Series 3 Manual (v42)

SERIES 3
National Commodity Futures Examination

Study Manual – 42nd Edition
The Final Exams are a critical part of your training.

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TABLE OF CONTENTS
INTRODUCTION
CHAPTER 1 COMMODITY FUTURES
Introduction .........................................................................................................1-1
Cash Forward Transactions ..............................................................................1-1
Futures Contract.................................................................................................1-1
Commodity Futures Contract ......................................................................1-2
Basis Grade ..................................................................................................1-2
Long and Short Positions...................................................................................1-2
Benefits Provided by the Futures Exchange ...................................................1-3
Futures Exchange..............................................................................................1-4
Exchange Committees ................................................................................1-5
Successful Exchange Markets....................................................................1-6
Speculators ...................................................................................................1-6
Hedgers.........................................................................................................1-6
Responsibilities of the Exchange......................................................................1-7
Processing an Order ....................................................................................1-7
Clearing House .............................................................................................1-7
Settlement .....................................................................................................1-8
Margin Requirements ..................................................................................1-8
Clearing Commodity Transactions .............................................................1-9
Delivery Process ..........................................................................................1-12
CHAPTER 2 REGULATIONS
Federal Regulation of Commodity Futures and Options ................................2-1
The NFA ..............................................................................................................2-1
NFA Membership Requirements ................................................................2-1
NFA Registration Requirements .......................................................................2-2
Futures Commission Merchant (FCM) .......................................................2-2
Introducing Broker (IB) .................................................................................2-3
Commodity Trading Advisor (CTA) .............................................................2-4
Commodity Pool Operator (CPO) ...............................................................2-4
Floor Broker ..................................................................................................2-4
Associated Person (AP) ...............................................................................2-4
Opening Customer Accounts ............................................................................2-5
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TABLE OF CONTENTS
Chapter 2 (Cont.)
Types of Accounts..............................................................................................2-5
Joint Accounts ..............................................................................................2-5
Partnership Accounts...................................................................................2-5
Corporate Accounts .....................................................................................2-6
Trust Accounts..............................................................................................2-6
Investment Company Accounts ..................................................................2-6
Risk Disclosure Statement ................................................................................2-6
Commodity Pool Operator Disclosure Documents .........................................2-8
Reporting to Pool Participants.....................................................................2-11
Commodity Trading Advisor Disclosure Document ........................................2-11
Options Disclosure Document ..........................................................................2-13
Communications with the Public .......................................................................2-15
Content of Promotional Material........................................................................2-15
Record Keeping..................................................................................................2-15
Discretionary Accounts (Controlled Accounts) ................................................2-17
Written Power of Attorney ............................................................................2-17
Duty to Review and Supervise ....................................................................2-17
Minimum Experience Required...................................................................2-17
Third Party Discretion...................................................................................2-18
Options Customer Complaints ..........................................................................2-18
Treatment of Customer Funds ..........................................................................2-18
Trading Standards .............................................................................................2-18
Confirmation of Options and Futures Transactions ........................................2-19
Disciplinary Proceedings ...................................................................................2-19
Compliance ...................................................................................................2-19
Surveillance ..................................................................................................2-19
Disciplinary Actions ......................................................................................2-20
Settlement of Disciplinary Actions...............................................................2-20
Reparation and Arbitration Proceedings ..........................................................2-21
CFTC Reparations .......................................................................................2-21
NFA Arbitration .............................................................................................2-21
Position Reporting Requirements and Speculative Trading Limits................2-21
Position Reporting Requirements...............................................................2-21
Speculative Position Limits ..........................................................................2-22

TABLE OF CONTENTS
Chapter 2 (Cont.)
Anti-Money Laundering ...............................................................................2-22

Ethics Training ..............................................................................................2-23
Disaster Recovery Plans and Business Continuity ...................................2-23
CHAPTER 3 PRICE FORECASTING

Introduction .........................................................................................................3-1
Crop Year ............................................................................................................3-1
Volume and Open Interest.................................................................................3-2
Effect of Open Interest on Prices ................................................................3-3
Relationship of Cash to Futures .......................................................................3-4
Types of Markets ................................................................................................3-5
Normal Market ..............................................................................................3-5
Inverted Market.............................................................................................3-6
Technical Analysis .............................................................................................3-7
Charts and Patterns .....................................................................................3-7
CHAPTER 4 PRICING
Price Limits ..........................................................................................................4-1
Agricultural Commodities...................................................................................4-1
Wheat ............................................................................................................4-1
Soybean ........................................................................................................4-1
Financial Futures................................................................................................4-1
Long-term......................................................................................................4-1
Short-term .....................................................................................................4-2
Foreign Currency Futures .................................................................................4-3
CHAPTER 5 ORDERS
Quotations...........................................................................................................5-1
Trading and Delivery Months ......................................................................5-1
Ticker Tape ...................................................................................................5-1
Types of Orders ..................................................................................................5-2
Market Order .................................................................................................5-2
Limit Order (Resting Order) .........................................................................5-2

TABLE OF CONTENTS
Chapter 5 (Cont.)
Sell Stop Order .............................................................................................5-3

Buy Stop Order .............................................................................................5-3
Strategies of Stop Orders ............................................................................5-3
Stop Limit Order............................................................................................5-4
Discretionary Order ......................................................................................5-5
Not Held Order..............................................................................................5-5
Fill or Kill Order .............................................................................................5-6
One Cancels the Other (OCO) Order .........................................................5-6
Switch Order .................................................................................................5-6
Give Up Order...............................................................................................5-7
Exchange for Physicals Order (EFP) ..........................................................5-8
CHAPTER 6 MARGIN
Introduction .........................................................................................................6-1
Commissions ......................................................................................................6-1
Margin on Commodity Futures....................................................................6-2
Margin Department ......................................................................................6-2
Original and Maintenance Margin ..............................................................6-2
Margin on a Long Position ...........................................................................6-3
Margin on a Short Position ..........................................................................6-4
Increases in Margin Requirements...................................................................6-4
Hedger Margin ....................................................................................................6-5
Leverage .............................................................................................................6-5
CHAPTER 7 SPECULATION
Introduction .........................................................................................................7-1
Speculation in Non-Financial Futures ..............................................................7-1
A Case Example (Long Futures) ................................................................7-1
A Case Example (Short Futures) ................................................................7-4
Advanced Application ..................................................................................7-6
Percentage Price Change ...........................................................................7-7
Speculation in Financial Futures.......................................................................7-8
Debt Instrument Futures..............................................................................7-8

TABLE OF CONTENTS
Chapter 7 (Cont.)
Stock Index Futures .....................................................................................7-10

Foreign Currency Futures ...........................................................................7-11
CHAPTER 8 SPREADS
Introduction .........................................................................................................8-1
Types of Spreads ...............................................................................................8-1
The Spread Market ............................................................................................8-2
Types of Orders ............................................................................................8-2
Determining Whether a Spread is Profitable..............................................8-3
Risk in Spread Trading ......................................................................................8-5
Bull and Bear Spreads .................................................................................8-5
Stock Index Spread - Bull Market ...............................................................8-5
Stock Index Spread - Bear Market..............................................................8-5
CHAPTER 9 HEDGING
Introduction .........................................................................................................9-1
The Hedger .........................................................................................................9-2
Long and Short Hedge.................................................................................9-2
Selling Hedge ...............................................................................................9-3
Buying Hedge ...............................................................................................9-4
The Imperfect Hedge .........................................................................................9-6
Basis ....................................................................................................................9-8
Negative or Positive Basis ...........................................................................9-9
Changes in Basis..........................................................................................9-9
Examples of Hedging.........................................................................................9-10
Short Hedge in a Normal Market ................................................................9-10
Long Hedge in a Normal Market .................................................................9-13
Determining the Month to Hedge ......................................................................9-14
Practical Applications of Hedging .....................................................................9-15
Plumbing Contractor ....................................................................................9-16
Cattle Raiser .................................................................................................9-17
Sugar Exporter..............................................................................................9-18
Meat Packer ..................................................................................................9-19

TABLE OF CONTENTS
Chapter 9 (Cont.)
Hedging in Financial Instruments .....................................................................9-19

Foreign Currency Hedging ..........................................................................9-19
Treasury Bond Hedging ..............................................................................9-21
CHAPTER 10 STOCK INDEX FUTURES

Introduction .........................................................................................................10-1
Non-Systematic Risk ..........................................................................................10-1
Systematic Risk ..................................................................................................10-1
Futures Contracts...............................................................................................10-2
Size of Contracts ..........................................................................................10-2
Contract Months ...........................................................................................10-2
Cash Settlement .................................................................................................10-2
Market Participants.............................................................................................10-2
Trading ................................................................................................................10-3
Index vs. Trading..........................................................................................10-3
Spreading Stock Index Futures ........................................................................10-3
Strategies ............................................................................................................10-3
Long Hedge ..................................................................................................10-4
Short Hedge..................................................................................................10-4
Calculating the Number of Contracts..........................................................10-4
CHAPTER 11 COMMODITY OPTIONS

Introduction .........................................................................................................11-1
Classification .......................................................................................................11-1
Buyer=s Rights Versus Seller=s Obligations .............................................11-1
Introduction of New Options ..............................................................................11-2
Opening and Closing Transactions ..................................................................11-2
Option Premiums ................................................................................................11-2
Intrinsic Value ...............................................................................................11-2
Time Value ....................................................................................................11-3
Option Premiums for Treasury Bond Futures............................................11-3
Strike (Exercise) Price..................................................................................11-3

TABLE OF CONTENTS
Chapter 11 (Cont.)
Expiration Date .............................................................................................11-3

Buying Calls ..................................................................................................11-4
Buying Puts ...................................................................................................11-4
Writing (Selling) Calls ...................................................................................11-4
Writing (Selling) Puts ....................................................................................11-5
Hedging with Options .........................................................................................11-5
Delta...............................................................................................................11-6
Constructing Synthetic Positions ......................................................................11-7
Synthetic Long Call.......................................................................................11-7
Synthetic Long Put .......................................................................................11-8
Synthetic Short Call ......................................................................................11-8
Synthetic Short Put .......................................................................................11-8
Synthetic Futures .........................................................................................11-9
Spreading with Options......................................................................................11-9
Calendar Spreads ........................................................................................11-9
Vertical Spreads ...........................................................................................11-9
Bull Call Spread ............................................................................................11-10
Bull Put Spread.............................................................................................11-10
Bear Put Spread ...........................................................................................11-11
Bear Call Spread ..........................................................................................11-11
Opposite Spreads ........................................................................................11-12
Summary .............................................................................................................11-12
Bull Call Spread ............................................................................................11-12
Bull Put Spread.............................................................................................11-12
Bear Put Spread ...........................................................................................11-13
Bear Call Spread ..........................................................................................11-13
Straddles .............................................................................................................11-13
Long Straddle ...............................................................................................11-13
Short Straddle ...............................................................................................11-13
Strangles .............................................................................................................11-14
Long Strangle ...............................................................................................11-14
Short Strangle ...............................................................................................11-14
Margins on Option Spreads...............................................................................11-14

INTRODUCTION
About the Series 3 Examination

The Series 3 Examination is a 2.5-hour, 120-question test, which uses both multiple-choice and True-False
question formats. Foreign candidates are given 3.5 hours to complete the exam. The test is presented as
one exam, but is graded in the following two parts:
Part I General Industry Knowledge 85 questions

Part II Rules and Regulations 35 questions
The minimum required passing score is 70% for each part.
Taking the Exam

In order to take an exam, you will need to make a test appointment. Please use the following information
to schedule an appointment and/or to learn more about the examination center:
Prometric Exam Centers
www.prometric.com/finra/
800.578.6273
The website will provide you with the most up-to-date information regarding “Test Center Security” and
“Test Break Policies.” At the testing facility, you will be provided with:
 A four-function calculator
 Two dry-erase boards
 Dry-erase pen
For more information regarding scheduling an exam, what to expect on the day of your exam, and what
happens after your exam, please use the following link which provides information from FINRA:
www.finra.org/sites/default/files/external_apps/proctor_tutorial.swf.html
About the Study Program

The Series 3 study materials are designed to be easily understood regardless of a student's industry
experience or educational level. The study program is divided into two parts:
1. A study manual containing 11 chapters
2. Six final examinations
We recommend that you visit our website www.stcusa.com to determine whether there have been any
changes or supplemental materials created for this exam.
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INTRODUCTION
Study Manual
The study manual represents the first phase of your study and is divided according to the areas covered on
the Series 3 Examination. While it’s important that you study all of the topics, please put additional
emphasis on Regulations and Hedging, since these topics make up the largest percentage of test questions
on the exam. Also, note that contract sizes and specific margin requirements will be given in a test
question and don’t need to be memorized.
Final Examinations
The final examinations and corresponding explanations represent the most important part of your test
preparation. These examinations will assist you in applying the information that you learned in the
study manual to questions that are posed in the multiple-choice and True/False format used in the
Series 3 Examination.
An examination should first be taken with the SHOW EXPLANATIONS turned on. As you read a
question, try to answer it. However, whether your answer is correct or incorrect, read the entire
explanation. You may find it helpful to highlight or take notes on any facts you didn’t know for use in
future studying. Studying each explanation is a crucial step to passing the Series 3 Examination. By
concentrating only on the correct response and disregarding the explanation, you run the risk of
memorizing answers without fully understanding the underlying concepts.
After completing all of the examinations with SHOW EXPLANATIONS switched on, and if time permits
based on the calendar you’re following, begin the process over again by retaking each examination without
the explanations shown. If taking the test for the second time, you should strive to achieve a score of 85%
or better to show maximum retention of the material.
Standardized Test-taking Tips

As with any standardized test, you may be able to increase your score by employing good test-taking
techniques. An efficient technique will ensure an overall understanding of the question while helping to
avoid careless errors. It will also help you to stay alert throughout the entire exam. The following list is a
step-by-step approach that may work well for you:
Step 1: Read the question the first time through without trying to answer it. At this point, merely
form an understanding of the substance of the question.
Step 2: Carefully read the four choices. Remember, since a multiple-choice examination actually gives
you the answer, your job is to recognize the correct choice from among the distractors. By keeping these
choices in mind when you reread the question, you will be able to pinpoint the important information and
filter out any extraneous material.
Step 3: Reread the question slowly and stop at the end of each sentence to absorb the information.
You may need to exaggerate this in the beginning as you get used to applying the intense concentration
required to assure that you recognize all of the important facts and catch the misleading words or phrases
(e.g., not, except, etc.).
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INTRODUCTION
Step 4: Make sure that you fully understand what the question is asking. You cannot possibly answer a
question correctly before you know what it’s asking. You may need to look back to the question for
additional facts before you are ready to choose your answer.
Step 5: Read each choice a second time. As you read a choice, decide whether it’s a possible answer. If
you’re able to eliminate three of the four choices, then you have your answer. However, if you only
eliminate one or two, it will still help you narrow it down to your best choices. Reconsider the remaining
choices by comparing their differences and decide which answer is more correct. Once you have made
your decision, DON’T LOOK BACK!
It’s important that you practice your technique to become proficient by the time you sit for the Series 3
Examination. The best place to practice is on the simulated final examinations. Not only will this practice
build your technique, it will also help you to identify potential problem areas.
Test-Taking Pitfalls
Reading the Question Too Fast Part of the battle in attempting to pass a standardized examination is
determining what a question is asking. Regardless of how many times you read a question, you cannot
absorb the information if you read the question too quickly.
Changing Answers Going back and changing an answer means that you are second-guessing yourself.
If you employ a good test-taking strategy, there is nothing you will gain from going back to a question for
a second time. If you think you are likely to obtain the information you need from another question,
remember that this examination is written by expert test writers who are not going to give anything away.
Formulating an Answer Too Quickly When you are ready to answer a question, make sure to consider
all four of the choices that are given. Don’t formulate an answer on your own and merely look for that
choice while disregarding the others. Remember, there will often be more than one correct choice and,
while your choice may be right, it may not be the best response.
Making Careless Errors Don’t form preconceived notions when reading a test question. Always read
what is written, not what you expect to see. By keeping an open mind, reading the questions slowly, and
reading them at least two times through, you should be able to avoid these types of errors.
Study Calendars
Following this Introduction, STC has included sample study calendars. These study calendars are designed
to help students in organizing their time and allowing for a manageable amount of daily study. View each
calendar and choose the one that best fits your needs. Remember, these calendars are simply suggestions
for how you may plan your studies. Feel free to make any modifications that you deem appropriate.
Please Note: When reviewing the online PDF Study Manual, a keyword search can be performed
by holding down the “Control” key and clicking on the “F” key (Ctrl + F) or, for Mac users, the
“Command” key and ”F” key (Cmd + F).
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Securities Training Corporation
Series 3 – Three-Week Training

To complete each chapter: * To create a Custom Exam: Log in to my.stcusa.com. From your Dashboard,
1. Watch the On-Demand Lecture for the chapter. select Final Exams, then scroll down and select Create a Custom Exam. Now,
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3. Build a 10-question Custom Exam for the chapter *
the Number of Questions box, and then select Build Exam. You can choose
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whether or not to have the explanation appear after each question is answered.
For the Final Exams: An examination should first be taken with the SHOW EXPLANATIONS turned ON. After completing all of the examinations with
SHOW EXPLANATIONS switched on (and if time permits), begin the process over again by retaking each examination without the explanations shown
(Explanations OFF).
MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY

Complete Chapters 1 – 2 Complete Chapters 3 – 5 Complete Chapters 6 – 8 Complete Chapter 9 Complete Chapters 10 – 11
Take Progress Exams (Approx. 6 hours) Take Progress Exams (Approx. 2 hours) Take Progress Exams
WEEK 1
1A and 1B 2A and 2B 3A and 3B

(Review incorrect answers) (Review incorrect answers) (Review incorrect answers)
(Approx. 4 hours) (Approx. 4.5 hours) (Approx. 4.5 hours)
Take Final Exam 1 Take Final Exam 3 Take Final Exam 5 Take Greenlight Exam 1 Repeat Final Exam 1
(Review incorrect answers from
Take Final Exam 2 Take Final Exam 4 Take Final Exam 6 Final Exams and Greenlight 1)
Repeat Final Exam 2
WEEK 2
(Approx. 6 hours) (Approx. 6 hours) (Approx. 6 hours)

(Explanations OFF)
(Approx. 3.5 hours)
(Approx. 6 hours)
Take Final Exams 3 Take Final Exams 4 Take Final Exams 5 Take Final Exams 6 Take Greenlight Exam 2
(Explanations OFF) (Explanations OFF) (Explanations OFF) (Explanations OFF) (Review incorrect answers from
Final Exams and Greenlight 2)
WEEK 3
(Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours)

Review Crunch Time Facts
(Approx. 4 hours)
PASS THE SERIES 3!
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Series 3 – Four-Week Training
To complete each chapter: * To create a Custom Exam: Log in to my.stcusa.com. From your Dashboard,
1. Watch the On-Demand Lecture for the chapter. select Final Exams, then scroll down and select Create a Custom Exam. Now,
2. Read the chapter in the Study Manual select the appropriate chapter number and, at the bottom of the screen, enter 10 in
3. Build a 10-question Custom Exam for the chapter *
the Number of Questions box, and then select Build Exam. You can choose
4. Create a custom Flashcard deck for the chapter
whether or not to have the explanation appear after each question is answered.
For the Final Exams: An examination should first be taken with the SHOW EXPLANATIONS turned ON. After completing all of the examinations with
SHOW EXPLANATIONS switched on (and if time permits), begin the process over again by retaking each examination without the explanations shown
(Explanations OFF).

