Understanding the Language of Futures Trading

This section is not a glossary of the terminology commonly used by investors in the realm of Commodity Markets and Futures Trading. It is one thing to look up definitions of the buzz words used in any business and quite another to understand how the terminology fits together to form a contemporary, clear picture.

Think about it, and probably you have heard words and terms tossed about by market analysts and advisors, while observing listeners who probably did not fully grasp the meaning, proceed as if they did. Nobody wants to be perceived as not being knowledgeable of how things work in such a popular topic as the markets. But, it is understandable that most people are only vaguely tuned in to the language of investors and speculators because, even if they hear the talk several times a day, it is not their full time pre-occupation. After all it’s not their job to know. Maybe this is more or less where you fit in. Well, it can be a costly mistake to proceed without really understanding what it is you are proceeding with.

Stock Trades always tries to give information with application. That is why this article is here in place of a dictionary or glossary. Let’s get a handle on what the talk really means. Here, we will walk through some futures topics, throwing out lots of terminology, whether needed or not, just to put it into a contextual application that makes it more understandable than a straight out definition.

Speculate or Invest?

So you are thinking about speculating in the futures market. We deliberately want to specify speculate over invest. To invest is to put your money to use in a way you should reasonably expect will yield a profit or income, but by speculating, you enter into serious risk for the reward of winning big. We must consider the futures market in this way because it is not as predictable as trading shares in the stock market. In fact, you don’t even trade futures. What you do is enter into a contract whereby you agree to buy or sell a product at a future date with the price and delivery terms set at the making of the deal. Even the product you may buy or sell can be a little bit difficult to define or identify. Not always so concrete as a stock certificate, futures can be a contract to sell a basic commodity such as potatoes, or to buy a misunderstood futures mutant like a derivative. Derivatives are futures contracts whose price is derived from one or more underlying. Here we go again. An underlying; what’s that? Well, an underlying is something whose price affects the price of the derivative asset that is linked to it.

So, you can contract in futures based on a mining stock index, and the price of XYZ Gold Mine stocks, which is a stock market traded security affect the index of all gold stocks or perhaps a price index of all mining stocks, which makes XYZ an underlying. That probably doesn’t seem important to you right now, but will later when we add hedging risk to the talk we talk.

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The long and short of futures contracts.

Speculators come into the futures market either going long or going short. Going long simply means you enter as a buyer anticipating profit from future price increases and going short means you are a seller figuring prices will fall. How to profit from falling prices you wonder? Well by selling now and locking in what you consider a high price, you speculate you can buy in at a future time when the price drops near to where you speculated and before you must deliver on your sell contract so you cover your sale at a profit. The talk gets twigged to where you will hear people say, “I took a long position on gold” or “I am short on oil futures”. They’re only buyers or sellers. The tag has become a descriptive adjective that tries defining the reasoning behind being a buyer or seller.

Margins are levers to moving large percentages of profit.

This is a good time to bring up margins when calculating your futures speculating profits. Going long on margin means it is not necessary to put up all the money needed to back your purchase. The percentage of cash required is really very low, so you can enter into highly leveraged contracts to make sweet sounding gains. Suppose you can take a long position on cotton at a 5% margin. That means you could buy a $20,000, 100,000 lb cotton future with only $1,000 cash if cotton was at 20 cents a pound. You are using little of your cash as leverage to move a big ball of cotton. Suppose too that cotton goes to 21 cents a pound before the settlement date so you decide to sell your contract for the $21,000 it now brings. Do not look at the transaction as a $1,000 gain on a $20,000 investment. Yes, you did speculate and the risk, had it gone bad, could conceivably have cost the whole 20,000 dollars, though highly unlikely. In fact, the profit on your money is 100% because the margin investment, the cash you put up for your long position was only $1000 and you sold at a $1000 increase.

Before moving on, let’s just repeat in different words, the brief above on gaining a profit from going short. Just to re-enforce the uncustomary mind set of profiting from falling prices.The short position speculator entered into his futures contract making a binding commitment to deliver the commodity or asset or underlying at an established price. There are only two reasons for doing this. One is if he is a real life producer of the product and the other is if he is there purely as a speculator. Both could have been motivated to hedge. The common thread is to profit, unless of course, the speculator can use some losses to offset gains elsewhere, but that is another story. We are sticking with profit. Let us continue with cotton and assume your research comes to the conclusion cotton prices are destined to fall over the next year. The speculator could enter into a sell contract now at the existing higher price. In the previous long position example 100,000 lbs of cotton would go for $20,000 and the speculator would only have to put up a margin deposit of $1,000. The short speculators research was correct in this example, and cotton falls from 20 cents to 19 cents a pound. The time is right to buy back in to cover the short commitment. Buying back the contract costs only $19,000, so the speculator has used their $1,000 margin deposit to leverage a $1,000 dollar profit, 100%, in a falling market.

