading Process
•Margins
Options on Futures
•Terminology
•Option Volatility
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What is a Futures Contract?
An obligation to buy, sell, or cash-settle a commodity that
meets set grades and standards on some future date.
Futures contracts are standardized based on:
Commodity:
What is being traded
including grade and quality specifications
Contract month:
When the contract will expire
open contracts must be delivered or cashsettled
Quantity:
The size of one contract
pounds, bushels, barrels, etc.
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Examples of Futures Contracts
Commodity:
Number 2 yellow corn
Contract month:
Quantity:
Nov, Dec, Jan, Mar, May, Jul, Sep
5,000 bushels
Commodity:
Contract month:
Quantity:
Class III fluid milk
All months available
200,000 pounds
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What About Price?
The price of a futures contract is determined through a
competitive auction.
Someone who wants to buy
Someone who wants to sell
the commodity will
the commodity will
bid
offer
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Who trades commodities?
Hedgers
• Produce or use the commodity traded
• Utilize futures contracts to manage price risk
Speculators
• Trade solely for profit
• Add liquidity to the market
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Buyers and Sellers
Buyers and sellers meet two different ways:
• In person, on an exchange trading floor
The “open outcry” system still accounts for
the majority of domestic futures volume
• Electronically
Increasingly popular, especially in foreign
countries
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Futures Exchanges
Futures exchanges are organized gatherings of
buyers and sellers.
Futures exchanges are located throughout the
United States and the world. A few examples:
Chicago Mercantile Exchange
Chicago Board of Trade
Tokyo Grain Exchange
Chicago
Mercantile
Exchange
London International Financial Futures and Options Exchange8
Futures Exchanges
Each commodity has its own trading pit on the
exchange floor where buyers and sellers meet.
Traders on the floor of the Chicago Mercantile Exchange
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Futures Exchanges
Traders in the pits use voice or hand signals
to bid, offer, and trade commodity contracts
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Electronic Trading
Below is an example of an electronic trading
platform screen.
Many CME
contracts are
traded both in
trading pits and
on the GLOBEX®
platform (right).
GLOBEX® terminal
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Electronic Trading
Similar to open-outcry trading, except:
• Bids and offers are posted electronically
• An order-matching system executes trades
Electronic trading dominates in Europe and is
rapidly gaining popularity in the U.S.
Eurex:
Fully electronic
CME:
Electronic (GLOBEX®) and open outcry
CBOT:
Electronic (a/c/e) and open outcry
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Most CME contracts are still traded by open-outcry
MM contracts
Annual CME Volume
450
400
350
300
250
200
150
100
50
0
1996
1997
1998
Total
1999
2000
GLOBEX
2001
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Where Do I Begin?
Establish a hedging account with a broker.
•Brokers place buy and sell orders for their
customers.
•A fee, or commission, is charged for this
service.
Your broker may also:
•Help you open your account
•Provide advice on appropriate trading strategies
•Answer your questions about futures trading
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How Do I Trade a Futures Contract?
1. Call your broker and place an order
2. The broker routes your order to the
trading pit via the brokerage firm’s central
order desk
3. A floor broker executes the trade
4. Your broker calls you back to confirm your
order has been filled
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Margins
You have taken a position in the futures
market. Now what?
Initial margin funds must be posted for each
contract bought or sold.
Since futures contracts are simply an agreement to
buy or sell something at a future date, no cash
changes hands when the position is opened. Instead,
a good-faith deposit must be made to guarantee
performance.
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Class III/IV Margins
• Initial margin: deposit made when position
is entered, $800/contract for hedgers
• Maintenance margin: minimum balance that
must remain in the account, $800/contract
•Exchanges set minimum margins for each
commodity based on historical volatility and
expected market conditions
• Margin funds may be withdrawn when the
hedge is exited
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Margins
Margin accounts are “marked to market” each
day to reflect changes in position value.