Complete Chapters 1 – 2 Take Progress Exams Complete Chapters 5 – 6 Complete Chapters 7 – 8 Complete Chapters 9 – 10
1A and 1B
(Approx. 4 hours) (Approx. 3 hours) Take Progress Exams (Approx. 4 hours)
(Review incorrect answers)
2A and 2B
WEEK 1
Complete Chapters 3 – 4 (Review incorrect answers)

(Approx. 4 hours) (Approx. 4.5 hours)
Complete Chapter 11 Take Final Exam 1 Take Final Exam 2 Take Final Exam 3 Take Final Exam 4
Take Progress Exams (Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours)
3A and 3B
WEEK 2
(Review incorrect answers)

(Approx. 3 hours)
Series 3 – Four-Week Training
Take Final Exam 5 Take Final Exam 6 Take Greenlight Exam 1 Repeat Final Exam 1 Repeat Final Exam 2
(Approx. 3 hours) (Approx. 3 hours)
(Review incorrect answers from (Explanations OFF) (Explanations OFF)
(Approx. 3 hours) (Approx. 3 hours)
WEEK 3
(Approx. 3.5 hours)
Repeat Final Exam 3 Repeat Final Exam 4 Repeat Final Exam 5 Repeat Final Exam 6 Take Greenlight Exam 2
(Explanations OFF) (Explanations OFF) (Explanations OFF) (Explanations OFF) (Review incorrect answers from
(Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours)
WEEK 4
Review Crunch Time Facts

(Approx. 4 hours)
PASS THE SERIES 3!
CHAPTER 1
Commodity Futures
CHAPTER 1 – COMMODITY F UTURES
Introduction
Let’s begin the discussion of commodity futures by first defining a futures contract and then examining the
reason why the market evolved for futures. A commodity futures contract is an agreement that’s entered
into between a buyer and a seller on the floor of an exchange. The buyer agrees to take delivery of the cash
commodity and pay the seller the contract price. The seller agrees to deliver the cash commodity, for
which he will receive the contract price. As will be examined later, both the buyer and the seller may
remove the obligation of making and taking delivery of the cash commodity through the process of
offsetting their futures positions.
Markets for trading in the cash commodity evolved centuries ago. Buyers and sellers of cash commodities
would meet at an agreed-upon location in order to transact business with one another. It was far more
convenient for both the buyer and the seller to meet at a specified time and place, rather than at various
locations.
Cash Forward Transactions

Trading was initially conducted in the cash commodity (spot) for on-the-spot delivery. However, trading
later evolved in cash forward transactions. A cash forward transaction involves an agreement between a
buyer and a seller for delivery of a specified amount of the cash commodity to be delivered at a specified
time, price, and delivery point. For example, the seller may agree to deliver 3,500 bushels of wheat to the
buyer in 10 weeks at the location that’s specified by the buyer. The price at the point of delivery will have
already been agreed upon.
Although the cash forward contract has similarities to a futures contract, it differs in certain other respects.
The cash forward contract could be for any amount of the cash commodity and for any quality, as agreed
by the buyer and seller. As will be shown, futures contracts are always for specific amounts of the
commodity (e.g., 5,000 bushels of wheat for each contract executed on the Chicago Board of Trade) and
for a specified grade of the commodity. On the CBOT, a futures contract in wheat could never be for any
amount other than a multiple of 5,000 bushels. The cash forward and the futures contract also differ in
another very important respect. The cash forward contract is a non-transferable agreement between the
buyer and the seller. In other words, both parties have obligations (the seller to deliver the commodity and
the buyer to pay for the commodity on receipt). Typically, neither the initial buyer nor seller are able to
transfer the obligation to a third party without the permission of the original partner to the agreement. On the
other hand, in a futures contract, both the buyer and the seller may transfer their obligation to a third party
without permission.
Futures Contract
The futures contract evolved out of the cash forward contract. A futures contract is negotiated on an
exchange, which is a single, central market on which all purchase and sale orders are channeled.
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A transaction in futures is made on the floor of the exchange between brokers who are members of the
exchange. A broker who represents the buyer will transact an order with a broker who represents the seller.
A futures contract occurs when the two brokers transact a purchase and sale.
In summary, a cash forward contract differs from a futures contract in that the futures contract is not
personally negotiated between the buyer and seller, it’s always for a specified grade and amount of the
commodity, and it’s delivered from locations and at times that are specified in exchange rules.
Commodity Futures Contract

A commodity futures contract is a standardized contract that’s set by a particular exchange and includes
the size (e.g., 5,000 bushels, 100 ounces, 42,000 gallons); the point from which delivery will be made
(e.g., a warehouse or depository that’s been approved by the exchange); the grade of the commodity that’s
to be delivered; and the price of the transaction.
Buyers and sellers of futures contracts both incur obligations. The buyer is obligated to take delivery and
make payment for the cash commodity. The seller is obligated to deliver the cash commodity, for which he
will be paid the contract price. However, both the buyer and the seller have the right to eliminate their
obligations through the process of offsetting, which will later be examined in detail.
Basis Grade
The grade of the commodity that may be delivered on a futures contract is determined by the exchange on
which the commodity is traded. The standard grade that may be delivered is referred to as the basis grade.
The exchange will allow the seller to deliver a substitute grade that’s lower in quality than the basis grade
at a discount in price or one that’s higher in quality than the basis grade at a premium in price. The
exchange specifies which lower and higher grades are deliverable.
The purpose of allowing the delivery of substitute grades is to increase the supply of the commodity that
may be delivered and thereby minimize the possibilities of “corners.” A corner exists when an individual
or group of individuals who are acting in concert accumulates all (or substantially all) of the available
supply of a commodity. By controlling the cash commodity, they’re able to dictate the price that a seller
must pay for the cash commodity in order to make delivery on his short position. This is also referred to as
a “squeeze.”
Premium and discount grades don’t apply to all futures contracts. For example, they apply to grains (e.g.,
wheat and corn) and also soybeans, but not to soybean oil and soybean meal. Soybean oil and soybean
meal must meet exchange specifications and only the basis grade may be delivered.
Long and Short Positions

The term “long” is used to describe a person who has an actual cash position. For example, a grain elevator
operator who has one million bushels of wheat in his elevators is long the cash wheat. The term “short” is
used to describe a person who has an obligation to deliver the cash commodity, but doesn’t own it.
S3 1-2 Copyright © Securities Training Corporation. All Rights Reserved.

The person with the obligation is short cash and will need to buy it at a later date. For example, an exporter
who has agreed to deliver one million bushels of wheat in three months has a contractual obligation to
deliver the cash wheat, but he doesn’t currently own it.
The terms “long” and “short” also apply to futures. An individual is long if he has purchased a futures
contract that’s still open. An individual is short if he has sold a futures contract that’s still open.
Let’s now examine some simple examples of hedging. An individual is long 100,000 bushels of wheat that
he purchased for $3 per bushel and he intends to sell the wheat at some time in the future. From the time
that he buys the cash wheat until he sells it, he’s vulnerable to a price decline. Let’s assume that the price
of wheat drops to $2.90. If he sold at this price, he would have a loss of $10,000. He could substantially
reduce his risk of loss from the price decline by hedging his position. He will hedge by selling futures. If
the price of cash declines, the price of futures will usually also decline by approximately the same amount.
Let’s assume that he sells futures at $3.10 when he bought cash at $3.00. When the price of cash declines
to $2.90, the price of futures also declines to $3.00. His loss of $0.10 (10 cents) on cash will be matched
by a gain of $0.10 in the futures market.
If an individual is not the owner of the cash commodity, but is obligated to deliver it at some later date,
he’s considered short cash. For example, a grain exporter agrees to deliver 100,000 bushels of wheat in
three months at the current price, which is $3.00. He doesn’t own the cash wheat and is therefore short.
His concern is that the price of wheat will rise when needs to buy it to fulfill his commitment. He will buy
futures as a temporary substitute for his later cash market purchase. If the price of cash wheat rises and
causes a loss, the price of futures will usually also rise. He will buy the cash commodity at the higher price
and at the same time sell the futures at a higher price. His loss on cash will be matched by a profit on futures.
Benefits Provided by the Futures Exchange

The first and principal benefit provided by the exchange is that it allows producers and users of the cash
commodity to hedge and thereby substantially reduce the risk of adverse price fluctuations for the cash
commodities that they use in their business operations. A hedge is the establishment of a futures position
that’s the opposite of a cash position. The purpose of the hedge is to establish a temporary substitute for a
cash market transaction that will be made at a future date. The individual who owns the cash commodity
will sell futures. The sale of futures will serve as a temporary substitute for the cash market sale that he
will make at a later time. If the price declines on his cash position, he will have a loss. However, this loss
will be substantially matched by a corresponding gain on futures.
The individual who has sold the cash commodity and who’s committed to buying it at a later date will buy
futures. The purchase of futures will serve as a temporary substitute for a later cash market purchase. If the
price of the cash commodity rises substantially, the hedger will be required to buy it at a higher price. Any
loss that he incurs on the cash market purchase will be substantially matched by a profit on futures.
Hedging will be examined in detail in a later chapter.

A second benefit provided by futures exchanges is a reduction in the price of the cash commodity to the
public. This benefit is the result of hedging which reduces the risk to producers and users of the cash
commodity. Through hedging, if a producer or user of the cash commodity is able to reduce most of the
risk of adverse price changes, he will be able to operate his business at a lower profit margin. The lower
profit margin is possible because the person is not required to add in an extra amount to offset his risk due
to adverse price change.
A third advantage of futures exchanges is that they provide a central point to channel the risk capital of the
speculator to a single location. A speculator is an individual who buys a commodity if he anticipates a
price rise or sells a commodity if he anticipates a price decrease. Speculators buy and sell futures contracts
in the hopes of making profits and are willing to accept the risk of price changes that producers or users of
the cash commodity are trying to avoid. By hedging their cash position through purchase or sales of futures,
producers or users thereby transfers their risk to the speculators. For example, if an individual is long a
cash commodity, he will hedge by selling futures. The person who buys futures from the hedger will often
be a speculator. If a speculator doesn’t have a cash position, he will buy futures with the expectation of a
price rise. Essentially, the speculator assumes the risk that the hedger is trying to avoid.
A fourth benefit provided by a futures exchange is that a producer or user of the cash commodity will be
able to obtain credit from banks and other lenders at a more favorable rate if his position is hedged. This
benefit will be examined in more detail later with hedging.
A fifth benefit of a futures exchange is that it provides a focal point to which all buy and sell orders are
sent. The price at which a transaction is made establishes the value of the commodity. The exchange also
disseminates valuable statistical information about commodities.
A sixth benefit of the futures exchange is that it provides an alternate market for the producer or user who
wants to buy or sell the cash commodity. Most producers and users of the cash commodity will use the
futures market for hedging purposes. In other words, they buy and sell the cash commodity in the cash
market. Their futures purchases and sales serve as temporary substitutes for the later cash market
purchases and sales that they make. However, a producer or user of the cash commodity may choose to
make or take delivery on his futures contracts. Therefore, the futures market provides an alternate channel for
marketing the cash commodity.
The responsibility for supervising trading in commodity futures is given to the Commodity Futures
Trading Commission (CFTC), which is a government agency. The CFTC has established certain rules that
must be followed by any person who trades in commodity futures. The CFTC allows the exchanges to
regulate themselves, but the regulation is subject to CFTC review. The exchanges have established rules
and regulations to ensure that all aspects of futures trading comply with the appropriate rules.

Futures Exchange
An exchange is an association of members, but it doesn’t buy or sell commodity futures for its own
account, doesn’t own any commodities, and doesn’t determine prices for commodity futures. The purpose
of an exchange is to provide facilities for members to conduct trading in commodity futures and to ensure
that members conduct business in a manner that’s just and equitable.
Memberships on a commodity futures exchange are owned by individuals. In order to be a member firm of
an exchange, a firm must be associated with at least one individual who owns a membership. Only
members of an exchange are allowed to transact orders on the floor of the exchange.
Exchanges are responsible for establishing rules that govern the conduct of its members. The exchange
investigates complaints and assesses appropriate penalties. The exchange will also arbitrate disputes
between members or, if requested, between members and customers.
Historically, there have been many different futures exchanges. Originally, some focused on grains, others
on soft commodities (e.g., sugar, coffee, cocoa) and others developed around metals (e.g., gold and silver)
and energy products (e.g., crude oil and gasoline). More recently, the exchanges have been merging and
now there are two large conglomerate firms that run futures exchanges:
1. The CME Group, which includes:

• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)
• CME Globex (electronic trading)
• Kansas City Board of Trade
• Minneapolis Grain Exchange
• New York Commodities Exchange (NYMEX)
• Commodities Exchange (COMEX)
2. The Intercontinental Exchange (ICE), which includes:

• ICE Futures U.S. (IFUS)
• ICE Futures Europe (IFEU)
• ICE Futures Singapore (IFSG)
• ICE Endex (NDEX)
On both CME and ICE exchanges, retail and institutional investors have access to the same prices.
However, CME contracts are cleared by the CME Clearinghouse and ICE contracts are cleared by ICE
Clear U.S., ICE Clear Europe, or ICE Clear Singapore. As a result, some CME Group contracts are
fungible (interchangeable) with other CME contracts and ICE contracts are fungible for other ICE
contracts. For example, an investor can buy several S&P 500 E-mini contracts and sell one S&P 500
futures contract on the CME’s electronic Globex platform.

Exchange Committees
The exchanges have various committees that perform specific functions and some of the most important
exchange committees include the following:
Arbitration Committee This committee settles disputes arising between members, member firms, and
the public. For an exchange to accept a dispute for arbitration, all parties involved in the dispute must
voluntarily agree to submit the dispute to arbitration.
Business Conduct Committee This committee investigates complaints against members and acts to
prevent price manipulation. Another responsibility is to supervises the conduct of members as well as
member firms and their employees to ensure compliance with the appropriate rules.
Floor Committee This committee establishes rules regarding trading on the floor of the exchange and
settles disputes that arise between members as it relates to transactions on the floor. The committee also
ensures that all transactions in futures are conducted in the trading pits in accordance with exchange rules.
Trading on the floor of the exchange is conducted in pits or rings by “open outcry.” This means that
brokers are required to announce their bids and offers in a loud and clear voice for any other brokers to
hear. Trades outside of the pit or ring (with the exception of “ex-pit transactions,” which will be described
later) are prohibited. Members who execute customer orders are referred to floor brokers.
Floor Traders These members trade for their own accounts and are also referred to as “locals” or
“scalpers.” Their willingness to buy and sell futures contracts for small profits adds to the total number of
bids and offers in the market and thereby aids the efficiency of the market. Floor traders typically establish
and close out a position during the same trading session, which is referred to as day trading. Traders who
hold positions for more than one trading session are referred to as position traders.
It’s important to note that floor traders are trading for their own accounts and risk. Their sole objective is
to make profits for themselves. Although a designated market maker (specialist) on a stock exchange also
buys and sells stocks for his own account and risk, a floor trader is different from a designated market
maker. The designated market maker on a stock exchange must buy stocks in which he specializes for his
own account when there are no other buyers in the market, and he must sell stock for his own account
when there are no other sellers in the market. In this way, the designated market maker is committing his
own funds to maintain an orderly market. Conversely, the floor traders are not designated market makers
and don’t have any responsibility to maintain an orderly market.
Successful Exchange Markets

For a futures market to be successful, there must be a large number of participants in the market. In a
“thin market,” which is one in which there are relatively few participants, the market will be inefficient.
For definitional purposes, an efficient market (also considered a continuous market or a liquid market) is
one in which there are small variations between bids and offers as well as small variations between
subsequent transactions.

If there are a large number of buyers and sellers actively competing with each other, the spread between
the bid and the offer will be small. This means that variations between subsequent trades will also be
small. However, if there are few participants in the market, the spread between bids and offers will be
relatively wide and there will be large fluctuations between successive transactions. This is referred to as
an illiquid or volatile market.
One factor that’s necessary for the success of a futures market is a minimum amount of government
control over prices and production so that the price of the commodity can reach its natural level without
any artificial influences. Tight controls will prevent the price of a commodity from reacting to changes in
supply and demand and will cause a lack of interest among both hedgers and speculators. Another factor that’s
required for a successful market is that the commodity must be one which is easily graded and
standardized. This is essential for buyers to have confidence that the commodity being delivered on a
futures contract will be acceptable. Without this assurance, buyers would need to inspect each shipment
before they enter into a futures transaction. In a futures market, since this would be impossible, the market
could not succeed.
Speculators
Individuals who trade in futures contracts may be either speculators or hedgers. Speculators buy and sell
futures for the purpose of making a profit. The speculator will take a long position (buy futures) when she
anticipates that the price will rise. On the other hand, she will take a short position (sell futures) when she
anticipates that the price will fall. If the speculator is correct in her judgment, she will make a profit.
However, if she’s incorrect, she will suffer a loss. By entering bids and offers for a commodity, the
speculator adds to the liquidity of the market. Without active participation of speculators, a market would
be thin. A thin market in one in which there’s a lack of sufficient liquidity and has volatile price changes.
Hedgers
The hedger is not primarily interested in making a profit through the purchase and sale of futures; instead,
the hedger is interested in shifting his risk of loss on the cash commodity as the result of adverse price
changes. The hedger does this by making a futures purchase or sale to serve as a temporary substitute for a
cash market transaction that he will make at a later date. The hedger is a businessperson who produces or
uses the actual cash commodity, such as a farmer or a wheat miller. The hedger uses the futures market
primarily as a means of shifting the risk of adverse price changes to other persons who are willing to
assume the risk. It’s the speculator who assumes the risk that the hedger is trying to avoid, and this
assumption of risk is one of the most important benefits that the speculator provides to the futures market.
Responsibilities of the Exchange

The exchanges establish the specifications of commodity contracts, including the grades that are
deliverable, the delivery months, how and where delivery will be made, and the size of the contract. The
exchange also establishes the amount of margin that a customer must deposit initially as well as the
amount he must maintain in his account subsequently (original margin and maintenance margin are not the
same amounts).

The exchange also establishes rules for the prevention of price manipulation and it designates which
warehouses are “regular for delivery,” which means those that may be used as depositories from which
deliveries are made. Delivery on futures contracts may only be made from warehouses or other
depositories that are approved by the exchange. The exchange also provides for inspection of the cash
commodity by inspectors who are licensed by the exchange.
Processing an Order
If a customer intends to establish a position in a futures contract, he will do so through a firm that’s
registered as a futures commission merchant and a clearing member of the exchange. The firm will send
the order to the floor of the exchange and a floor broker will enter the trading pit from which he will
announce his bid or offer by open outcry. Side transactions from outside of the trading pits are prohibited. All
orders in commodity futures must be done on an exchange. In other words, there’s no over-the counter
market in commodity futures. As orders are completed, a floor reporter will make note of the trade and
will see that the trade is reported on the ticker tape. Floor brokers on an exchange may be independent
agents who transact orders for any firm that’s willing to give them an order, or they may be associated
with a single member firm and only transact orders for that firm. Floor brokers who fail to execute orders
properly are responsible for any losses that might be caused by their errors. The brokerage firm that’s
handling the customer's order will charge the customer a commission for executing the order.
Clearing House
Every commodity futures exchange is affiliated with a clearing house since it’s not possible for the futures
exchanges to operate as they do without one. Clearing member firms are required to clear all purchases
and sales that they transact during a trading session. For that reason, the member firm will report all of
their trades to the clearing house. For example, if a firm buys 30 contracts of corn for some of its
customers and sells 20 contracts of corn for other customers, the firm is required to report to the clearing
house 30 long contracts and 20 short contracts.
The clearing house will require the member firm to deposit original margin for the trades that it clears. Most
clearing houses, including the Chicago Board of Trade, require that margin be deposited for the net trades
that are cleared. In the above example, the firm was required to clear 30 long contracts and 20 short
contracts. However, in that case, the firm is only required to deposit margin for 10 net long contracts.
Every futures commission merchant must arrange to clear its trades with the clearing house of the
exchange. A futures commission merchant may accomplish this by being a member of the clearing house,
or it may arrange to have its trades cleared, for a fee, through another member firm that’s a member of the
clearing house. As it relates to integrity and financial capability, membership requirements for the clearing
house are stringent. Remember, a membership on the exchange may only be owned by an individual;
however, member organizations may themselves be members of the clearing house.
In addition to requiring margin for net trades that are cleared on the CBOT by member firms, the clearing
house may also impose limits on the number of trades that a member firm may clear, or may require that
additional margin be deposited by a member firm that clears more than a specified number of contracts.
The purpose of these requirements is to ensure the clearing house’s financial integrity and capability.

Settlement
The clearing house settles all positions on a daily basis. Member firms that owe money to the clearing
house are required to deposit the money prior to the opening of business on the following day. When a
customer takes an initial position, she’s required to deposit original margin with the member firm.
Thereafter, the member firm deposits the original margin with the clearing house. The member firm’s
deposit with the clearing house must be made before the opening of trading on the next business day.
Margin Requirements
The amount of money that the member firm is required to have on deposit with the clearing house will
fluctuate as changes occur in the market price of the futures contracts. The clearing house will compare the
margin deposit of the member firm with the current market price of the futures contract. If money is owed
by the member firm, the clearing house will issue a call for additional margin. This additional margin is
referred to as variation margin.
The clearing house uses the settlement price that’s established by the exchange as the basis to determine
whether more money is due from the member firm. The settlement price is typically a price within the
range of the contract's closing prices. If no trading occurs in a particular futures contract, a nominal price
will be established by the exchange, which is normally an average between the closing bid and offer.
If the price of a futures contract moves in an adverse direction and causes a decrease in equity, the member firm
will be required to deposit additional margin. For example, let's assume that the original margin on a long
position is 20 cents per bushel, the maintenance margin is 15 cents a bushel, and the size of the contract is
10,000 bushels. The member firm will be required to deposit $2,000 in original margin. If the price of the
contract drops by 6 cents per bushel, the amount of equity will decrease to 14 cents, or $1,400. The
member firm will be required to deposit additional margin. If the price of the futures contract moves
favorably, causing an increase in equity, the member firm will receive a check for the amount in excess of
the original margin requirement from the clearing house. For example, in the above example, if the price
of the contract advanced by 5 cents per bushel, the clearing member would receive a check for $500 from
the clearing house.
Normally, both original margin and variation (additional) margin must be deposited with the clearing house
before the opening of trading on the next business day. If a market is especially volatile, the clearing house
has the right to call for variation margin during the trading session. In this case, the variation call must be
answered within one hour.
Clearing Commodity Transactions

Once the clearing house has received a report of a trade from a selling broker and a buying broker, it
performs the very important function of acting as a buyer to all sellers and a seller to all buyers. The
clearing house acting as the counter-party to each transaction is essential if the exchange is to perform
its function.