Keep listening to the talk on futures trading and derivatives, and a whole new group of buzz words will come floating in to the conversation. As in the previous discussion, you will be quick to understand how it is such seemingly confusing jargon dovetails with other parts of the talk among futures traders to make perfect sense.{mospagebreak}

Options are a good page from the story-line to get accustomed to tuning your ear to.

Option contracts are a derivative instrument which gives the option holder a right but not an obligation, to complete a specified transaction with an option issuer, in accordance to specified terms. As a speculative instrument, a speculator might purchase an option to sell a specified number of shares of a stated stock, at any time during the limited life of the option, at a price fixed in the option contract, and regardless of the market price of that stock. There are also options, with all the same specifications attached, to buy stocks. This is an article on understanding the talk, but take a pause right here to know the reason for trading or contracting in options. Options allow you the opportunity to make money regardless of whether the stock market is going up or down. Of course, you would only want to exercise your option if it was profitable to do so, therefore, you could lose what it cost to acquire an unused option. The talk of the trade doesn’t word things the way we have just done, so let’s get on with the terminology. You want to know about things like puts, calls, call options, strike price, underlying security and Euro exercise, right?

A common statement straight from the analysts mouth might be worded like, “consider a three-month, European exercise, strike USD 22.50 put option on 100,000 barrels of Brent oil. You can get these derivative contracts OTC”. We will put that statement in to usable terms immediately following a walk through calls and puts.

Calls and Puts

There are two categories of options the speculator can purchase.

A call option gives the speculator the right to buy a stock at his own discretion (option), from the person who sold the call, on or before a specific future date, and at a price specified on the option. A call becomes more costly to acquire as the market value of the underlying (which is the stock to which it is pinned) increases and less costly as the market value of the underlying decreases.A put option gives the speculator the right to sell a stock at his own discretion (option), to the person who sold the put, on or before a specific future date, and at a price specified on the option. A put becomes more costly to acquire as the market value of the underlying (which is the stock to which it is pinned) decreases and less costly as the market value of the underlying increases.

So, just as with any other instrument the speculator buys, depending what he anticipates happening in the market place, he can buy a call or a put and profit from the movement.

We have been discussing buying of calls and puts. Keep in mind, if you are the owner of an underlying, and by now you know what an underlying is, you can be a seller of calls and puts.

Checking out a call

Let’s suppose you purchased a call giving the right to buy XXYY Corp stock for $100 (the stated price is called the strike price in the jargon we want to get you using), any time before the last trading day in December (after which your call options expire and become worthless), regardless of the trading price on the day you wish to use your call option and exercise your right to buy. Of course you won’t want to use it if XXYY Corp stock is trading below the strike price. If XXYY stock is selling for $200 you only have to pay the $100 strike price for your shares. If you bought the call for $2, then you have turned an instant profit of $98. You could also sell your option at a profit if you do not intend using it. The other side of the coin is that as long as XXYY stock remains priced below your option’s strike price, your call is worthless because no one is interested in buying a right to purchase at a price higher than the market price.

Putting a put into action

The opposite of a call is a put. Now you are buying the right to sell XXYY Corp stock for the strike price (you know what that means now) of $200, any time before the last trading day in December, regardless of the trading price on the day you wish to use your put option and exercise your right to sell. You won’t want to use it if XXYY stock is trading above the strike price. Suppose XXYY stock drops to $100. You have purchased the right to sell them for $200 which would be a nice thing to do. What you will want to do is purchase the XXYY shares just before exercising your put option. Using the example, of our market price at $100, you will buy for $100, then turn around, use the put and sell for $200.{mospagebreak}

It’s a wrap

So now you are ready to decipher that earlier statement and really know what it means and call this read a success.“Consider a three-month, European exercise, strike USD 22.50 put on 100,000 barrels of Brent oil. You can get these derivative contracts OTC”. First off, you see he is talking about a put option or right to sell something, but unlike our XXYY Corp example, there doesn’t seem to be any mention of shares or stocks. OK, it’s to sell barrels of oil, so he is dealing in commodities. A futures derivative in commodities with oil as the underlying. A three month to expiry option to sell 100,000 barrels of a specified type of oil named Brent for US $22.50 per barrel. What’s this European exercise? Well we haven’t filled you in on that yet, but you do know he must be talking about exercising your option. Unlike an American exercise which allows the option to be exercised any time before expiry, a European exercise can be used only on the expiration date of the contract. All that remains is to figure out this OTC. It’s where you can get the derivative and we know stock exchanges don’t trade in commodities so take a guess. This put option is sold Over The Counter.