Buyer
Price Rises
May withdraw
margin excess
Seller
Must deposit
additional margin
Price Declines Must deposit
May withdraw
additional margin margin excess
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Margin Example
On March 7, a dairy producer sold one Class III
contract at $12.20 and an end-user purchased an
identical contract
Margin Adjustment
Date
Price
Producer
End-User
March 7
$12.20
Post $800 initial margin
March 8
$12.26
-$120
$120
March 11
$12.27
-$20
$20
March 12
$12.21
$120
-$120
March 13
$12.26
-$100
$100
March 14
$12.26
$0
$0
March 15
$12.22
$80
-$80
March 18
$12.05
$340
-$340
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The Clearing House
For each matched trade, the exchange’s
Clearing House:
1. Is substituted as the buyer to the seller
2. Is substituted as the seller to the buyer
• Eliminates counter-party credit risk (the clearing
house guarantees performance)
• Futures positions can be offset by executing an
equal but opposite transaction with anyone, not
necessarily the original party
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The Clearing House
The Clearing House is made up of brokerage
firms that are clearing members.
In the case of a customer default, financial
liability rests with:
1. The customer’s margin money/equity
2. The customer’s clearing member firm
3. All clearing member firms
4. The exchange
No clearing firm has ever defaulted on its
financial obligations.
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Options on Futures
Options are the right, but not the obligation,
to buy or sell a futures contract at a
specified price.
Call Option: The right to buy futures at a
predetermined price

Put Option: The right to sell futures at a
predetermined price

For every option buyer, there must be a seller.
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Options on Futures
Option buyers:
• Receive price insurance
• Protect against rising or falling prices
• Must pay a premium
• Risk limited to the premium paid
(plus commissions and fees)
Option Sellers:
• Collect the premium
• Are obligated to take the opposite side of a futures
trade if the buyer chooses
• Risk unlimited (unless position is covered with futures,
another option, or the cash commodity)
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Option Example
July Class III Milk $12.50 put
Month
Commodity
Strike Price
Put/Call
Buyer
Has the right to sell one July Class III contract at
$12.50
Seller
Has the obligation to buy one July Class III contract at
$12.50 if the owner of the put chooses to exercise it
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Options Terminology
Intrinsic value: The value of the option if it were
exercised today
Time value: The remainder of the option premium
Date: April 10
August futures price: $13.20
Strike / Type
Premium
Intrinsic Value Time value
Aug $12.75 Put
$.48
$0.00
$0.48
Aug $13.25 Put
$.72
$0.05
$0.67
Aug $13.00 Call
$.79
$0.20
$0.59
Aug $13.50 Call
$.56
$0.00
$0.56
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Options Terminology
At-the-money option: Option strike price is
identical to the price of the futures contract
In-the-money option: An option with intrinsic
value
Out-of-the-money option: An option with no
intrinsic value (only time value)
In-the-money call: Futures price is currently above
option strike price
In-the-money put: Futures price is currently below
option strike price
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Margins on Options
Buyers:
• Pay entire option premium up front
• No margin calls
Sellers:
• Margin will vary
• Based on risk characteristics of the option
• Never exceeds the futures margin
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Option Valuation
The 4 primary factors that impact the price of an option:
1. Option strike price
In-the-money vs. Out-of-the-money
2. Current underlying price
3. Time until option expiration
4. Volatility of the underlying
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What is Volatility?
The degree to which prices fluctuate over
time
The price of the underlying, not the price of the option itself!
Measured as the standard deviation of daily price changes
Rising volatility
(usually accompanies a big
move or report)
Falling volatility
(market settling down)
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Types of Volatility
Historical:
Based on daily data from past trading days
Implied:
Use quoted option price to back out volatility
(market’s estimate of future volatility)
Future volatility is the key to option value!
The more volatile the underlying commodity is expected to
be, the more an option is worth. Historical volatility is a
guide to what future volatility may be.
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