Of course, when a futures contract is traded, there’s one buyer and one seller. For example, if a trader buys
a contract, he’s obviously buying it from a person who’s selling the same contract. The seller has the
obligation to make delivery of the cash commodity during the delivery month, while the buyer has the
obligation to take delivery during the delivery month and pay for the cash commodity. These obligations
remain in force unless either party makes an offsetting transaction.
When the trade is made on the floor, neither the buyer nor the seller knows, nor cares about, the identity of
the other party to the trade. However, each side is obligated to the other to perform on the terms of the
contract. If the buyer wants to eliminate his obligation of accepting delivery of the cash commodity, he
could do so by selling his long position.
In cash market transactions, the buyer is required to consult with the seller to obtain permission to transfer his
obligation to another party. However, through the facilities of the clearing house, neither party to the
transaction requires permission of the other party to eliminate his obligation by offsetting his position. This is
because the clearing house has assumed the role of buyer to all sellers and seller to all buyers. When the trade
was made between the buyer and the seller and it was subsequently cleared, the clearing house became the
buyer for the seller and the seller for the buyer. If the seller decides to make delivery, he looks to the clearing
house to provide him with a buyer who will stand for delivery and pay for the cash commodity. It doesn’t
matter to the seller that the person who’s accepting delivery is not the original party to the trade. The seller
will be provided with a buyer by the clearing house and the buyer will pay for the cash commodity.
It’s because the clearing house stands ready to provide a buyer for a short who wants to make delivery, or
provide a seller for a long who wants to accept delivery, that the process of offsetting is able to work in the
futures market. Let’s consider an example of how offsetting works.
A trader in Los Angeles decides to sell a contract of corn. He gives his order to his account executive who
has the order transmitted to the floor of the exchange. At the same time, another trader in New York
decides to buy a contract of corn. His order is also transmitted to the floor. The floor brokers meet at the
trading pit and transact the order at $2 per bushel. The trader in Los Angeles is now short a contract at $2
and the trader in New York is long a contract at $2. The seller has incurred the obligation of making
delivery of the corn, while the buyer has incurred the obligation of taking delivery and paying for the corn.
The obligation to make and take delivery during the delivery month may be eliminated through offsetting.
Let’s assume that, prior to the expiration of trading during the delivery month, the seller decides to end his
obligation. He will buy an equivalent contract on the same exchange. Because he bought back one contract
of corn, he cancels his short position. The original seller buys the contract on the floor from any person
who’s willing to sell a contract. The new seller of the contract replaces the old seller on the clearing
house’s books.
How does this affect the original buyer in New York? He bought a contract from a seller in Los Angeles who
has now left the market by offsetting his original short position. There’s no impact on the buyer in any
way because the clearing house will provide a new short to make delivery if the long chooses to stand for
delivery. It doesn’t matter to the buyer whether the delivery is made by the original seller or any other
seller. All that really matters is that some person delivers one contract of corn.

In the above example, if the parties decided to offset their positions by selling an equivalent amount of
contracts (to offset a long position), or by buying an equivalent amount of contracts (to offset a short
position), the futures commission merchant that carries each trader’s account would compute the profit
or loss for each trader. For example, let’s assume that the buyer bought a contract of corn at $2 per
bushel, which makes him contingently liable for accepting 5,000 bushels of corn and paying $10,000.
The seller has the obligation of delivering 5,000 bushels of corn, for which he will be paid $10,000.
During the time the contract is trading, if both parties decide to eliminate the obligation through
offsetting, they may do so by simply making an opposite trade on the same exchange. Let’s assume that
the trader who’s long decides to offset his position by selling one contract at the current price of $1.95.
In this case, he will be credited with $1.95. Since his original purchase was made at $2, he therefore has
a loss of $0.05 per bushel, or $250.
Two weeks later, the original seller decides to offset his position by buying one contract on the same
exchange on which he made the original sale at the current price of $1.90. Since his original sale was made
at $2, he has a profit of 10 cents per bushel, or $500.
When an offsetting trade is made, it’s typically required to be done on a contract with the same underlying
commodity and in the same delivery month in which the original position was taken. For example, if a
trader buys one contract of September wheat on the Chicago Board of Trade and he wants to offset his
position by selling one contract, he must sell one contract of September wheat on the Chicago Board of
Trade. He cannot offset his position by selling one contract of May wheat on the Chicago Board of Trade.
Since the Kansas City wheat contract has a different type of wheat, he cannot offset his position by selling
one contract of September wheat on the Kansas City Board of Trade.
Very few contracts are settled by delivery of the cash commodity. In fact, approximately 98% of all contracts
are offset prior to the expiration of trading. Now, let’s consider one more example to identify how
contracts are established, offset, and delivered.
A trader in Boston buys a contract of wheat from a trader in San Francisco. Neither party has any intention
of making or taking delivery, although both are obligated to do so when they establish their positions. The
party in Boston cancels his obligation to take delivery by selling one contract to a new buyer in Cleveland.
Now, the Boston trader is out of the market, having sold the same amount that he originally purchased. Any
profit or loss that he has will be computed by the futures commission merchant. The trader in San Francisco is
still short and has the obligation to make delivery. However, he offsets his obligation by buying one
contract from a trader in Detroit who replaces him as a short on the books of the clearing house. If the
delivery month now arrives, the clearing house will instruct the clearing member futures commission
merchant that’s carrying the account of the trader in Detroit (the last seller) to deliver the cash commodity
to the clearing member futures commission merchant that’s carrying the account of the trader in Cleveland
(the last buyer). Therefore, all intermediate parties who have bought and sold from the inception of trading
are not involved in the final delivery and payment for the cash commodity because they have offset their
positions. This is possible because of the clearing house.

Delivery Process
Delivery of the cash commodity is made only during the delivery month. For example, on January 15th an
individual sells a contract of September wheat on the Chicago Board of Trade. He cannot deliver the
wheat until September. When the delivery month arrives, the clearing house will direct a short to deliver
the cash commodity to a long.
Delivery may be made only from a warehouse or other depository that’s “regular for delivery.” This means
a facility that has been approved by the exchange as a location from which delivery may be made. The
commodity will be inspected when it’s deposited by the seller to ensure that it meets the exchange’s
standards. The seller will determine the specific day and location (the exchange may have more than one
approved delivery point) from which delivery will be made.
The buyer doesn’t have any control on when or from where the cash commodity will be delivered. The
short who intends to deliver the cash commodity will notify his broker to send a notice of intention to
deliver to the clearing house. The notice will contain information regarding the grade of the commodity
that will be delivered (either the basis grade or an approved discount or premium grade), the weight to be
delivered, the place from which delivery will be made, and the date on which delivery will be made.
There’s one exception to the rule that the seller determines the details regarding delivery. On trades involving
currencies on the Chicago Mercantile Exchange, it’s the buyer who determines the location from which
settlement will be made. Settlement of currency contracts is made from a bank in the country of issuance
at the option of the buyer. For example, on a contract involving the Swiss franc, the buyer determines the
bank in Switzerland from which settlement will be made.
There are different methods used by the clearing houses to determine which buying clearing member will
receive the delivery notice. The Chicago Board of Trade sends the notice to the clearing member that has the
oldest long position. Other exchanges send the notice to the clearing member that has the largest net long
position or the largest gross long position. Certain exchanges require that a delivery notice be “stopped.”
This means that a buyer who’s assigned a delivery notice must accept delivery. On other exchanges, the
notice may be passed to another party by selling an equivalent amount of the commodity and passing the
notice to a new buyer. For example, if an individual is long a contract during the delivery month and he’s
assigned a delivery notice, he may immediately sell a contract in the same delivery month on the same
exchange and retender the delivery notice to a new buyer.
The actual transfer of the cash commodity from a short to a long takes place when the seller transmits the
proper delivery papers to the buyer and the buyer pays for the cash commodity. The delivery papers that
are passed from the buyer to the seller are referred to by different names on different exchanges. For example,
grains are delivered by means of a warehouse receipt, gold by means of a depository receipt, plywood by
means of a shipping certificate, and iced broilers by means of a demand certificate.

Speculators should not accept delivery on futures contracts because they’re generally not in a position to
handle the actual commodity. In the event that a speculator does accept delivery, he must pay for the full
value of the cash commodity or arrange for financing from his broker, paying interest to the broker.
Speculators should leave the market by offsetting their position once the first notice day begins. The term
“first notice day” refers to the first day in the delivery month on which delivery of the cash commodity
may be made.
If a speculator wants to maintain his position without being concerned that he will be assigned a delivery
notice, he may do so by entering a switch order. This is an order whereby the trader offsets his original
position through an opposite trade on the same exchange in the same delivery month and, at the same time,
reestablishes his original position in a later delivery month. For example, if a trader is long one contract of
July wheat on the Chicago Board of Trade, he will sell one contract of July wheat on the Chicago Board of
Trade and take a new long position in a later delivery month (e.g., December). An offsetting transaction
may only be made before the last trading day during the delivery month. Any person who remains long
beyond the last trading day must accept delivery of the cash commodity.

Chapter 1 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Understand the difference between cash forward and futures contracts
‒ Cash forwards are personal and can be customized
‒ Futures are exchange traded, have predetermined delivery sizes, and basis grades
 Recognize the long and short positions
‒ Long positions are bullish
‒ Short positions are bearish
 Know the different market participants and their objectives
‒ Hedgers want to limit the risk associated with cash price movements
‒ Speculators want to buy and sell in order to make a profit
 Identify the exchange committees and their roles
 Understand the functions of the clearinghouses
‒ Collect margin and eliminate counter-party risk
 Understand the process behind clearing futures contracts, final settlement, assignment and delivery
Create a Chapter 1 Custom Exam

Now that you’ve completed Chapter 1, log in to my.stcusa.com. From your Dashboard, select Final Exams,
then scroll down and select Create a Custom Exam. Now, select Chapter 1 and, at the bottom of the screen,
enter 10 questions in the Number of Questions box, and then select Build Exam.

CHAPTER 2
Regulations
CHAPTER 2 – REGULATIONS
Federal Regulation of Commodity Futures and Options

The commodity futures and options industry is regulated by the Commodity Futures Trading Commission
(CFTC) and the National Futures Association (NFA). The CFTC is an independent federal agency that was
established by Congress in 1975 as part of a major revision of the Commodity Exchange Act. The principal
functions of the CFTC are to prevent the manipulation of futures and options prices; establish and enforce
customer protection rules and minimum financial and ethical standards for commodity firms and
professionals; prohibit the spread of false and misleading market information; approve new futures and
options contracts; regulate exchanges and floor members; and provide for settlement of customer claims.
While the CFTC has overall responsibility to regulate futures and options, it has delegated certain
responsibilities to the NFA and the contract markets (exchanges). In turn, the NFA and the exchanges
carry out these delegated responsibilities, but are still subject to the supervision and review of the CFTC.
The National Futures Association

The NFA is a self-regulatory organization of the commodities industry. The principal functions of the
NFA are to audit its members to ensure that they meet minimum financial requirements; enforce ethical
standards and customer protection rules; provide for arbitration of disputes between member firms and
customers; conduct registration screening of commodity personnel; and establish training standards and
proficiency testing (e.g., the Series 3 Exam) of commodity personnel.
NFA Membership Requirements

Membership in the NFA is mandatory for futures commission merchants (FCMs), introducing brokers (IBs),
commodity pool operators (CPOs), and commodity trading advisors (CTAs) who decide on trades or place
orders for customers.
Any person who acts as an associated person (AP) of a member firm must become an NFA associate
member. Although floor brokers and floor traders are exempt from NFA membership, they’re still subject
to the regulation of the exchange on which they have trading privileges. Exchanges are subject to direct
CFTC oversight and are fully regulated without NFA membership. Commodity trading advisors are
exempt from membership in the NFA if they neither direct nor place trades for customers.
The NFA prohibits its members from conducting futures or options related business with a suspended
NFA member, or with an FCM, IB, CPO or CTA that’s a non-member, but is required to be an NFA
member. By forbidding NFA members from conducting business with non-members, the NFA is able to
enforce its requirements for membership.
The NFA’s prohibits its members from conducting business with non-member FCMs, IBs, CPOs and CTAs
unless the non-member comes under a specific exemption of the CFTC’s requirements for registration.

A person or firm that’s exempt from registration is also exempt from NFA membership requirements. A firm
may be registered despite the fact that registration is not required. If this is the case, NFA membership is
considered optional.
NFA Registration Requirements

Futures Commission Merchant (FCM)
A futures commission merchant can be an individual or a business entity (e.g., a partnership, corporation or
trust) that solicits or accepts orders for futures or options contracts traded on an exchange and accepts money
(or securities or property) from a customer to margin, guarantee, or secure the option or futures transaction.
An individual who trades for her own account only is exempt from registering as a futures commission
merchant. An FCM must maintain adjusted net capital that’s equal to, or in excess of, $1 million.
Futures commission merchants may be either clearing or non-clearing firms. A clearing firm is one that
processes trades that are executed on an exchange. A non-clearing firm is one that processes its trades through
a clearing firm. In order to become a clearing member futures commission merchant, the futures commission
merchant must satisfy the particular exchange’s capital requirements and must agree to abide by exchange
rules. The exchange will conduct audits of its clearing member futures commission merchants periodically.
Futures commission merchants that are not clearing members of an exchange must open an “omnibus account”
with a clearing member futures commission merchant in order to have its customers’ trades cleared. The
omnibus account consists of the trades that belong to all of its customers and is carried by the clearing
member futures commission merchant on a “non-disclosed basis.” In other words, the account only shows
she name of the non-clearing member futures commission merchant, but not in the names of its customers. In
turn, the non-clearing member futures commission merchant will issue individual confirmations, purchase
and sale statements, and monthly statements to each of its customers.
Before trading begins, when a customer opens an account with a futures commission merchant, the FCM
must obtain specific background information from the customer. If the account is introduced to the futures
commission merchant by another futures commission merchant or by an introducing broker or commodity
trading advisor, then it’s the responsibility of the NFA member that actually solicits the account to obtain
the background information. The information to be obtained includes the customer’s name, address,
occupation, annual income and net worth, previous investment and trading experience, and age.
After the associated person obtains the background information, it must be reviewed by a branch office
manager, supervisory employee, director, officer, or partner of the futures commission merchant. The
person performing the review must also determine whether to approve the opening of the account before
the associated person can execute a trade for the customer.
The futures commission merchant and associated person may rely on the customer as the sole source for the
background information. There’s no requirement for the futures commission merchant and associated
person to verify or independently check the customer’s background information.

If a customer refuses to provide background information other than his name, address, age, and
occupation, the futures commission merchant still may open the account for the customer as long as the
FCM or associated person makes a written record of the fact that the customer refused to disclose
background information and the account has been approved.
Futures commission merchants usually enter into a written account agreement with their customers before
executing any trades for the account. If the futures commission merchant (or any other person) has
discretion over the account, it must be evidenced in writing by a power of attorney that’s signed by the
customer. If discretion is subsequently revoked or canceled, the revocation must be in writing. Discretion
is also canceled upon the death of the customer.
The account agreement will define the rights and obligations of the futures commission merchant and the
customer. For example, the customer is required to post adequate margin in the account, and if he doesn’t, the
futures commission merchant is permitted to liquidate the position. In addition, the futures commission
merchant is required to provide written confirmation of the customer’s trades following their execution and
is also required to segregate the customer’s funds from the futures commission merchant’s funds.
If a customer also has a securities account with the futures commission merchant, the customer may enter
into a transfer agreement. The transfer agreement allows the futures commission merchant to transfer funds
from the commodities account to the securities account without contacting the customer. If a transfer
agreement is not executed by the customer, this type of transfer may only be accomplished with the
customer’s specific written consent for each individual transfer.
Introducing Broker (IB)

An introducing broker is an individual or business entity that solicits or accepts orders for futures or
options contracts traded on an exchange, but doesn’t accept money, securities or property, or extend credit to
its customers. Introducing brokers cannot accept funds in their customers name or in the name of the firm.
IBs may accept customer funds in the name of the FCM if they have (and maintain) written authorization
from the FCM.
The checks must be deposited in a qualified bank account on the same day they’re received. A qualified
bank account is an account that’s in the name of the FCM and titled “Customer Segregated Funds.” Also, it
must be a one-way account for the FCM. The introducing broker will place orders with one or more
futures commission merchants who maintain the account.
An IB must maintain adjusted net capital that’s equal to or in excess of $45,000. If an IB chooses not to
maintain its own net capital, it may satisfy the minimum financial requirement by entering into a guarantee
agreement with a registered FCM. This agreement doesn’t have an expiration date and continues until
termination. An IB may only be guaranteed by one FCM. The guaranteed IB may introduce accounts to
more than one FCM; however, the guaranteeing FCM may require an exclusive agreement.

Commodity Trading Advisor (CTA)

A commodity trading advisor is an individual or business entity that advises others on the trading of
futures or options contracts for compensation or profit. The definition of a commodity trading advisor may
include a person or firm who regularly issues analyses or reports concerning commodities. A CTA cannot
accept customer funds to margin or place futures or options trades. Certain entities are exempt from
registering as commodity trading advisors since their services are solely incidental to the rest of their
business activities. Examples include banks, accountants, newspaper reporters and publishers, and
employees of business or financial periodicals.
Other exemptions apply to individuals who have not advised more than 15 other persons during the last
12 months and don’t claim to be commodity trading advisors, commodity pool operators who advise only
the pools for which they’re registered, individuals who operate in the cash market whose advice relates only
to its cash market business, and registered personnel (e.g., associated persons, futures commission
merchants, and introducing brokers) who render advice in the normal course of their business. The
commodity trading advisor may not accept customer funds in his name or the name of the firm.
Commodity Pool Operator (CPO)

A commodity pool operator is an individual or business entity which pools the funds of several customers
to trade as one account. A commodity pool operator may accept customer funds for the purpose of trading
futures or options contracts. The funds received by a CPO from a customer must be in the name of the
pool in which the customer will participate. Exempt from the registration requirements are pools that have
less than $400,000 in contributions and 15 participants (excluding the pool operator), as well as trading
advisors and their immediate families. Also exempt are pool operators who receive no compensation
(other than administrative expenses), don’t distribute advertising, and operate only one pool at a time.
Floor Broker
A floor broker is an individual who executes futures or options orders on the floor of an exchange. Floor
brokers are exempt from NFA membership and are exempt from registration as an associated person.
Associated Person (AP)

An associated person—also referred to as a registered commodity representative—is a natural person
(not a corporation or partnership) who’s associated with a futures commission merchant or an
introducing broker as a partner, officer, or employee and solicits customer orders, or supervises any
person so engaged. An associated person may be registered with more than one firm. The registration form
must contain an acknowledgment that, in addition to each sponsor’s responsibility to supervise such AP,
each sponsor is jointly and severally responsible for the conduct of the AP. However, the registration
form must contain a statement whereby each sponsor acknowledges their joint responsibility for
supervision over the conduct of the AP.
An associated person also includes a partner, officer, or employee of a CPO who solicits funds or
supervises persons who do so. Also included are partners, officers or employees of CTAs who are engaged
in the solicitation of discretionary accounts or the supervision of persons who do so.

Opening Customer Accounts

For a customer to be able to trade commodity futures or options, she must open an account with a futures
commission merchant or with a commodity pool operator. She can do this by dealing directly with an
associated person of the futures commission merchant or the commodity pool operator she has contacted.
The customer may also open an account through an associated person of an introducing broker or a
commodity trading advisor who will then introduce the customer’s account to an FCM or a CPO. The
introducing broker or the commodity trading advisor will receive a commission for this service.
If the customer dies, the member firm is required to cancel all open orders and liquidate all open positions. This
provision is included in the customer account agreement. Failure to do so may make the member firm liable to
the estate for any loss subsequently incurred in the account. No other action will be taken in the account and no
cash will be distributed until instructions are received from the executor of the decedent’s estate.
Types of Accounts
Joint Accounts
Joint accounts may be established as either joint accounts with rights of survivorship or as tenants in
common. In a joint account with rights of survivorship, if one of the parties to the account dies, the
surviving party receives the full interest in the account. However, in a joint account as tenants in common,
if one of the parties to the account dies, his estate inherits his interest in the account and the surviving
tenant receives only her particular interest in the account (not that of the decedent as well). For example, let’s
assume that two individuals have a joint account in which each has a 50% interest and one of the
individuals dies. If it was a joint account with rights of survivorship, the surviving party will own the
entire account. If it was a tenant in common account, the surviving party would retain his 50% interest and
the estate of the deceased party would own the balance. In either type of account, the customers are required
to fill out a joint account form.
If a member firm opens an account for an agent who’s sharing in the profits of the account along with the
customer, the exchange must be notified of the agent’s percentage of participation. Confirmations of any
transactions and account statements must be sent to the customer.
Partnership Accounts
In addition to the documents that are required to open any account, partnership accounts require a partnership
agreement which authorizes one or more partners to act for the account.
Corporate Accounts
Corporate accounts require a copy of the corporation’s charter and by-laws which specify that the
corporation is authorized to trade in commodity futures. A resolution of the corporation’s board of
directors which authorizes an individual to act for the corporation is also required.

Trust Accounts
Trust accounts require a copy of an indenture which specifies that the trust is eligible to trade in
commodity futures.
Investment Company Accounts

Investment company accounts require the approval of the Chicago Board of Trade before the member firm
may accept them. The purpose of the approval is to ensure the financial stability of the investment
company and also to ensure that the person who’s handling the trading in the account is qualified to do so.
Any changes in management of the investment company also requires exchange approval.
Risk Disclosure Statement

Before allowing or executing any trade for a customer, the NFA requires all members and associate
members to disclose the risks of futures and options trading. Before opening customer accounts, each
futures commission merchant and introducing broker must provide all customers with a standardized risk
disclosure statement and obtain a signed and dated acknowledgment from the customer that he understands
the risks. If a customer intends to trade option contracts, the firm must provide an additional options risk
disclosure statement and obtain a signed and dated acknowledgment from the customer as well. A risk
disclosure statement must be provided only the first time the customer opens an account with the NFA
member. A futures commission merchant’s risk disclosure statement may be used by an introducing
broker, but the customer’s acknowledgment must be kept on file by the introducing broker.
Each commodity trading advisor and commodity pool operator must print a standardized risk disclosure
statement on page 1 of the disclosure document that’s provided to prospective customers.
As required under Rule 1.55 of the Commodity Futures Trading Commission, the text of the risk
disclosure statement is as follows:

Risk Disclosure Statement

“THE RISK OF LOSS IN TRADING COMMODITY FUTURES CONTRACTS CAN BE
SUBSTANTIAL. YOU SHOULD, THEREFORE, CAREFULLY CONSIDER WHETHER SUCH
TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN
CONSIDERING WHETHER TO TRADE, YOU SHOULD BE AWARE OF THE FOLLOWING:
(1) YOU MAY SUSTAIN A TOTAL LOSS OF THE INITIAL MARGIN FUNDS AND ANY
ADDITIONAL FUNDS THAT YOU DEPOSIT WITH YOUR BROKER TO
ESTABLISH OR MAINTAIN A POSITION IN THE COMMODITY FUTURES
MARKET. IF THE MARKET MOVES AGAINST YOUR POSITION, YOU MAY BE
CALLED UPON BY YOUR BROKER TO DEPOSIT A SUBSTANTIAL AMOUNT
OF ADDITIONAL MARGIN FUNDS, ON SHORT
NOTICE, IN ORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE
THE REQUIRED FUNDS WITHIN THE PRESCRIBED TIME, YOUR POSITION MAY
BE LIQUIDATED AT A LOSS, AND YOU WILL BE LIABLE FOR ANY RESULTING
DEFICIT IN YOUR ACCOUNT.
(2) UNDER CERTAIN MARKET CONDITIONS, YOU MAY FIND IT DIFFICULT OR
IMPOSSIBLE TO LIQUIDATE A POSITION. THIS CAN OCCUR, FOR EXAMPLE,
WHEN THE MARKET MAKES A “LIMIT MOVE.”
(3) PLACING CONTINGENT ORDERS, SUCH AS “STOP-LOSS” OR STOP-LIMIT”
ORDERS, WILL NOT NECESSARILY LIMIT YOUR LOSSES TO THE INTENDED
AMOUNTS, SINCE MARKET CONDITIONS MAY MAKE IT IMPOSSIBLE TO
EXECUTE SUCH ORDERS.
(4) A “SPREAD” POSITION MAY NOT BE LESS RISKY THAN A SIMPLE “LONG”
OR “SHORT” POSITION.
(5) THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN
FUTURES TRADING BECAUSE OF THE SMALL MARGIN REQUIREMENTS
CAN WORK AGAINST YOU, AS WELL AS FOR YOU. THE USE OF LEVERAGE
CAN LEAD TO LARGE LOSSES AS WELL AS GAINS.
THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER
SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. YOU SHOULD, THEREFORE,
CAREFULLY STUDY THIS DIS- CLOSURE DOCUMENT BEFORE YOU TRADE.”
Prior to trading, futures commission merchants and introducing brokers must make information available
concerning the costs associated with future transactions to their customers. If fees and charges are not
determined on a per trade or round-turn trade basis, the customer must be provided with a complete written
explanation of such fees and charges, including a reasonable example(s) of such fees and charges on a per
trade or round-turn basis. Futures commission merchants must provide customers with purchase and/or sale
confirmation statements which include a break-down of all fees and charges.

Commodity Pool Operator Disclosure Documents

Each registered commodity pool operator must provide each prospective pool participant with a risk
disclosure statement and a disclosure document prior to accepting funds from that customer. Prior to
accepting a customer’s funds, the commodity pool operator must also obtain a signed acknowledgment from
the customer that he has read and understands the risk statement. The commodity pool operator is required
to file with the NFA a copy of each disclosure document it uses at least 21 days prior to providing that
document to the public. A commodity pool operator that’s exempt from registration as a commodity pool
operator must disclose its exemption, describe the basis under which exemption is claimed, and file copies
of this statement with the CFTC and NFA.
Before a registered commodity pool operator may directly or indirectly solicit, accept, or receive funds,
securities, or other property from a prospective participant, the commodity pool operator must deliver a
disclosure document to the prospective participant. The date on which the disclosure document was
prepared must appear on the cover page of the document. All information, except for performance
information, must be current as of the date on which the document was prepared. Performance information
that’s used in the document may not be older than three months before the date on which the disclosure
document was prepared. Information that’s contained in the disclosure document may be furnished to the
public for up to 12 months after the date which appears on the cover page.
The commodity pool operator disclosure document must contain the following information:
1. Name, form of business, address, and telephone number of the main business office of the
commodity pool and also that of the pool operator, commodity trading advisor, and each of their
principals. The disclosure document must also include the address where the books and records are
located.
2. The business background for the last five years of the commodity pool operator, each major
commodity trading advisor, the pool trading manager, and each trading principal, including the name
and main business of each employer and the nature of the person’s duties.
3. Any actual or potential conflict of interest of the commodity pool operator, commodity trading advisor
and each of their principals. If none of these persons will trade for their own accounts, there must be
a statement to the effect for each such person. Conflicts of interest include:
 An arrangement whereby the CPO, the CTA, or their principals benefit in the maintenance of the
pool’s account with the FCM
 When a pool operator receives a portion of the commissions which are charged to the pool and
also acts as a trading advisor, and
 Commission sharing which is considered a conflict of interest and is examined during NFA audits
4. The commodity pool operator and each of its principals must disclose specific actual performance
and/or additional data depending upon how long the pool has traded commodity interests as follows:
 If the pool being solicited has traded commodity interests for more than three years and at least
75% of the contributions to the pool were made by persons not affiliated with the pool, the pool
operator must disclose the actual performance for the preceding five years or the lifetime of the
pool, whichever is less.

Example 1: If the pool has been in existence for seven years, the pool operator must
provide actual performance information for the preceding five years.
Example 2: If the pool has been in existence for four years, the pool operator must provide
actual performance information for the lifetime of the pool.
 For pools in existence less than three years, performance history for the lifetime of the offered
pool must be provided. If the pool has no performance history, the following statement must be
prominently displayed: “THIS POOL HAS NOT COMMENCED TRADING AND DOES NOT
HAVE ANY PERFORMANCE HISTORY.”
For these pools (with less than three years of performance history), the performance of other pools
operated by the CPO or trading manager must also be disclosed. In addition, the disclosure
document must include the performance of any accounts or pools that are directed by a major
Commodity Trading Advisor or the performance of any major Investee Pools for the preceding five
years or the lifetime of the pools, whichever is less.
Certain information must be displayed in a table showing quarterly performance, including the beginning
and ending net asset value, all additions, withdrawals, and redemptions during the period, the net
performance and rate of return for the period and the number of outstanding units. Net performance figures
must be reduced by the amount of any up-front fees.
The additional information that must be in the document are:

 The name of the person who will make the trading decision.
 The minimum amount of funds required for the pool to commence trading. If there’s no such
minimum, this must be stated.
 If there’s a maximum amount of funds that the fund will accept, the amount must be stated.
‒ If there’s no such maximum, this must be stated.
 If funds are received prior to trading, it must be stated where the funds will be deposited and who will
receive the interest earned.
 The types of commodity interest the pool will trade and any restrictions or limitations on trading.
 The actual performance record of the pool’s commodity trading advisor and each of its principals.
 A prominent statement must be disclosed if the commodity trading advisor and its principals have not
previously directed an account.
 The extent of any beneficial interest of the commodity pool operator, commodity trading advisor, and
their principals.
 A description of the expenses, including any up-front fees or expenses.

 Pool disclosure documents must include a tabular presentation which shows customers how much
trading profit they need in the first year of their investment in the pool to break even on their original
investment.
 The manner in which the pool will fulfill its margin requirements. If margin is met in a non-cash form,
the nature of the non-cash items must be stated as well as who will receive the interest.
 A complete description of any restrictions upon the transferability of a participant’s interest in the pool.
 The extent to which a participant may be held liable for obligations of the pool in excess of the funds
contributed.
 The pool’s policies with respect to the payment of distributions from profit or capital.
 Any administrative, civil, or criminal action taken against the commodity pool operator, commodity
trading advisor, futures commission merchant, introducing broker, as well as any of their principals
within the last five years.
 Any commission or other fee that’s paid by the pool, the pool’s operator, commodity trading advisor,
and their principals.
 A statement as to whether trading in commodity interests will be done or is intended to be done for its
own account.
 A statement that the commodity pool operator must provide all participants with monthly or quarterly
statements of their accounts and a certified annual report.
Risk Disclosure Statement for Commodity Pool Operators

The following information must be prominently displayed on the first page of the risk disclosure:
“YOU SHOULD CAREFULLY CONSIDER WHETHER YOUR FINANCIAL CONDITION
PERMITS YOU TO PARTICIPATE IN A COMMODITY POOL. YOU MAY LOSE A
SUBSTANTIAL PORTION OR EVEN ALL OF THE MONEY YOU PLACE IN THE POOL.
IN CONSIDERING WHETHER TO PARTICIPATE IN A COMMODITY POOL, YOU
SHOULD BE AWARE THAT TRADING COMMODITIES CAN QUICKLY LEAD TO
LARGE LOSSES AS WELL AS GAINS. SUCH TRADING LOSSES CAN SHARPLY
REDUCE THE NET ASSET VALUE OF THE POOL AND CONSEQUENTLY THE VALUE
OF YOUR INTEREST IN THE POOL. ALSO, MARKET CONDITIONS MAY MAKE IT
DIFFICULT OR IMPOSSIBLE FOR THE POOL TO LIQUIDATE A POSITION.
IN SOME CASES, COMMODITY POOLS ARE SUBJECT TO SUBSTANTIAL CHARGES
FOR MANAGEMENT, ADVISORY AND BROKERAGE FEES. IT MAY BE NECESSARY
FOR THOSE POOLS THAT ARE SUBJECT TO THESE CHARGES TO MAKE
SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETION OR EXHAUSTION OF
THEIR ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE
DESCRIPTION OF EACH EXPENSE TO BE CHARGED TO THIS POOL.
SIGNIFICANT ASPECTS OF PARTICIPATING IN A COMMODITY POOL. YOU SHOULD
THEREFORE CAREFULLY STUDY THIS DISCLOSURE DOCUMENT AND COMMODITY
TRADING BEFORE YOU DECIDE TO PARTICIPATE IN A COMMODITY POOL.

If the potential liability of a participant is greater than her contributions, the following statement must be
prominently disclosed as the last paragraph:
“ALSO, BEFORE YOU DECIDE TO PARTICIPATE IN THIS POOL, YOU SHOULD
NOTE THAT YOUR POTENTIAL LIABILITY AS A PARTICIPANT IN THIS POOL FOR
TRADING LOSSES AND OTHER EXPENSES OF THE POOL IS NOT LIMITED TO THE
AMOUNT OF YOUR CONTRIBUTION FOR THE PURCHASE OF AN INTEREST IN
THE POOL AND ANY PROFITS EARNED THEREON. A COMPLETE DESCRIPTION
OF THE LIABILITY OF A PARTICIPANT IN THIS POOL IS EXPLAINED MORE FULLY
IN THIS DISCLOSURE DOCUMENT.”
The following cautionary statement is to be disclosed prominently on the cover page:

“THE COMMODITY FUTURES TRADING COMMISSION HAS NOT PASSED UPON THE
MERITS OF PARTICIPATING IN THIS POOL, NOR HAS THE COMMISSION PASSED
ON THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.”
If up-front expenses are charged, the cover page must also include a standardized investment amount, the
related fees, and the net proceeds available for trading after the deduction of the up-front expenses.
Reporting to Pool Participants

Each commodity pool operator must distribute an Account Statement of Income (loss) and a Statement of
Changes in the Net Asset Value, including all withdrawals and deposits to the pool. If the net assets are
more that $500,000 at the beginning of the pool’s fiscal year, the report must be sent monthly. If the net
assets are $500,000 or less, the report must be sent quarterly. An annual report must be distributed to each
pool participant and three copies must filed with the CFTC within 90 calendar days after the end of the fiscal
year. The statements must be computed in accordance with generally accepted accounting principles and
certified by an independent CPA.
Upon request, copies of certain records and financial reports must be made available to participants for
inspection and copying during normal business hours. Also, upon request, copies must be sent by mail to
any participant within five business days, if reasonable reproduction and distribution costs are paid. A
commodity pool operator must maintain books and records for five years (in a readily accessible location
for the first two years).
Commodity Trading Advisor Disclosure Document

Each registered commodity trading advisor that exercises trading discretion or recommends trades by
means of a systematic program is required to distribute a disclosure document to each prospective
customer before entering into an agreement to provide advisory services.
If the commodity trading advisor charges any up-front fees, he must disclose those fees. Additionally, on
the cover page of the disclosure document, he must include a standardized investment amount as well as
the related fees and the net proceeds available for trading after the deduction of the up-front expenses.

If the commodity trading advisor is not a registered futures commission merchant, the cover page must
include a standardized warning that the commodity trading advisor is prohibited by law from accepting
customer funds for trading, and that such funds must be deposited directly with a futures commission
merchant. The statement must also disclose that the CFTC has not passed on the merits of the trading
program, or passed on the accuracy or adequacy of the disclosure document.
Risk Disclosure Statement for Commodity Trading Advisors

The following risk disclosure statement must appear on the first page of the disclosure document:
“THE RISK OF LOSS IN TRADING COMMODITIES CAN BE SUBSTANTIAL. YOU
SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS
SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION, IN CONSIDERING
WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU.
YOU SHOULD BE AWARE OF THE FOLLOWING:
1. IF YOU PURCHASE A COMMODITY OPTION, YOU MAY SUSTAIN A TOTAL LOSS
OF THE PREMIUM AND ALL TRANSACTION COSTS.
2. IF YOU PURCHASE OR SELL A COMMODITY FUTURE OR SELL A COMMODITY
OPTION, YOU MAY SUSTAIN A TOTAL LOSS OF THE INITIAL MARGIN FUNDS
AND ANY ADDITIONAL FUNDS THAT YOU DEPOSIT WITH YOUR BROKER TO
ESTABLISH OR MAINTAIN YOUR POSITION. IF THE MARKET MOVES AGAINST
YOUR POSITION, YOU MAY BE CALLED UPON BY YOUR BROKER TO DEPOSIT
A SUBSTANTIAL AMOUNT OF ADDITIONAL MARGIN FUNDS, ON SHORT
NOTICE, IN ORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE
THE REQUIRED FUNDS WITHIN THE PRESCRIBED TIME, YOUR POSITION MAY
BE LIQUIDATED AT A LOSS, AND YOU WILL BE LIABLE FOR ANY RESULTING
DEFICIT IN YOUR ACCOUNT.
3. UNDER CERTAIN MARKET CONDITIONS, YOU MAY FIND IT DIFFICULT OR
IMPOSSIBLE TO LIQUIDATE A POSITION. THIS CAN OCCUR, FOR EXAMPLE, WHEN
THE MARKET MAKES A “LIMIT MOVE.”
4. THE PLACEMENT OF CONTINGENT ORDERS BY YOU OR YOUR TRADING ADVISOR,
SUCH AS A “STOP-LOSS” OR “STOPLIMIT” ORDER, WILL NOT NECESSARILY LIMIT
YOUR LOSSES TO THE INTENDED AMOUNTS, SINCE MARKET CONDITIONS MAY
MAKE IT IMPOSSIBLE TO EXECUTE SUCH ORDERS.
5. A SPREAD POSITION MAY NOT BE LESS RISKY THAN A SIMPLE “LONG” OR
“SHORT” POSITION.
6. THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN
COMMODITY TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE
USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS. IN
SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO
SUBSTANTIAL CHARGES FOR MANAGE- MENT AND ADVISORY FEES.

IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT ARE SUBJECT TO

THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID
DEPLETION OR EXHAUSTION OF THEIR ASSETS. THIS DISCLOSURE
DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH FEE TO BE
CHARGED TO YOUR ACCOUNT BY THE COMMODITY TRADING ADVISORY.
SIGNIFICANT ASPECTS OF THE COMMODITY MARKETS. YOU SHOULD THEREFORE
CAREFULLY STUDY THIS DISCLOSURE DOCUMENT BEFORE YOU TRADE.”
The disclosure document must also disclose the following categories of information:
 Name, address, and telephone number of the commodity trading advisor and of each principal
 A description of the trading program
 The name of the futures commission merchant or introducing broker, if any are required to be used
 The types of commodities to be traded, and any limitations on the type or number of trades
 The business background for the last five years of the commodity trading advisor and each of its
principals, including the name and main business of each employer and the nature of the person’s duties
 Any actual or potential conflict of interest on the part of the commodity trading advisor and its trading
principals and, if one is required, on the part of the futures commission merchant or introducing
broker and its principals
 The actual performance record of the commodity trading advisor and of each principal for the previous
five years. Performance tables are required showing quarterly trading results, reduced by any up-front
fees. Performance must be accompanied by a standard cautionary statement that past results may not
indicate future results.
 A complete description of fees, including any up-front fees
 Any commission sharing arrangement between the commodity trading advisor and futures commission
merchant that’s carrying the account or introducing broker that introduced the account, and a description
of any other actual or potential conflicts of interest; whether the commodity trading advisor or any of
its principals will trade for their own accounts
 Disclosure of all material administrative, civil, or criminal actions within the past five years preceding
the date of the document against the commodity trading advisor and any of its principals
 The futures commission merchant with which the client is required to maintain his account, and any of
the futures commission merchant’s principals; and the introducing broker through which the client will
be required to introduce his account to the futures commission merchant, and any of the introducing
broker’s principals
Options Disclosure Document

Before a futures commission merchant can open an account, or before an introducing broker can introduce
an account for an options customer, the futures commission merchant and introducing broker must provide
their customers with a separate disclosure document and obtain the customer’s signed acknowledgment that
he has read and understood the document.

The disclosure document begins with a standardized cautionary statement of the risks involved. The text of
the document contains disclosures on risks, fees, the mechanics of option trading, margin requirements,
and profit potential.
Options Disclosure Statement

BECAUSE OF THE VOLATILE NATURE OF THE COMMODITIES MARKETS, THE PURCHASE
AND GRANTING OF COMMODITY OPTIONS INVOLVE A HIGH DEGREE OF RISK.
COMMODITY OPTION TRANSACTIONS ARE NOT SUITABLE FOR MANY MEMBERS OF THE
PUBLIC. SUCH TRANSACTIONS SHOULD BE ENTERED INTO ONLY BY PERSONS WHO
HAVE READ AND UNDERSTOOD THIS DISCLOSURE STATEMENT AND WHO UNDERSTAND
THE NATURE AND EXTENT OF THEIR RIGHTS AND OBLIGATIONS AND OF THE RISKS
INVOLVED IN THE OPTION TRANSACTIONS COVERED BY THIS DISCLOSURE STATEMENT.
BOTH THE PURCHASER AND THE GRANTOR SHOULD KNOW WHETHER THE PARTICULAR
OPTION IN WHICH THEY CONTEMPLATE TRADING IS AN OPTION WHICH, IF
EXERCISED, RESULTS IN THE ESTABLISHMENT OF A FUTURES CONTRACT (AN “OPTION
ON A FUTURES CONTRACT”) OR RESULTS IN THE MAKING OR TAKING OF DELIVERY OF
THE ACTUAL COMMODITY UNDERLYING THE OPTION (AN “OPTION ON A PHYSICAL
COMMODITY”). BOTH THE PURCHASER AND THE GRANTOR OF AN OPTION ON A
PHYSICAL COMMODITY SHOULD BE AWARE THAT, IN CERTAIN CASES, THE DELIVERY
OF THE ACTUAL COMMODITY UNDERLYING THE OPTION MAY NOT BE REQUIRED AND
THAT, IF THE OPTION IS EXERCISED, THE OBLIGATIONS OF THE PURCHASER AND
GRANTOR WILL BE SETTLED IN CASH.
A PERSON SHOULD NOT PURCHASE ANY COMMODITY OPTION UNLESS HE IS ABLE
TO SUSTAIN A TOTAL LOSS OF THE PREMIUM AND TRANSACTION COSTS OF
PURCHASING THE OPTION. A PERSON SHOULD NOT GRANT ANY COMMODITY
OPTION UNLESS HE IS ABLE TO MEET ADDITIONAL CALLS FOR MARGIN WHEN THE
MARKET MOVES AGAINST HIS POSITION AND, IN SUCH CIRCUMSTANCES, TO
SUSTAIN A VERY LARGE FINANCIAL LOSS.
A PERSON WHO PURCHASES AN OPTION SHOULD BE AWARE THAT IN ORDER TO
REALIZE ANY VALUE FROM THE OPTION, IT WILL BE NECESSARY EITHER TO OFFSET
THE OPTION POSITION OR TO EXERCISE THE OPTION. IF AN OPTION PURCHASER DOES
NOT UNDERSTAND HOW TO OFFSET OR EXERCISE AN OPTION, THE PURCHASER
SHOULD REQUEST AN EXPLANATION FROM THE FUTURES COMMISSION MERCHANT OR
THE INTRODUCING BROKER. CUSTOMERS SHOULD BE AWARE THAT IN A NUMBER OF
CIRCUMSTANCES, SOME OF WHICH WILL BE DESCRIBED IN THIS DISCLOSURE
STATEMENT, IT MAY BE DIFFICULT OR IMPOSSIBLE TO OFFSET AN EXISTING OPTION
POSITION ON AN EXCHANGE.
THE GRANTOR OF AN OPTION SHOULD BE AWARE THAT, IN MOST CASES, A COMMODITY
OPTION MAY BE EXERCISED AT ANY TIME FROM THE TIME IT IS GRANTED UNTIL IT
EXPIRES. THE PURCHASER OF AN OPTION SHOULD BE AWARE THAT SOME OPTION
CONTRACTS MAY PROVIDE ONLY A LIMITED PERIOD FOR EXERCISE OF THE OPTION.

THE PURCHASER OF A PUT OR CALL IS SUBJECT TO THE RISK OF LOSING THE ENTIRE
PURCHASE PRICE OF THE OPTION—THAT IS THE PREMIUM PAID FOR THE OPTION
PLUS ALL TRANSACTION COSTS.
Communications with the Public

Written communications with the public (e.g., promotional material) require the prior approval of a partner
or officer of the firm. Advertising and sales practices must be honest and straightforward. Employment
advertising for professionals, including those which appear in a newspaper, are routinely monitored by the
NFA. Statements of opinion that are included in the promotional material must be clearly identifiable as
such and must have a reasonable basis in fact. Copies of all promotional material, along with a record of
the approval, must be maintained by each member for a period of five years from the date of last use.
The CFTC and the NFA prohibit fraud, misrepresentation, and deceit by member firm personnel in the
solicitation of customers to open accounts. An NFA member or associate member may not make
statements to the public which operate as a fraud, deceit, part of a high-pressure sales approach, or which
claim that futures trading is appropriate for all persons.
No commodity pool operator, commodity trading advisor, introducing broker, or futures commission
merchant or their associates may represent or imply that they or their principals have been sponsored,
recommended, or approved, or that their abilities or qualifications have been approved by the CFTC or NFA.
Content of Promotional Material

The NFA has established specific prohibitions relating to the content of promotional materials that are
provided to the public. Promotional materials include written material that’s sent to the public as well as
the text of any standardized oral presentation. The NFA prohibits:
 Fraudulent, misleading, and deceptive statements, and materials which fail to state material facts
 Emphasizing profits without giving equal emphasis to the risks of trading
 Referring to hypothetical trading results, unless a standardized cautionary statement is given
 Citing past trading profits without also disclosing that such profits may not indicate future profits, and
 Citing past trading performance statistics which cannot be substantiated
Recordkeeping
Firms must maintain their books in accordance with generally accepted accounting principles. Also, they
must maintain records to support their accounting records, financial statements, and trading activities.
Records that are prepared by all NFA member firms must be kept five years.

A futures commission merchant must promptly provide each customer a monthly statement as of the close
of the last business day of each month or as of any regular monthly date that’s selected by the FCM. This
requirement applies to all accounts except those in which there are neither open positions at the end of the
statement period nor any changes to the account balance since the prior statement period. If this is the
case, a statement must be provided at least once every three months.
If a customer is introduced to an FCM by an IB, the daily and monthly trade confirmation statements that are
sent to customers must show that the account was introduced by the IB and must include the names of both
the FCM and the IB. These statements are required to be kept by the FCM. The IB may also keep a copy;
however, this is not required.
Orders received by IBs and FCMs must be time-stamped upon receipt and include the account number and
order number. Option orders must also be time-stamped upon transmittal for execution. A journal or
record must be kept each day that indicates all commodity transactions and the name of the carrying FCM
for each of the IB’s customers. If some orders are placed directly with the FCM by a customer, the IB
must still keep a complete record or journal for all trades for that customer. If an IB refers a customer to an
FCM, but is NEVER involved in the order, then the IB is not required to keep a journal for that customer.
If the customer is introduced to the FCM by the IB, the customer’s account form must be kept on file by both
the FCM and the IB. The risk disclosure statement must be kept on file by the IB as well as by the FCM.
An IB must give written authorization to an FCM if the FCM carries an account for affiliated persons of an
IB. For these types of accounts, the FCM must give to the IB copies of statements and orders.
Orders for proprietary accounts and accounts of affiliated persons cannot be placed before a customer’s order
that may be executed at or near the market. Orders may not be disclosed unless the disclosure is necessary
for the effective execution of the order. IBs or APs of an IB cannot knowingly take the other side of a
customer’s order.
The CPO must maintain all activity statements that are received from an FCM. He must also maintain an
itemized daily record of each commodity transaction that’s executed for the pool. If a CPO or CTA or its
principals has a personal account, he must maintain a daily itemized record of each transaction executed for that
personal account. He must also maintain all activity statements that are provided by an FCM for that account.
Each commodity trading advisor must maintain certain records at its main business office. The client’s
records should include the following data:
 Name and address of each client, all powers of attorney, and all other written agreements including
authorization for management fees
 A complete list of all commodity interests for each client
 Copies of each confirmation, purchase and sale statement, and monthly statement from a futures
commission merchant, and
 Copies of each report, letter, circular, memorandum, publication, writing, advertisement, or other
literature or advice (including texts of standardized oral presentations) and the date of first use

It’s the primary responsibility of the FCM to ensure that each client of a CTA receives a monthly account
statement.
Bunched Orders When an FCM receives an order from a customer, it must prepare a written record of
the order (order ticket) which includes appropriate account identification. The purpose of this requirement
is to prevent various forms of customer abuse (e.g., fraudulent allocation of trades) and to provide an
adequate audit trail that allows customer orders to be tracked through each step of the order-processing
system. The rules also require CTA members to provide FCMs with the same required information.
However, in the current electronic market environment, CTAs may place orders for many accounts in one
order, which is commonly referred to as a bunched order.
CTAs may place bunched orders with an FCM for different accounts and allocate those contracts after
execution. Rules require account managers to observe the following three requirements if allocating
contracts post-execution:
1. Allocations must be fair and equitable among accounts.
2. The allocation methodology must be sufficiently objective and specific to permit independent
verification of the fairness.
3. Rules permit the account manager to exercise discretion over the allocation methodology and
recognizes that allocation strategies may need to vary in order to treat all customers fairly. However,
the CFTC must be able to reconstruct the allocation method sufficiently to verify that it’s not biased.
Account managers must provide allocation information to FCMs before the end of the trading day and are
required to make the following information available to customers upon request:
 The general nature of the allocation method, and
 Summary or composite data sufficient for customers to compare their allocation and execution results with
those of other relevant customers
Discretionary Accounts (Controlled Accounts)

Written Power of Attorney
An NFA member or associate member must obtain written consent from a customer before he’s able to
exercise discretion over the customer’s futures or options account. Written consent is generally referred to
as a power of attorney. A person is not deemed to be exercising discretion if the customer specifies the
commodity, year and delivery month of the contract, the number of contracts, and whether the transaction
is to buy or to sell.
Duty to Review and Supervise

A futures commission merchant has a continuous obligation to supervise discretionary accounts. Each trade
that’s executed pursuant to a grant of discretion must be reviewed by a principal or supervisor of the
futures commission merchant by no later than the day after its execution.

Minimum Experience Required

In order to exercise discretion over a customer account, an associated person must have a minimum of two
consecutive years of working experience as a registered associated person. However, this requirement
doesn’t apply to a person who’s also registered as a commodity trading advisor.
Third Party Discretion

A futures commission merchant cannot accept an account (and an introducing broker cannot introduce one) if
discretion is exercised by a third party. However, this prohibition doesn’t apply if the FCM obtains a copy of
the customer’s written grant of discretion and a signed acknowledgment from the customer that he has
received a disclosure document. Additionally, the prohibition doesn’t apply for situations in which the person
who owns the account and the person who’s exercising discretion are members of the same family.
Options Customer Complaints

For complaints made by options customers, a futures commission merchant or introducing broker must:
 Retain all written complaints and both make and retain written records of all oral complaints
 Make and retain a record of the date on which the complaint was received, the person who serviced
the account, a general description of the complaint, and the action taken regarding the complaint
Customer complaints that a firm receives are not considered public information.
Treatment of Customer Funds

Futures commission merchants and commodity pool operators (and leverage transaction merchants) are the
only category of registrants that may accept customer funds to trade futures and options contracts. A
futures commission merchant must segregate all customer funds from its own. Therefore, customer funds
cannot be treated as the futures commission merchant’s own property, and cannot be used to pay its rent,
telephone bills, etc. In the case of a commodity pool operator, the pool operator must operate its pool as a
separate legal entity from that of the commodity pool operator. Similar to a futures commission merchant,
a commodity pool operator cannot treat customer funds as its own and must segregate them.
Trading Standards
The CFTC prescribes the following minimum ethical standards governing trading for customers:
 Futures commission merchants are responsible for supervising the conduct of their associated persons.
 Futures commission merchants, associated persons, and introducing brokers must ensure (to the extent
possible) that a customer order, which is able to be executed at or near the market, is transmitted to the
exchange floor before an order for a personal or proprietary account of the futures commission
merchant or associated person.
 Futures commission merchants, introducing brokers, and associated persons may not disclose a
customer order to any other person unless it’s necessary for the execution of the order.

 Futures commission merchants, introducing brokers, and associated persons may not knowingly take
the opposite side of a customer order without prior specific consent of the customer.
 Associated persons may not have an account with another futures commission merchant without the
consent of his employer.
Confirmation of Options and Futures Transactions

Each futures commission merchant must provide a written confirmation to its account holder within one
business day of the execution of a futures or options transaction to give specific details of the trade. Each
confirmation statement must contain the name of the futures commission merchant and, if appropriate, the
introducing broker. The futures commission merchant must also provide its customers with a monthly
statement to show open positions and their unrealized profit or loss as of the last business day of the month.
In the case of an expired or exercised option, a confirmation must be made of the expiration or exercise,
including date and details of current position. For controlled or discretionary accounts, a separate copy of
the confirmation statement must be given to the account owner and the controller. For a commodity pool,
the futures commission merchant is required to provide a confirmation statement only to the commodity pool
operator, not to each pool participant.
Disciplinary Proceedings
Compliance
The NFA compliance rules and regulations that apply to members and associated members are designed to
ensure the integrity of customer relationships. These rules and regulations focus on the antifraud
provisions that are covered in the Commodity Exchange Act and the CFTC regulations. The NFA
compliance director can require statements under oath from any member or associated person of a member
and can also subpoena documents. If an applicant has been found guilty of conduct that’s inconsistent with
just and equitable principles of trade, her membership can be denied.
Surveillance
The financial status of futures commission merchants is subject to regular surveillance to ensure that
they’re adequately capitalized. Additionally, member firms that are required to maintain segregated
customer accounts must conduct a financial analysis on a daily basis.
At least once every 24 months, a “full scope” audit is conducted by the NFA covering every facet of a
firm’s business activities. The NFA also conducts “limited scope” unannounced audits. If violations are
found, this can trigger an in-depth investigation. The NFA president, with concurrence from the board of
directors, can initiate (with or without a hearing) a member responsibility action which, at the extreme, can
require the firm to immediately cease doing business.

The NFA has an office of compliance which employs a variety of techniques that are designed to provide an
early warning of potential financial or other problems. If an audit or investigation reveals a potential violation
of NFA rules, the infraction is reported to the Regional Committee in the region in which the respondent
member or associate resides. If the Regional Committee determines that the facts justify the issuance of a
formal complaint, the respondent must answer and is entitled to a hearing before the committee. Although the
NFA member is involved in the proceedings, there’s no trading restriction until the matter is resolved. A
decision can be appealed to the Appeals Committee, which is a subcommittee of the Board of Directors. Any
decisions of the Appeals Committee are final and subject to review only by the CFTC.
Disciplinary Actions
Upon conclusion of a disciplinary proceeding, the Regional Committee or the Appeals Committee (on
appeal or review) may impose one or more of the following penalties:
 Expulsion or suspension from NFA membership for a specified period (requires 2/3 vote of the
committee members that are present)
 Prohibition or suspension for a specified period from association with an NFA member
 Censure or reprimand
 A monetary fine that cannot exceed $250,000 per violation
 Issuance of a cease and desist order, or any other reasonable penalty or remedial action that’s not
inconsistent with NFA rules
Note: The Appeals Committee may increase, decrease, or set aside the penalties that were imposed
by the Regional Committee.
The CFTC maintains exclusive disciplinary jurisdiction over floor brokers and exchanges. The CFTC
is empowered to bring administrative or federal court actions against any registered person or entity for
any violation of the Commodity Exchange Act and CFTC Regulations, regardless of whether the NFA
also has jurisdiction. Penalties that may be imposed by the CFTC include a maximum fine of the
greater of $168,142 (indexed for inflation) or three times the monetary gain per violation, a suspension
or revocation of registration; a suspension or revocation of trading privileges, and a cease and desist
order from future violations.
Settlement of Disciplinary Actions

A respondent (party charged with a violation) may settle all charges brought by the NFA, CFTC, or
exchange, on mutually agreeable terms without admitting or denying the allegations. Such settlements
avoid a hearing, but may carry penalties as those which may be applied following a hearing. When a
complaint by a regulatory agency is issued against a member, it becomes a matter of public record.

Reparation and Arbitration Proceedings

CFTC Reparations
The CFTC administers a reparations forum for any customer claim against a registered person or entity
which alleges a violation of the Commodity Exchange Act or CFTC Regulations. The claim is heard and
decided by a CFTC Administrative Law Judge and may be appealed to the Commission.
The three categories of Reparations Proceedings are:

1. Formal Decisional Procedure – the amount of damages claimed exceeds $10,000 (exclusive of
interest and costs). With this procedure, the parties may have an oral hearing if either so chooses.
2. Summary Decisional Procedure – the amount of damages claimed doesn’t exceed $10,000
(exclusive of interest and costs). With this procedure, if an oral hearing is not held due to either party
so choosing, a decision is based on submitted documents.
3. Voluntary Decisional Procedure – a Judgement Officer gives an expedited decision which cannot
be appealed. Both parties must agree to the use of this procedure.
NFA Arbitration
The NFA provides an arbitration forum to handle disputes that are related to futures trading. The disputes
may be between members or between customers and members or the members’ associates. Proceedings must
be initiated within two years of the event in dispute. If the aggregate claim is less than $50,000, the NFA will
appoint one arbitrator. Also, for disputes between $50,000 and $250,000, the NFA will generally appoint one
arbitrator. However, if both parties submit a written request, the NFA will appoint three arbitrators.
For disputes exceeding $250,000, the NFA will automatically appoint three arbitrators. Parties involved in
the dispute are notified of the decision within 30 days following the completion of the hearing. Decisions
of the arbitrator(s) are not subject to appeal and may be enforced in any court of competent jurisdiction.
CFTC regulations also require exchanges to provide arbitration procedures for disputes between members,
as well as for disputes between members and their customers.
Position Reporting Requirements and Speculative Trading Limits

Position Reporting Requirements
The CFTC requires each person who owns or controls one or more accounts to report his gross long or
short position, in each commodity, once it reaches a certain threshold level. For example, a person who owns
or controls 200 or more Crude Oil Futures Contracts on either the long or short side of the market must
provide a report regarding his holding to the CFTC. In addition, the futures commission merchant that carries
this person’s account must also report his position to the CFTC. On the first day that the account drops
below the reporting level, a report must be filed with the CFTC.

The reporting level applies to both speculators and hedgers. A trader who’s at the reporting level must
report all of his trades, all deliveries of the cash commodity taken or made, and the number of open
contracts that he maintains. Reports must be made daily and commence on the first day that the
reporting level is reached. Reports are filed on each day that any trade is made, or if the trader makes
or takes delivery of the cash commodity. The trader may cease reporting only after his position drops
below the reporting level.
Speculative Position Limits

Speculative limits determine the maximum number of contracts that an account (or group of accounts under
common control or ownership) may carry at any time, whether during the course of a trading day or
overnight. Speculative trading limits apply to the gross long or gross short positions in an account. The purpose
of the trading limits is to prevent price manipulation and distortion of commodity futures prices.
A bona fide hedger (i.e., a producer or user of the commodity in the cash market) may apply for an
exemption to the CFTC (or to the exchange if it’s a limit set by the exchange) if his business needs justify
exceeding the limits. Only certain commodities are covered by federal regulation as it relates to trading and
position limits. Other commodities are limited by the exchange on which they’re traded, and some
commodities are not limited either by federal law or by exchange rules.
Position reporting requirements and speculative position limits apply to all transactions, regardless of the
exchange on which the transaction is made. For example, a purchase of 2 million bushels of wheat on the
Chicago Board of Trade and 1 million bushels of wheat on the Kansas City Board of Trade are added
together, and the total position of 3 million bushels are the maximum that the speculator could hold.
It’s important to note that speculators are not limited to the reporting levels (as described above) in regard
to the maximum positions they may hold. The reporting level, which is lower than the position limit, is the
point at which all traders are required to file notice of their position with the CFTC if any subsequent
trades are made.
Anti-Money Laundering
NFA Rule 2-9 incorporates provisions on Anti-Money Laundering (AML) as required under the USA
PATRIOT Act that was signed into law October of 2001. The amendments address those rules already
required for banks and financial institutions and coincide with the anti-money laundering of the securities
industry. The requirements for futures commission merchants and introducing brokers include:
1. Establishing and implementing policies, procedures, and internal controls that are reasonably
designed to assure compliance with the applicable provisions of the Bank Secrecy Act
2. Providing for independent compliance testing to be conducted by member personnel, or by a
qualified outside party.
3. Designating an individual(s) to be responsible for implementing and monitoring the day-to-day
operations and internal controls of the program
4. Providing on-going training for appropriate personnel

Establishing Anti-Money Laundering Compliance Programs One of the main provisions of NFA
Rule 2-9 requires FCMs and IBs to have existing anti-money laundering compliance programs and to
appoint a compliance officer to administer the program. Firms are required to conduct on-going training of
personnel and a review of their procedures to ensure that they remain in compliance. A diligent
commitment by the firm will detect money-laundering schemes and make those engaged in money
laundering reluctant to use such firms for these practices.
It’s important for firms and their associated persons to develop a sound relationship with each of their
customers. The process begins with customer identification and verification. IB and FCM firms are
required to develop a Customer Identification Program (CIP) and, within a reasonable period, they must
check and verify the identity of customers who open accounts. This customer information must then be
checked against a list that’s maintained by the U.S. Treasury Department Office of Foreign Assets Control
(OFAC). This list is referred to as the Specially Designated Nationals and Blocked Persons List, or simply
the SDN List. The list identifies known and suspected terrorists and other criminals, as well as pariah
nations. Conducting business with any of these individuals or entities is prohibited. In fact, if a firm
discovers that one of its clients is on the SDN List, it must immediately block all transactions and inform
the appropriate law enforcement authorities.
Reporting Requirements NFA members are required to file a report if a customer engages in a cash
transaction or a series of cash transactions in a single day that exceeds $10,000. In addition, a member is
also required to file a report if the amount of the cash transaction is $5,000 or more and the member
suspects suspicious activity.
Ethics Training
NFA members are required to establish an Ethics Training Program under NFA Compliance Rule 2-9. The
CFTC has created a “Statement of Acceptable Practices” which lists the topics that should be addressed in
the training program. NFA members are allowed flexibility as to the frequency, use of training providers,
and method used to fulfill its ethics training obligation. Proper documentation is also required. Members
should keep records of the types of materials used, when and to whom they were distributed and, if
applicable, the date and record of attendance of any classroom training program.
Disaster Recovery Plans and Business Continuity

Due to recent events concerning disasters that could affect the financial service industry, the NFA adopted
Rule 2-38. According to this rule, members are required to implement a plan that enables them to operate
their business with a minimal disruption to its customers and other NFA members in the event of a disaster.

Chapter 2 Summary
 Understand the responsibilities of the Commodity Futures Trading Commission (CFTC)
 Identify the role of the National Futures Association (NFA)
 Recognize the different NFA members
‒ Futures commissions merchant (FCM)
‒ Introducing broker (IB)
‒ Commodity trading advisor (CTA)
‒ Commodity pool operator (CPO)
‒ Associated person (AP)
 Understand the different types of accounts
‒ Joint accounts
‒ Partnership accounts
‒ Corporate accounts
‒ Discretionary accounts, including third party authorizations and AP requirements
 Understand the disclosure requirements for CTAs, CPOs, and options accounts
 Interpret the NFA’s customer communication and recordkeeping rules
 Identify the CFTC and NFA disciplinary actions, arbitration processes, and maximum fines
 Understand the purpose of reporting levels and position limits
 Understand how NFA members can comply with the ongoing ethics training requirement

Now that you’ve completed Chapter 2, log in to my.stcusa.com and create a 10-question custom exam.

CHAPTER 3
Price Forecasting
CHAPTER 3 – PRICE F ORECASTING
Introduction
For reasons that will become clear later, the price of commodity futures must trade in a definite
relationship to the price of the cash commodity. If this relationship did not exist, traders would react quickly
to bring prices into their proper relationship. In order for this relationship between cash and futures to exist,
it’s necessary for the cash commodity to be deliverable against a futures position. If the cash commodity was
unable to be delivered against futures, there would be no economic tie between cash and futures and,
therefore, no reason for the prices to trade in a related way.
It’s important to pay close attention to the quantity of a commodity that’s in position for delivery against
short futures positions. The CFTC publishes weekly reports on grain that’s in a deliverable position. In
addition, every Monday, the Chicago Board of Trade issues a report on visible supply. Visible supply
refers to stocks of grain that are in public elevators, stocks of grain that are afloat, and stocks of grain that
are in store at certain loading centers. However, stocks of grain on farms are not included in the visible
supply. Generally speaking, the movement of grain from farms and country elevators into public elevators
indicates that supply of the commodity is increasing. Conversely, movement of grain out of visible supply
may indicate that there is or will be a scarcity of the grain and indicates the possibility of higher prices for
futures. For commodities other than grains, each exchange reports daily on the supply of the commodity
that’s inspected and approved for delivery on futures. This is referred to as certificated stock.
Crop Year
In order to understand prices for farm commodities, let’s first examine the crop year. The crop year is
considered to begin with the harvest and to run to the next harvest. For example, the crop year for corn runs
from September 1 to August 31. The crop year for wheat runs from June 1 to May 31. In the case of wheat,
since July represents the beginning of the harvest, it’s expected that the price of wheat will be the lowest
for the year because large amounts of new supply are coming to market. There’s selling pressure exerted on
the price of the commodity because many farmers must sell their crops at the same time in order to raise
money to repay loans and prepare for the following crop year. It’s expected that the price of July wheat will
be selling under the price of the preceding May wheat because the May futures price still reflects the old
crop year, when supplies presumably are lower since it’s later in the crop year. May wheat futures will sell
at a higher price because there’s less supply later in the crop year.
However, in the event that the preceding crop year was especially large, with a large amount of the crop
still remaining and the outlook for the new crop year is for a poor harvest, it would be expected that the
May wheat will sell at a lower price than July wheat.
Trading in grain futures is related to the crop year. For example, the first contract month in wheat is July,
which is the beginning of the crop year. However, it’s important to note that futures contracts have a
termination date. The life of a futures contract is established by the exchange on which it’s traded and may
run from 12-to-18 months in advance of the day that trading ceases. If a long has failed to offset his
position by selling an equal amount of the commodity, he must accept delivery. In the same manner, a
short who has not offset her position by buying an equal amount of the commodity must make delivery.

Volume and Open Interest

In commodity futures trading, two important concepts are volume and open interest. Figures for volume and
open interest are published daily. Volume refers to the total of purchases or sales during the trading
session, not the total of purchases and sales. Of course, for every contract purchased, there’s one contract
sold, and therefore purchases and sales are not added together. For example, if 10 contracts of wheat are
purchased during the trading session, then obviously 10 contracts were also sold. The volume is 10 contracts,
not 20 contracts.
Open interest reflects all contracts that are still in effect and have not been liquidated. Let’s consider some
examples of how open interest is determined. On the first day of trading in a new contract, a trader in New
York buys a contract from a trader in Los Angeles. The positions appear as follows:
Long Short Open Interest
New York Los Angeles One open contract has been established
A trader in Houston now purchases a contract from a trader in Seattle. There are now two open contracts
and the positions appear as follows:
New York Los Angeles One new open contract has been added to
Houston Seattle the open interest because a new long and a
new short position have been taken
The trader in New York now liquidates his position by selling a contract to a trader from Chicago, who’s
establishing a new long position. Since the trader from Chicago has replaced the trader from New York,
there are still two open contracts. The positions appear as follows:
Chicago Los Angeles The long in Chicago has replaced the long
Houston Seattle in New York. Open interest remains as two
contracts.
The trader in Seattle, who is short, decides to offset (liquidate) his short position with a purchase. The trader
in Houston, who is long, also decides to offset his position with a sale. The trader in Seattle buys a contract
from the trader in Houston. Since both the trader in Seattle and the trader in Houston have left the market, the
open interest now declines to one contract. The open interest is represented by the long position of the trader
in Chicago and the short position of the trader in Los Angeles. The positions are as follows:
Chicago Los Angeles Only the long in Chicago and the short in
Los Angeles remain in the market and the
open interest is reduced to one contract

Open interest can be summarized as follows:

 Open interest increases when a new long position and a new short position are established.
 Open interest remains the same when an existing long sells his contract to a new long, or when an
existing short buys a contract from a new short.
 Open interest is decreased when an existing long sells his contract to an existing short.
Effect of Open Interest on Prices

Traders examine the open interest figures in relation to the price of the futures. This enables them to assess
the condition of the market and helps them make trading decisions. In the following instances, let’s
consider the changes in the open interest and in the price of the contract.
Open Interest Increases While Prices are Going Up In this case, new buyers and new sellers are
entering the market. Buyers are more aggressive than sellers as evidenced by the fact that prices are
increasing. This type of market is considered to be technically strong. However, a market such as this can
become an overbought market if prices continue to rise.
Open Interest Increases While Prices are Going Down Once again, new buyers and new sellers are
entering the market. However, the sellers are more aggressive than the buyers as evidenced by the fact that
prices are going down. This type of market is considered to be technically weak.
Open Interest Decreases While Prices are Going Up Since open interest is decreasing, it’s evident that
existing long and short positions are being liquidated to a greater extent than new positions are being
established. Short positions are liquidated through covering purchases. Since prices are going up, it’s clear
that existing short positions are being covered more aggressively than existing long positions. This is
considered a technically weak market because it eliminates potential future buying that was represented by
the short positions. Once the shorts have covered, they cannot be relied on in the future to provide buying
strength in the market.
Open Interest Decreases While Prices are Going Down Once again, it’s evident that existing
positions are being liquidated more aggressively than new positions are being taken. Since prices are going
down, it’s clear that longs are liquidating their positions more aggressively than shorts, selling their
positions in order to leave the market and offering the contracts at progressively lower prices in order to
offset their positions. This type of market is considered to be technically strong and is referred to as a
liquidating market.
At harvest time, open interest tends to be the highest for the year since farmers and elevator operators are
establishing hedges. As the crop year proceeds, open interest tends to diminish as hedges are lifted.

Relationship of Cash to Futures

As already described, futures prices must bear a relationship to the price of the cash commodity. (Other
terms that are used for the actual commodity are “spots,” “physicals,” and “actuals”). Remember, less than
2% of all contracts are settled by delivery of the cash commodity. However, the fact that delivery may be
made means that the price of futures must relate realistically to the price of cash.
Let’s consider an example to see why the price of futures and the price of actuals must be related to each
other, and why the price of futures and the price of actuals must converge during the delivery month. Let’s
assume that the current price of wheat is $2.00 per bushel and that it costs 3 cents per bushel to carry the
wheat. Carrying charges include storage, insurance, and finance costs.
The current price of wheat is $2.00 per bushel. A user of wheat (e.g., a baker) could go into the cash
market and negotiate a purchase with a farmer, paying him $2.00 per bushel. He would then store the
wheat until it’s time to use it. Let’s assume that he intends to use the wheat in the next month. In this
case, his cost will be $2.00 per bushel plus 3 cents for carrying charges, for a total of $2.03. He checks the
price of next month’s futures and discovers that the price is $1.97. In this case, the processor will not buy
the cash wheat. Instead, he will buy the futures at $1.97 and accept delivery. Therefore, his cost would
be $1.97 plus commission on the futures contract, which is 6 cents less than the cost of buying and
carrying the wheat.
Conversely, let’s assume that the price of wheat is still $2.00, but futures for next month delivery is
selling at $2.10. In this case, the farmer will sell futures, hold his wheat for one month, and deliver against
the futures contract, realizing $2.10 rather than the $2.00 he would receive if he sold in the cash market.
His additional profit in holding the wheat for one month and delivering against his short position will be
$0.07 ($0.10 less his carrying costs).
For the reasons shown above, it’s evident that the price of cash and the price of futures must converge
during the delivery month. If they did not, traders would either buy or sell futures and take or make
delivery rather than operate through the cash market.
The price for futures, as well as the price of the cash commodity, will vary from month-to-month in
accordance with supply and demand. If the general opinion is that supply will be less, while demand will
stay the same or increase, the price will be expected to rise. Conversely, if supply increases, while demand
remains the same or decreases, the price will decline. These supply and demand factors will be reflected in
the price of both the cash commodity and the futures. However, the price relationship between cash and
futures, and between successive futures months, will move in unison because of the ability to deliver cash
against futures contracts.

Types of Markets
When examining the prices of commodities for the different delivery months, one would expect the price
for the nearest futures month to be lowest while the prices for advanced months are selling at progressively
higher prices. This type of market is referred to as a normal market, a carrying charge market, or a
premium market. In a market where the nearby month is selling at the highest price and successive months
are selling at lower prices, this is referred to as an inverted market or a discount market. The factors that
determine whether a market will be a carrying charge or an inverted market are dependent on supply and
demand factors.
Normal Market
Let’s examine the economic factors that will cause a carrying charge market. A carrying charge market
will appear as follows:
$3.20 September
$3.16 July
$3.12 May
$3.05 March
$3.00 Cash
In farm commodities, the harvest period occurs annually within the space of a relatively short period, such as
a few weeks or a month. Farmers will sell a substantial part of the harvest at this time to raise money to
repay loans, to purchase seed and fertilizer for the following year, and to meet other needs. This selling
will cause the price of the cash commodity to decline, as supply will tend to exceed demand. Those who
have accumulated the commodity (e.g., elevator operators) will tend to hedge in the near month. Since
they’re long the cash commodity, they will hedge by selling near futures, causing the price to decline.
However, distant futures will not be under the same selling pressure. As already described, if the price of
near futures did not maintain a normal relationship with the cash price, traders would take advantage of the
price disparity by buying the lower-priced cash commodity and selling the higher-priced futures, thereby
guaranteeing themselves a profit.
It’s been shown that the price of cash and the price of near futures must trade within the range of the
carrying charges. In addition, the maximum that a distant month may sell over a near month is the amount
of the carrying charges. It’s not possible for the distant months to sell above the amount of the carrying
charges because traders would take advantage of any disparity and act to narrow the premium. The
following example will show why this is the case.
Once again, let’s assume that the carrying charge for wheat is 3 cents per bushel, the price of March wheat
is $2.00, and the price of July wheat is $2.20 per bushel. The number of months between March and July
is four, as wheat that’s sold for July delivery may be delivered on July 1. In this case, a trader could buy
the March wheat for $2.00 per bushel and immediately sell a July contract for $2.20. The trader would
accept delivery of the March wheat, hold it for four months at a total cost of $0.12 (4 months times $0.03
per month carrying charges) and deliver the wheat on July 1.

The trader would be assured of a profit of 8 cents per bushel. By buying the near month and selling the
distant month, traders would receive a guaranteed profit. However, this guaranteed profit could not
continue indefinitely. By purchasing the near month, the traders would cause the price to rise. Conversely,
by selling the distant month, traders would cause the price to fall. This would continue until the
difference in prices between the two futures months reached the normal carrying charge premium.
The situation described above applies to non-perishable commodities (e.g., wheat); however, it would
not apply to perishable commodities (e.g., eggs) which have a danger of spoilage. Obviously, if a person
buys a contract in a perishable commodity and takes delivery, with the intention of delivering against a
sale of a deferred futures contract, his opportunity for profit disappears if the commodity spoils in the
interim. Therefore, in a perishable commodity, the premium of the distant month over the near month
could exceed carrying charges.
Inverted Market
An inverted market is one in which the near month sells at the higher price, and advanced months sell at
progressively lower prices. The inverted market will appear as follows:
$3.20 Cash
$3.10 March
$3.00 May
$2.90 July
$2.80 September
As indicated, the carrying charge market arises because there’s an oversupply of the cash commodity at
harvest time. An inverted market occurs when there’s a shortage of the commodity. Since there’s a
shortage of the cash commodity, trade users who must have the cash commodity immediately will
aggressively buy whatever amount of cash is available, and thereby force up the price of cash. In addition,
because there’s a shortage of the cash commodity, trade users will turn to the futures market and buy the
near month in order to assure near-term supplies. This will cause the price of the near month to rise.
Distant months will not usually be under the same buying pressure. Trade users may assume that the
situation that’s causing the shortage will be alleviated within the next few months as new supplies come to
market. Therefore, the price of cash will be at the highest level as users buy whatever cash is available.
Near months will be higher than deferred months as users buy the near months with the intention of taking
delivery if the shortage persists. Distant months are not under the same buying pressure and therefore their
price is progressively lower.
It’s been shown that in a carrying charge market, the difference in prices between cash, near futures, and
deferred futures cannot exceed carrying charges. In an inverted market, this limitation doesn’t apply since
there’s no limit to the amount of the premium of the near futures month over the distant futures month. For
example, the price of March wheat is $2.00 per bushel, the price of July wheat is $1.80 per bushel, and the
carrying charges are $0.03 per bushel. There’s no possibility of taking advantage of this price differential.

Let’s assume that a trader buys the March wheat and sells the July wheat with the intention of taking
delivery on the March contract. The trader would hold the cash wheat for four months and then deliver on
the July contract, thereby sustaining a loss. If he bought the March wheat for $2.00 and stored it for four
months at a total cost of $0.12, his total cost would be $2.12. If he delivered against a July futures sale of
$1.80, he would lose $0.32.
There are other factors that must be considered in assessing the price of a commodity. One of the factors is
substitution. For example, it’s not sufficient to examine only the price of corn when assessing the price of corn
futures. One must also consider the price of commodities that can be substituted for corn (e.g., oats). Since
corn and oats are interchangeable as feed for livestock, and since corn has approximately twice the feed
value of oats, it’s reasonable to expect the price of corn to be approximately twice the price of oats. Other
commodities that can serve as substitutes for one another are soybean oil, cottonseed oil, and corn oil.
Another price relationship exists between the price of soybeans and the prices of soybean oil and soybean
meal, which are derived from the crushing of soybeans. If the price of soybeans is high in relation to the
price of soybean oil and soybean meal, crushers will not be able to realize a profit and will close down
their operations. This will mean that soybeans are not being purchased, which will cause the price of
soybeans to decline. Soybean oil and soybean meal are not being produced and, as available stocks are
used up, the price will tend to rise. In time, this will cause the margin between soybeans and the end
products to widen to the point at which it’s profitable to resume the crushing operation.
Technical Analysis
Technical analysis uses averages, theories, price trends, and charts in an attempt to predict the direction of
futures contracts. Technical analysts tend to ignore the fundamental approach; instead, they look at the
past history to formulate their opinions. Technicians look to identify trends as early as possible and then
advise clients as to the investments which should profit from the trend until there’s a reversal.
Charts and Patterns

A major part of technical analysis is the use of charts to uncover trends in the price of a commodity. These
price patterns will be used to make buy and sell recommendations to investors.
Resistance and Support Levels Over time, a futures market (or a commodity) tends to trade within a
certain range. In some cases, there’s an increase to a particular price level at which heavy selling pressure
is encountered. This is referred to as an area of resistance. Prices are too expensive and cause buying to
cease. At this point, analysts will describe the market as being overbought. In other cases, there’s a decline
to a particular price level which causes investors to purchase at the attractive lower price. This buying
stops the price decline and is referred to as an area of support. Prices become so enticing that selling stops
and buying begins. At this point, analysts will describe the market as being oversold.

The following diagrams illustrate areas of support and resistance levels.
Levels A and B show an area of resistance. At this level, selling pressure tends to prevent the market (or
commodity) from increasing. In some cases, investors feel that previous buying has left prices too high
and will consider the price level to be overbought.
Levels C and D show an area of support. At this level, buying pressure tends to prevent the further decline
of the market (or commodity). In some cases, investors feel that previous selling has left prices at an
attractive level and will consider the price level to be oversold.
A breakout occurs when the price either increases above a resistance level or declines below a support
level. When this happens, a technical analyst believes the price will continue on its course. A breakout
above the resistance level is considered a bullish signal. To profit from this, investors could buy futures.
Another alternative is for investors to purchase call options once the breakout has occurred. A breakout
below the support level is a bearish signal. To profit investors may want to sell futures slightly below the
support level. Another method is to purchase put options.
If a commodity is trading in a tight range and doesn’t breakout above resistance or fall below a support
level, it may be referred to as trading in an area of congestion.

Head and Shoulders Patterns A head and shoulders formation indicates the reversal of a trend. A
head and shoulders top formation is bearish since it signifies the reversal of an upward trend.
The commodity rises in price (Point A) and then declines to form the left shoulder. It then increases in
price to a point above the previous high (Point B), only to fall back to the previous low. The commodity
increases again (Point C), but fails to reach a new high. The last indication occurs when it falls to the level
of the previous low point and then declines further (Point D). After observing a head and shoulders top
formation, technical analysts may instruct their clients to either sell their existing position to avoid a large
loss, or to profit by selling the commodity short.
An inverted head and shoulders (also referred to as a head and shoulders bottom) is the opposite of a head
and shoulders top. This pattern is the reversal of a downward trend and is considered a bullish signal.
Double Bottom As shown below, a double bottom is a bullish chart pattern that indicates a reversal of a
downtrend. It’s formed when a commodity drops to a certain level (Point A), increases (Point B), falls
back to the same level as the original drop (Point C), then rebounds above the high in the formation (Point D).

Ascending Triangle An ascending triangle is a bullish chart pattern that usually forms during an
uptrend. This pattern is created with two trendlines. The top trendline connects the highs and is horizontal,
but the bottom trendline connects a series of increasing lows. Technical analysts generally believe the
breakout will be above the resistance line and the uptrend will continue.
Descending Triangle A descending triangle is a bearish chart pattern that typically forms during a
downtrend. This pattern is created with two trendlines. The bottom trendline connects the lows and is
horizontal, but the top trendline connects a series of descending highs. Technical analysts generally
believe the commodity will fall below the support line and the downtrend will continue.
Flags and Pennants Flags and pennants are chart patterns that typically indicate a commodity will
continue in its current trend. A flag has a mast, then two parallel trendlines that resemble a rectangle. A
pennant is identified by two converging trendlines. Prices will generally exit the chart pattern in the same
direction that they entered and the trend will continue.
Moving Averages Moving averages smooth data to make it easier to spot trends. A simple moving
average is formed by computing the average (mean) price over a number of periods. For example, a 10-
day moving average is calculated by adding the price for the last 10 days (many analysts use the closing
price) then dividing by 10. The calculation is repeated on the next day with the new price added and the
oldest day dropped from the average. The averages are then plotted on a chart and connected to create a
moving average line. Technical analysts can use many different moving averages. However, all moving
averages will lag behind price moves.

Chapter 3 Summary
 Recognize the difference in volume and open interest
‒ When price and open interest move in the same direction, the market is technically strong
 Understand the relationship between cash and futures prices
‒ In a normal market, cash is under futures (i.e., carrying charge market)
‒ In an inverted market, cash is over futures
‒ Prices must converge on the first delivery date
 Recognize the different types of technical patterns
‒ Support and resistance levels
‒ Head and shoulders
‒ Double top and bottoms


CHAPTER 4
Pricing
CHAPTER 4 – PRICING
Price Limits
In general, futures markets have daily price limits above or below which the market may not trade during a
given trading session. Daily price limits are established by the Board of Directors and must be approved
by the CFTC. On most exchanges, the current month or spot month has no daily price limit.
There’s a provision in the rules for expanded daily price limits in periods of extreme price volatility. On
the Chicago Board of Trade (CBOT), when three or more delivery months of a given commodity close at
the limit higher or lower, the daily price limit is raised to 150% of the current level for all contract months
and remain there for three successive business days. Minimum margin rates are also increased by 150%
when the price limits are expanded. The Chicago Mercantile Exchange doesn’t automatically raise margin
rates when expanded daily price limits are in effect.
Agricultural Commodities
Wheat
As previously described, a wheat contract on the CBOT is 5,000 bushels. Prices are quoted in cents and
quarter cents per bushel. The minimum price fluctuation (tick) is one quarter (1/4) cent per bushel or $12.50
per contract (5,000 bushels x $.0025 = $12.50).
Soybean
On the CBOT, the soybean contract is 5,000 bushels. Prices are quoted in cents and quarter cents per
bushel. A tick is one quarter (1/4) cent per bushel or $12.50 per contract.
On the CBOT, the soybean oil contract is 60,000 pounds and prices are quoted in dollars and cents per
hundredweight. The daily price limit is 1 cent per pound or $1.00 per hundredweight. The expanded limit is
$1.50 per hundredweight. The minimum tick is 1/100 of a cent per pound or 1 cent per hundredweight or
$6.00 per contract ($.0001 x 60,000 lbs. = 6.00).
The soybean meal contract is 100 tons and prices are quoted in dollars and cents per ton. The daily price
limit is $10 per ton and the expanded limit is $15 per ton. The minimum price fluctuation is $0.10 per ton
or $10 per contract ($0.10 x 100 tons = $10.00).
Financial Futures
Long-Term
The Chicago Board of Trade has a futures contract that trades U.S. Treasury bonds, also referred to as
T-bond futures. The T-bond futures contract is $100,000 face value of U.S. Treasury bonds maturing at least
15 years from delivery date. The bonds may not be callable for 15 years after the delivery date.

T-bond futures are not obligations of the U.S. Government. T-bond futures call for the delivery of U.S.
Treasury bonds which are backed by the full faith and credit of the U.S. Government, but the futures
contracts are not backed by the government.
T-bond futures prices are quoted as a percentage of par in minimum increments of one thirty-second (1/32)
of a point, or $31.25 per tick. If a contract is quoted at 89-07, this is 89 7/32% of 100,000, or $89,218.75.
The daily price limit is ninety-six thirty-seconds (96/32nds), or $3,000 per contract. The expanded limit is
144/32nds, or $4,500 per contract. Delivery months are March, June, September, and December.
Bond prices move in an inverse relationship to interest rates. In other words, when interest rates rise, bond
prices drop, and when interest rates drop, bond prices rise.
Treasury bond futures are referred to as long-term financial futures. Other long-term financial futures are
U.S. Treasury notes (U.S. T-notes) and Government National Mortgage Association Contracts (GNMA
futures).
Short-Term
The Chicago Mercantile Exchange (CME) trades short-term financial futures. The three short-term interest
rate futures contracts are:
1. U.S. Treasury bills (U.S. T-bills)
2. Domestic Certificates of Deposit (CDs)
3. Eurodollar Time Deposits
U.S. T-bills are sold on a discount basis (less than face value) and mature at face value. The contracts are
agreements to buy or sell $1 million ($1,000,000) of the securities at a given time in the future. The
contracts are traded using a price index, which is derived by subtracting the interest rate from 100.00. An
interest rate of 8 1/4% is an index price of 91.75 (100.00 − 8.25 = 91.75). If interest rates decline, the price
of the contract rises. Conversely, if interest rates rise, the price of the contract declines.
Since each futures contract is $1 million face amount of three-month securities, each “basis point” (0.01) of
price change (minimum tick) is $25 (.01% x 1,000,000 x 1/4 yr. = $25). The contract months are March,
June, September, and December. There’s no daily trading limit.
For example, a trader believes that interest rates will rise to 7.75% and decides to sell a
T-bill futures contract at 92.25. Interest rates rise to 8.25% and the trader covers his short
position with a purchase in the futures market at 91.75 for a profit of $1,250 (50 x $25).
If a trader believes that interest rates will rise, he should sell T-bill futures contracts. On the other hand, if
he believes that interest rates will fall, he should buy T-bill futures contracts.

Foreign Currency Futures

Foreign exchange rates are established in the Interbank Market. The Interbank Market involves the
purchase and sale of foreign currencies between financial intermediaries, such as commercial and
investment banks.
The Interbank Market is unregulated and decentralized. The most common type of transactions that take
place in this market are spot transactions, which settle in two business days from the trade date. Another
type is a forward transaction, which settles in more than two business days.
Factors that affect the supply or demand of a country’s currency play a major role in establishing its spot
rate. These factors include:
1. Demand for a country’s products and/or raw materials
2. A country’s balance of payments
3. The level of affluence of a country’s population
4. The level of foreign investment by the country
5. Government monetary and fiscal policy
6. Direct government intervention
Other factors, which include a country’s political atmosphere, the existence or threat of war, and trade
embargoes may also contribute to the strength or weakness of a foreign currency.
With the exception of the Euro, most countries have their own currency.
The Euro A number of countries in Europe decided to create a single currency so that their capital,
goods, and services could move more freely among these participating countries. The Eurosystem, which
is made up of the national central banks and the European Central Bank (ECB), was formed to implement
monetary policy, conduct foreign exchange operations, and operate the payment system of the Euro. The
Euro helps to eliminate currency risks in capital markets on securities which are issued and traded among
the countries that have accepted the Euro as a single currency.
The Chicago Mercantile Exchange (CME) has futures contracts on foreign currencies and the price of a
currency futures contract is the U.S. dollar price for one unit of the currency. The value of the contract is
that price times the number of currency units in the contract.
For example, on the CME, the Swiss franc (SF) contract is for SF125,000 and the price is
quoted in U.S. dollars per Franc. Therefore, if the SF price is .7500, the value of the contract
is $93,750 (.7500 x 125,000). There’s no daily price limit and the minimum tick is $12.50.

Chapter 4 Summary
 Understand price limits
 Recognize various contract sizes
‒ Corn, wheat, and soybean contracts are for 5,000 bushels
‒ T-bond and T-note futures have a par value of $100,000 per contract
‒ T-bond and T-note futures are quoted in percentages of par with minimum increments of 1/32,
which is worth $31.25
‒ T-bills and Eurodollar futures are quoted in percentages of par and each basis point (0.01%) is
worth $25


CHAPTER 5
Orders
CHAPTER 5 – ORDERS
Quotations
When commodity futures are transacted on the floor of an exchange, prices are reported to member firms
that receive them on a quotations board. The board will show each commodity with its separate delivery
months. For example, wheat trades in March, May, July, September, and December and there will be a
column for each delivery month. Each column will show the high and low for the contract; the previous
closing price; the opening, high and low for the day; and the close for the day, which is either the last price
or the settlement price. The price will appear on the board as “984" or as “3426". In both examples, the
last figure that’s underlined refers to the 1/8 point differential. In the first example, the commodity is
trading at 98 4/8 cents, which is $0.98 1/2 per bushel. In the second example, the commodity is trading at
3.42 6/8 cents, which is $3.42 3/4.
Trading and Delivery Months

Each commodity has its own trading months. In the case of wheat, trading will occur one year in advance
of the current month. Other commodities may trade as much as 18 months ahead.
The delivery months are generally related to physical properties regarding the commodity, such as the
beginning of the crop year, the period when the waterways that are used to transport the crop close for
the season, the period when the waterways reopen, and the end of the crop year. Deliveries are restricted
to certain months rather than to all months in order to focus orders in particular periods and therefore
add to the continuity and efficiency of the market. If all months traded, orders would be spread over
too many months and there would be a decrease in continuity because no single month would attract
sufficient bids and offers.
Ticker Tape
In addition to the quotation board, there’s a ticker which is similar to the stock ticker. Each commodity has
a symbol. The following list provides some of the symbols that are used by the various vendors offering
the reporting service:
S&P 500 SP Silver SV Japanese yen JY

Soybean meal SM Wheat W Corn C
Oats O Soybeans S Soybean oil BO
Sugar SU Gold GC Crude oil CL
NYSE Index YX Platinum PL U.S. Treasury Bonds US
In addition to the symbol of the commodity, the tape will also include the delivery month. The delivery
month symbols are letters that follow the symbol of the commodity and are the following:
January F May K September U

February G June M October V
March H July N November X
April J August Q December Z

Therefore, a transaction in May wheat will print on the tape with the symbol “WK.” A transaction in January
platinum will appear on the tape as “PLF.” A transaction in November silver will appear as “SVX.”
If trading is very active, certain transactions may be not reported on the tape. In this case, the tape will
print the word “Fast” to indicate that certain trades have been deleted. The tape will also show bids and
offers as well as transactions. It’s important to note that a print on the tape is not necessarily a transaction.
Unless it’s clearly indicated to be a trade, a price may be either a trade, a bid, or an offer. Only prices are
printed on the tape, never volume figures.
Orders in commodities are written in terms of the number of contracts. For example, a contract in gold is
100 troy ounces. If a customer wants to buy 300 troy ounces, he will enter an order as follows: “Buy 3
September Gold.” Since there are no odd lots in commodities, if a trader wants to buy gold, he’s only able
to do so in multiples of 100 troy ounces.
There are a variety of orders that customers may place for the purchase or sale of commodities. Some are
the same as orders in securities, while others have no counterpart in the securities business. Still others
have the same name, but differ slightly from securities orders.
Types of Orders
Market Order
A market order is an order that’s to be executed at the best possible price when the order reaches the ring.
The market order will be written as follows:
Buy 1 May crude oil at MKT
When the floor broker reaches the ring, he will buy one contract of crude oil at the lowest prevailing offer.
Limit Order (Resting Order)

A limit order is an order to buy at the limit price or lower or to sell at the limit price or higher. The buy
limit order will be written as follows:
Buy 5 December crude oil at 19.20
When the broker enters the ring, he will buy the five contracts (if possible) at 19.20 or less. However, he
will not pay more than 19.20 and, if he can only fill part of the order, he will buy only that part and hold
the balance of the order for possible execution later in the trading session.
The sell limit order will be written as follows:

Sell 5 December crude oil at 19.20
The broker will sell crude oil (if possible) at 19.20 or higher. If he can fill only part of the order, he will
sell only that part and hold the balance of the order for possible execution later in the trading session.

Sell Stop Order

A stop order to sell becomes a market order if the contract trades at or below (or is offered at or below) the
stop price. The sell stop order will be written as follows:
Sell 3 June crude oil at 19.20 stop
The broker will go to the ring and observe the trading in crude oil. If a contract trades at or below 19.20
(or if there’s an offer from another broker at or below 19.20), he will sell the three contracts at the market
and will hit the highest bid available at the time. For example, let’s assume that the first trade after the
broker enters the trading ring is at 19.22. No action will be taken since the contract has not traded down to
the stop price. Another trade occurs in the ring at a price of 19.20. Since a trade has now occurred at or
below the stop price, the stop order will now be executed at the best available price. This may be 19.20, or
19.19, or any other price.
If another broker entered the ring and announced an offer at 19.20 (which is at the same price as the stop
price), the stop order will also be immediately executed on the basis of the offer. Please note that a stop
order to sell commodity futures differs from a stop order to sell stock. With commodity futures, the order
becomes a market order when there’s a trade or an offer at the stop price, whereas a stop order for stock
becomes a market order only when there’s a trade.
Buy Stop Order

A stop order to buy becomes a market order if the contract trades at or above (or is bid at or above) the
stop price. The buy stop order will be written as follows:
Buy 1 June crude oil at 19.20 stop
In this case, the broker will buy the contract if crude oil trades at or above (or is bid at or above) the stop
price. If a trade occurs at 19.20 or higher, or another broker bids for crude oil at 19.20 or higher, the stop
order will be executed immediately at the best available price.
Strategies of Stop Orders

The purpose of a stop order is to limit a loss or protect a profit. For example, the customer may have
purchased the crude oil contract at 19.35. He’s willing to accept a loss of approximately 15 points, but
because he doesn’t want to take a loss much beyond that amount, he therefore instructs his broker to enter
a sell stop order as protection if the price goes that low. The broker will fill the order at the best price
possible if the contract goes down to the stop price of 19.20. Since the stop order becomes a market order,
the customer may not necessarily receive 19.20. Instead, he may need to sell for less (e.g., 19.18) if that’s
the best bid available after the contract trades at the stop price. Now, let’s consider how a stop order can be
used to protect a profit. The customer may have purchased the contract at 19.05 and it’s now trading at
19.25. If the market turns down, the customer may instruct his broker to enter a sell stop order at 19.20 to
protect as much of his profit as possible.

To limit a loss on a short position, a buy stop order may be placed. For example, a customer sells a crude
oil contract at 19.05 because he believes the price will fall. He’s concerned that the price may rise and,
therefore, he enters a stop order to buy at 19.20. If the price of crude oil advances by 15 points, he wants to
buy a contract to cover his short position and thereby limit his loss to approximately 15 points. Of course,
there’s no assurance that he will not lose more than 15 points. Remember, because it becomes a market
order, it’s possible that the broker may need to buy the contract at 19.22 to cover the short position once it
trades through the stop price. If that happens, the customer’s loss would be 17 points. On the other hand, if
he had sold short at 19.35 and the price is now at 19.15, he would have an unrealized profit of 20 cents. In
order to protect most of his profit, he may enter a stop order to buy at 19.20.
In the examples above, the stop order has been entered to liquidate an existing position. A stop order could
also be entered to establish a new position. For example, a trader may decide that the price of a contract
will rise sharply if it breaks through a resistance level. For that reason, he may enter a stop order to buy if
the price goes up to this level in order to establish a new long position.
Stop Limit Order

A stop limit order incorporates the provisions of both a stop order and a limit order. In the case of a sell
stop limit, the order becomes a limit order (not a market order) once the commodity trades at or below (or
is offered at or below) the stop price. The sell stop limit order will be written as follows:
Sell 10 December crude oil at 19.20 stop, limit 19.18
In this case, the broker is directed to sell the crude oil once the price goes down to 19.20 only if he can get
at least 19.18 or higher. If crude oil trades down to 19.20 (or is offered at 19.20), the stop goes into effect.
At this point, the broker will try and sell the crude oil for 19.18 or more. If there are no traders willing to
pay this price, he will hold the order for possible execution later in the trading session.
The buy stop limit order would be written as follows:

Buy 10 December crude oil at 19.20 stop limit
With this order, the customer is stipulating to his broker that if the commodity trades at or above 19.20 (or
is bid at or above 19.20), he should buy 10 December contracts, but at a price no higher than 19.20. In this
case, both the stop and the limit are at the same price.
Market-If-Touched (MIT) Order

A market-if-touched order (also referred to as a board order) to buy becomes a market order when the
commodity trades at (or is offered at or below) the limit price. The buy MIT order will be written as follows:
Buy 50 July wheat at 2.38 MIT (10 contracts)
A buy MIT order is placed below the prevailing price in the market. This order is used by a person who
wants to establish a long position or to cover a short position when the market declines to a certain level.

For example, when the above order is placed, July wheat is trading at 2.44. If the market declines and
trades at or below 2.38 (or is offered at or below 2.38), the broker will buy 10 contracts of July wheat at
the best available price since it becomes a market order when it’s “touched” (elected).
An MIT order to sell becomes a market order when the commodity trades at (or is bid at or above) the
limit price. The sell MIT order will be written as follows:
Sell 25 September corn at 1.65 MIT (5 contracts)
A sell MIT order is placed above the prevailing price in the market. This order is used by a person who
wants to establish a short position or to liquidate a long position when the market rises to a certain level.
For example, when the above order is placed, September corn is trading at 1.60. If the market rises and trades
at or above 1.65 (or is bid at or above 1.65), the broker will sell 5 contracts of September corn at the best
available price since it becomes a market order when it’s “touched” (elected).
The difference between the limit order and the MIT order is that the limit order must be bought or sold at
the limit price or better. On the other hand, the MIT order may be bought or sold at any price once a trade
occurs at the price specified in the order.
Please note, the sell limit, the sell MIT, and the buy stop are placed above the market; however, the buy
limit, the buy MIT, and the sell stop are placed below the market.
Discretionary Order
A discretionary order is placed to either buy or sell at a limit price, but the broker is given a certain amount
of discretion, as stated in the order, to buy at a higher price or to sell at a lower price. The discretionary
order will be written as follows:
Buy 10 December copper at 64.90 with 5 points discretion
In this case, the broker is instructed to buy the copper if it’s offered at 64.90 or less. However, if the broker
believes that copper will not trade at this price, he may buy it as high as 64.95 because the customer has
given him discretion of 5 points.
In the case of a discretionary order to buy, the broker will be given discretion above the limit. However, in
the case of a discretionary order to sell, discretion will be given below the limit.
Not Held Order

A not held order is similar to a discretionary order in that it gives the floor broker discretion regarding the
handling of the order. However, in the case of a not held order, the broker is given full discretion as to
whether to take a position. Regardless of whether the broker decides to take a position, he cannot be held
responsible for his action (or inaction).

The not held order will be written as follows:

Sell 50 May corn at 1.69 Not Held
In this case, the broker is instructed to sell 10 contracts of corn at $1.69 if he determines that such action is
warranted. At this point, the broker will enter the crowd and observe the market. If corn is bid for at 1.69,
but the broker believes that the market will go up and allow him to get a better price for the customer, he
may wait. If the market goes down and the broker fails to execute the order, the customer cannot hold the
broker liable for an execution.
Fill-or-Kill Order
This is an order that’s to be executed as soon as the order is presented in the crowd and, if it cannot be
executed at the limit, it’s simply canceled. The order may be executed in part if the broker is unable to
execute the entire order, but any part that’s not filled is canceled.
The fill-or-kill order will be written as follows:

Buy 10 September soybean meal at 235.40 FOK
The broker will attempt to buy 10 contracts of soybean meal at 235.40 per ton or lower. If he’s able to buy
only 5 contracts at that price, he will do so and immediately cancel the remainder of the order.
One Cancels the Other (OCO) Order

With an OCO order, the customer is instructing the broker to execute one of two alternative orders.
Whichever he does first will automatically cancel the other. The OCO order will be written as follows:
Buy 10 December corn at 1.70 or buy 10 December corn at 1.80 stop
In this example, the trader’s original position was a sale of 50,000 bushels of corn 1.75. He anticipates that
the price will go down. If he’s right, he wants to offset his position by buying the corn at 1.70 for a profit
of $0.05 per bushel. However, if he’s wrong and the price advances to 1.80, he wants to cover his short
position with a loss of no more than approximately $0.05 per bushel. Therefore, the broker is instructed to
watch the market and act in either case. Of course, once he acts, the customer no longer has a position and
the other part of the order is canceled.
Switch Order
This is an order to switch a contract from one delivery month to another delivery month, or from one
exchange to another exchange. In either case, the customer must pay a full round-turn commission because
it’s considered to be a new order. A switch order will be written as follows:
Sell 1 August live beef cattle at 68.40
Buy 1 December live beef cattle 69.10

In this example, the customer bought a contract of live beef cattle. Let’s assume that it’s now August and
the customer must either offset his position by selling the contract, or he must be prepared to accept
delivery. Since he doesn’t want to accept delivery, he will offset and immediately buy a contract in a more
distant delivery month.
Give Up Order
This is an order that a floor broker or FCM executes on behalf of another floor broker or NFA member.
The firm that’s giving the order away is also “giving up” its commissions on the trade (as the order name
suggests). Give up orders are often used to execute larger, “block” trades for CTAs or CPOs.
Exchange for Physicals Order (EFP)

This type of order (also referred to as an “against actuals” order) is an ex-pit transaction. Ex-pit transactions
are trades that are made outside the trading ring. Commodity futures orders must normally be done in the
trading pit of an exchange by open outcry. In this type of order, two hedgers (outside of the trading pit) will
prearranged to exchange their cash and futures positions. The hedger who’s long the cash commodity (and
therefore short futures) will deliver the cash commodity to the hedger who’s short cash (and therefore long
futures) in exchange for the latter’s long futures position.
Another type of ex-pit trade involves the transfer of a customer’s account between clearing member firms.

Chapter 5 Summary
 Understand the different types of orders
‒ Market orders are executed immediately
‒ Buy limit orders are executed at the limit price or lower
‒ Sell limit orders are execute at the limit price or higher
‒ Buy stop orders are activated only if the price rises to the stop price
‒ Sell stop orders are activated only if the price falls to the stop price
‒ Stop orders become market orders once activated
‒ Stop-limit orders become limit orders once activated
‒ Buy market-if-touched (MIT) orders will become market orders if the price falls to the MIT price
‒ Sell market-if-touched (MIT) orders will become market orders if the price rises to the MIT price
‒ Not held orders give an AP discretion as to the time and/or price of execution
‒ Fill-or-kill (FOK) orders need to be executed immediately, then canceled. Partial fills are
acceptable.
‒ One cancels the other (OCO) orders ensure only one of two orders is executed
‒ Switch orders are used to exit positions in futures that are about to expire in order to establish
positions in later delivery months
‒ Give up orders are used when one FCM is giving an order to another FCM for execution


CHAPTER 6
Margin
CHAPTER 6 – MARGIN
Introduction
Since there are a number of significant differences between trading in commodity futures and trading in
securities, customers should be informed of these differences. One of the differences between commodity
futures trading and securities trading is that the initial margin deposit in commodity futures is substantially
less than the margin required in securities. Margin in commodity futures is often as low as 10% of the
value of the contract, whereas margin in stock purchases is much higher. Therefore, the customer’s
leverage (and risk) is significantly higher in futures trading than it is in securities trading.
A second difference between futures trading and securities trading is that all transactions in futures are
executed in a margin account. Unlike securities trading, there’s no cash account in futures trading.
A third difference is that the prices of commodity futures tend to fluctuate more than prices of securities.
For that reason, major price changes are more likely in futures than in securities.
Commissions
Future commission merchants charge customers a commission for executing their commodity futures
orders. Commissions on futures are “round-turn,” which means that they’re for both the purchase and sale of
a contract. For example, if a trader assumes a long position in a futures contract and the commission is
$50, this commission will apply to both the original purchase transaction and the subsequent sale.
Commissions on commodity futures are negotiable between member firms and customers.
Commissions on a spread order are approximately 70% of the equivalent commission for two single
trades. A spread involves the simultaneous purchase and sale of related commodity futures. An example of
a spread is the purchase of September wheat on the Chicago Board of Trade and the simultaneous sale of
September wheat on the Kansas City Board of Trade. In order to receive the lower commission applicable
to the spread, both sides of the spread must be assumed during the same trading session.
If a customer has a position with a futures commission merchant and subsequently decides to transfer his
account and his open position to another futures commission merchant, he will be required to pay the new
firm a full round-turn commission despite the fact that he paid the original firm a full commission.
If a customer has a position during the delivery month and he wants to maintain the position without being
concerned about making or taking delivery of the cash commodity, he may enter a “switch order,” which
will shift his position to a later month. He will pay a full commission on the new order. For example, let’s
assume that an individual is long September wheat. At the end of August, he decides to offset his
September position through a sale in order to avoid receiving a delivery notice. However, he believes the
price of wheat will continue to rise. He will buy a contract in a later month (e.g., December) when he sells
his September contract.

Margin on Commodity Futures

As stated earlier, trading in futures may only be done in a margin account. Margin refers to the amount of
equity that must be deposited when a futures position (either long or short) is established. The margin
requirement is the same for long and short positions in futures contracts. The rules of the exchanges
require customers to deposit margin promptly after assuming a position and, if equity is not deposited, the
member firm must liquidate the customer’s position.
Margin for each contract is determined by the board of directors of the exchange. On most exchanges, hedge
customers are allowed to deposit a lower rate of margin than speculators. For example, if an individual is
long 3,000,000 bushels of cash wheat, she will hedge by selling 3,000,000 bushels of wheat futures. The
member firm will require a lower margin for her futures position than it would require from a speculator
because the hedger has an offsetting cash position. Any loss that she may sustain on her futures position
will be essentially neutralized by a corresponding gain on her cash position. If the individual in the above
example were to sell 3,250,000 bushels of wheat futures, she will be required to deposit the lower hedge
margin on 3,000,000 bushels and regular speculator margin on the 250,000-bushel excess.
Margin Department
The margin department is one of the most important operating departments of a member firm. It’s the
responsibility of the margin department to determine a customer’s equity on a daily basis. In computing
the customer’s equity, the margin department takes into consideration the amount of unrealized profit or
loss in the customer’s account by computing the customer’s position against the exchange’s settlement
price of the preceding day. If any additional margin is required, a margin call will be sent to the customer
and the call for additional margin must be met promptly. The member firm will assign the responsibility of
contacting the customer and collecting the necessary margin to the Registered Commodity Representative
who handles the account.
Original and Maintenance Margin

Original margin is the amount of money that’s required to be deposited in an account when an initial
futures position is assumed. Original margin is also referred to as initial margin.
Original margin may be met by deposit of cash, either from a new deposit or by transfer from another
account (e.g., a securities account). Certain eligible securities may be deposited in lieu of cash. The value
of these securities is reduced for margin purposes based on the type and maturity of the security.
Maintenance margin refers to the minimum amount that must be maintained in the account. If the account
drops below this level, a call must be made for additional margin and is referred to as variation margin. The
need for additional margin to restore an account to original margin is considered a variation call. An
investor may meet this call by the deposit of cash, by the transfer of funds from another account, or by the
liquidation of sufficient positions to bring the account to the required level.

If a customer wants to establish a new position in an account that’s undermargined as the result of an
adverse price movement, the account executive may accept the order if the customer indicates that he’s
sending in the necessary margin to cover the new position and the existing deficit in his old position.
Funds may not be withdrawn from an account unless all positions are fully margined at the original margin
level. For example, if the original margin is $1,000 and the maintenance margin level is $750, the
customer cannot withdraw any funds if the equity drops below $1,000. Any excess above the $1,000 level
may be withdrawn in cash or may be used to take a new position. The term “pyramiding” refers to the use
of excess equity to take new positions, generally in decreasing increments. For example, if a customer has
an unrealized profit on 10 wheat contracts, she may use the excess as margin on five additional contracts.
Let’s consider an example to determine how both original and maintenance margin work. The original
margin is $1,000 and the maintenance level is $750.
The customer will deposit the original margin of $1,000 when she takes her position. As long as the equity
in the account remains at least $750, no additional deposit will be required. However, once the equity
drops below $750, the customer must deposit an amount that’s sufficient to bring the account up to the
original margin level. If the equity decreases to $700, the futures commission merchant will send out a
variation call for $300 to bring the account back to $1,000.
In another example, a trader buys a contract which consists of 5,000 bushels, with original margin of $600
and maintenance margin of $500. The price of the futures is $2.50, but then drops to $2.49. This is a loss
of $0.01 on 5,000 bushels, which equals $50. The trader’s equity is reduced to $550. Since this is above
the maintenance level, no call will be made for additional margin. Later, the market price drops to $2.47.
This additional loss of $0.02 equals $100, and the equity now declines to $450. Since this is below the
$500 maintenance level, a call will be made for additional margin of $150 in order to bring the equity back
to $600. If the price of the commodity subsequently advances to $2.62, the trader has an unrealized gain of
$0.12 per bushel, which equals $600. She could withdraw this sum in cash or use it as margin to purchase
one additional contract.
Margin on a Long Position

If a customer is long, he will be called for additional margin if the price of the contract decreases to a
price that brings the equity in the account below the maintenance margin level. For example, let’s
assume that the original margin on a contract consisting of 5,000 bushels is $600 and the maintenance
margin is $500. Therefore, original margin is $0.12 per bushel ($600 divided by 5,000) and maintenance
margin is $0.10 per bushel. A long position is taken when the price of the futures contract is $2.50 and
margin of $600 is deposited with the futures commission merchant. If the price of the contract drops to
$2.47 (a decrease of $0.03 per bushel), the equity will decline to $450 and the trader will receive a call
for $150 of additional margin.

Margin on a Short Position

In the preceding example, if the customer were to take a short position, he would receive a call for
additional margin if the price of the contract advanced above $2.52. The increase of $0.03 per bushel on a
short position would cause a decrease of $150 in equity and a call would be sent for additional margin.
Increases in Margin Requirements

The exchanges have the right to increase the margin required on any contract. This will typically occur if the
market is volatile and the price of the contract is high. For example, let’s assume that the original margin
requirement is $1,000 and the maintenance margin requirement is $750. The customer will be required to
deposit $1,000 when he assumes the original position and will be called for additional margin if his equity
drops below $750. Now let’s assume that the original margin is increased to $1,250 and maintenance
margin is increased to $1,000. No additional margin will be required above the $1,000 that’s already deposited
despite the fact that the original margin level has been increased because the $1,000 fulfills the new
maintenance required. However, if a customer’s equity drops below the maintenance margin requirement,
then additional margin will be required up to the new original margin requirement ($1,250).
Margin is not a down payment on the actual commodity. Instead, it’s a good faith deposit or performance
bond whereby the customer deposits the required equity to indicate his willingness and ability to perform
on the contract in the event that it’s not offset before the delivery month. Margin is an earnest deposit to
evidence good faith on the part of the customer. A futures commission merchant has the right to require
higher margin (but not lower margin) from its customers than the amount required by the exchange in
regard to both original and maintenance margin.
On a long futures position, the holder of the contract doesn’t own the cash commodity. He has the
right to take delivery (in which case he will be required to pay the full purchase price to the seller), but
he’s not the owner of the cash commodity until he takes delivery. Therefore, no money is loaned by
the futures commission merchant to finance ownership of the cash commodity and no interest is
charged to the customer.
Higher margin is usually required for commodity futures whose market is relatively volatile. In the case
of spread positions, which involve assuming both a long and a short position in the same or related
commodity futures, margin is generally lower because of the lower risk involved. This is because the
fluctuation in the difference between the long and short position is generally less than the fluctuation on
a net long or a net short position. For example, let’s assume that Speculator A takes a long position by
buying July wheat at $3.00. Speculator B establishes a spread position by buying July wheat at $3.00
and selling September wheat at $3.10. The price of wheat now declines. July wheat drops to $2.90 and
September wheat drops to $3.02. In the case of Speculator A, who has a net long position, he will suffer
the entire loss of 10 cents per bushel. Speculator B, who has a spread position, will also lose $0.10 on his
long July position, but this will be partially offset by a gain of $0.08 on his short September position.
Therefore, his net loss is $0.02 rather than $0.10. Because the spreader has a lower risk, margin on
spreads is lower.

Hedger Margin
As just explained, the margin requirements for hedge customers are usually lower than the margin
requirement for speculators. This is because the hedger has a cash position that’s opposite to his futures
position. Any decrease in equity on his futures position will likely be offset by an increase in equity on his
cash position. A second reason for a lower margin requirement for a hedger is because the hedger is in a
better position to perform on the cash contract than the speculator. The hedger is a businessperson who uses
the cash commodity and therefore he’s better able to make or take delivery as compared to the speculator.
A third reason for a lower margin requirement for the hedger is because it’s generally easier for the
member firm to ascertain the financial condition of the hedge customer than that of the speculator.
Leverage
One of the major differences between speculating in securities and commodity futures is that the amount of
leverage is much greater in commodity futures. Leverage represents the amount of control a person has over
an asset with a given dollar amount.
Let’s consider an example of using futures to provide leverage. A trader purchases five contracts of corn.
The margin requirement is $500 per contract and the trader deposits $2,500. Since a corn contract consists
of 5,000 bushels, the trader now controls 25,000 bushels. When the purchase is made, the price of corn is
$2.00, but corn then advances in price by 20%, to $2.40, and the contracts are sold. The profit is $0.40 per
bushel on 25,000 bushels, for a total profit of $10,000. This represents 400% profit on the initial
investment ($10,000 ÷ $2,500).
Note that the same dollar investment ($2,500) and the same advance in price (20%) produced a profit of
40% in securities and 400% in futures. This is because of the substantially lower margin requirement on
futures.
Now let’s consider another example of how small changes in futures prices can cause large profits or losses
for a speculator. An individual takes a short position in five soybean contracts when the market price is
$5.25. His margin deposit is $0.40 per bushel. Since a soybean contract consists of 5,000 bushels, he
deposits a total of $10,000 ($0.40 x 25,000 bushels). His margin deposit represents 7.6% of the value of
the soybeans. This is determined by dividing the margin deposit per bushel ($0.40) by the value of the
soybeans per bushel ($5.25).
If the price of soybeans declines by 4%, what’s the trader’s margin of profit? A 4% decrease in the price of
soybeans will be equal to $0.21 per bushel ($5.25 x .04). Of course, if an individual is short, a decrease in
the market price will represent a profit. Since his initial investment was $0.40 per bushel and his profit is
$0.21 per bushel, his margin of profit will be 52 1/2% ($0.21 ÷ $0.40).

Let’s examine some additional examples in order to determine how to compute profit or loss when the price
of a futures contract changes. A trader buys one wheat contract at $2.50 and his margin deposit is 12 cents
per bushel. A wheat contract consists of 5,000 bushels. Later, the price of wheat advances to $2.57 and the
contract is sold. Commission is $30 per contract. What’s the trader’s net profit and what’s the percentage
of profit on his original investment?
The first point to determine is his margin investment in dollars. If margin is $0.12 per bushel, and a wheat
contract is 5,000 bushels, the margin investment is $600 (5,000 x $0.12). If wheat advances in price by
$0.07 cents per bushel (from $2.50 to $2.57), the gross profit is $350 (5,000 x $0.07). In order to determine
his net profit, the commission of $30 must be subtracted; therefore, his net profit is $320 per contract. To
determine the net profit as a percentage of his investment, divide the profit per contract ($320) by the
margin deposit per contract ($600), which indicates a profit margin of 53.3%.
Now, let’s consider one final example. An investor assumes a long position in live cattle when the price is
$39.50. His margin investment is $600 and commission is $50. Later, the price of live cattle advances to
$41.25 and the position is offset through a sale. Let’s determine the percentage of the margin deposit in
relation to the value of the contract, the net profit, and the net profit as a percentage in relation to the
margin deposit.
Livestock (e.g., cattle and hogs) are quoted in dollars and cents per hundredweight. A quote of $39.50
represents $39.50 per hundred pounds, or $0.395 per pound. Since a cattle contract consists of 40,000
pounds, the value of the contract is $15,800 (40,000 x $0.395). Since the margin is $600, this represents
3.8% of the value of the contract ($600 ÷ $15,800). The profit is $1.75 per cwt. (hundred-weight), or
$0.0175 per pound. Multiplying 40,000 pounds by $0.0175 indicates a gross profit of $700. The net profit
is $650 after deducting the commission of $50. The percentage of profit in relation to the margin deposit is
determined by dividing the net profit ($650) by the margin investment ($600), indicating a net profit
margin of 108.3%.

Chapter 6 Summary
 Understand the difference between half-turn and round-turn commissions
‒ Half-turn commissions include only one trade
‒ Round-turn commissions include two trades (e.g., both a buy and sell)
 Recognize the basics of margin requirements
‒ Margin requirements are set by the exchanges, represent a good faith deposit, and can be changed
daily
‒ Margin requirements for hedgers are lower than the margin requirements for speculators
‒ Long and short positions have the same margin requirement
‒ Original margin is the requirement to establish a position
‒ Variation or maintenance margin is the minimum requirement
‒ Equity = Original Margin +/ ‒ Open Trade Equity (OTE)
‒ If the equity falls below the maintenance requirement, it must be promptly brought back to the
original margin requirement (e.g., by the opening of the next trading day)
‒ Equity above the original margin requirement is excess equity and can be used to establish
additional positions (i.e., pyramiding)


CHAPTER 7
Speculation
CHAPTER 7 – SPECULATION
Introduction
Speculators are investors who buy and sell futures contracts with the expectation of making profits. Since
speculation may occur in all types of futures, questions may involve speculation on wheat, corn, soybeans,
sugar, and meat products (e.g., livestock and hogs). Speculation also occurs in metals (e.g., gold, silver,
palladium, and copper) and in oil and oil products (e.g., crude oil, gasoline, and heating oil). The most
active component of the futures markets is in financial futures, such as stock indexes, foreign currencies,
and financial debt instrument futures (the most active of all).
Speculators risk capital by going long futures when they expect the price to rise, attempting to employ the
basic rule of investing—buy low and sell high. Speculators go short when they expect the price to fall. By
shorting (selling) the future at its present value, and then covering later by buying at a lower price, the
short speculator will also profit. Speculators include floor traders, commodity pool operators, commodity
trading advisers, large professional traders, and even small investors.
Speculation in Non-Financial Futures

A Case Example (Long Futures)
After a long stretch of stormy weather, an individual realized that if this weather pattern continues, the
agricultural crops in the area will be destroyed. Her belief was that everyone will be paying higher
prices for groceries in the future. If she’s correct, she wonders if she can profit from higher prices for
agricultural products?
If she believed that the price of corn was going to rise, she could purchase corn, store the corn, and sell
it in the market (hopefully) at a higher price. This may be very inconvenient. In all likelihood, the
individual doesn’t have the capacity to store the corn. Also, she’d be required to pay the full price for
each bushel of corn.
The individual does some quick math and determines that the current price for corn is $2.80 per bushel.
The individual realizes that she will need to pay a person to store the corn and that she will want to insure
the corn. Finally, if she intends to borrow any of the funds necessary to purchase the corn, there will be
finance charges. The individual calculates these costs (commonly known as carrying charges) to be
$0.0333 per bushel, per month. For a three-month period, the individual will have a cost per bushel of
$2.80 + ($0.0333 x 3) = $2.90. In truth, there’s a more effective means for the individual to profit if she’s
correct about the movement of corn prices. She can profit through speculation in the futures market.
As it happens, corn futures trade on the Chicago Board of Trade (CBT). Once the individual opens a
futures account and is eligible for speculation, she may purchase and sell futures contracts. Unlike
purchasing the underlying commodity, the individual is only required to deposit a required amount of
margin. The individual has already learned that the price of corn is $2.80 per bushel. Futures contracts
(which can result in the delivery of corn) have a contract size of 5,000 bushels and are available for a
number of different months of delivery.

The individual examines a contract for delivery in three months. The price of the futures contract is
presently bid at $2.8850 and offered at $2.90. The individual believes that the market price will rise
and goes long a futures contract. She purchases the corn futures contracts and pays the offered price of
$2.90 per bushel.
The individual had already been informed by her broker that the required margin for the futures contract
on corn is $0.2175 per bushel. This amounts to only 7.5% of the futures contract price per bushel ($0.2175
÷ $2.90 = .075 or 7.5%). For each futures contract that the individual goes long, she will need to deposit
$1,087.50 ($0.2175 x $5,000). The individual will be required to pay round-turn commissions of $35.00
per contract. This means that a single fee is paid to establish the long futures position and later to liquidate
(sell) those contracts.
The individual is very interested in pursuing a speculation strategy in futures contracts. She decides to
go long 10 July futures contracts at $2.90. As required, she deposits $11,225. This represents equity of
$10,875 and commissions of $350 for the 10 contracts. After one trading session, the individual realizes
that the closing price of the July futures contract is $2.92 per bushel. She then checks to determine her
current equity value.
The individual is long at $2.90 per bushel and the closing value for the July corn futures is $2.92 per
bushel. The increase of $0.02 per bushel represents an increase in the individual’s equity by the same
amount. Her margin (equity) deposit was $0.2175 per bushel and the value is now $0.2375. The total
equity for the individual’s account is $11,875.00 ($0.2375 x 5,000 bushels x10 contracts). This represents an
increase of $1,000. Before the individual gets too excited, she must consider the impact of the commissions.
Round-turn commissions of $35.00 per contract amount to $350. If the individual had liquidated her
position based on the closing market value, her profit would equal the $1,000 increase in equity minus the
commission expense of $350.00, or $650.00 profit.
In the days that pass, the individual finds that the increase in the value of corn is short-lived. One week has
passed since she established the corn futures contracts and the most recent close was $2.8550. The decline
in the value of the futures has had a direct and negative impact on her equity. She’s long the corn futures at
$2.90 per bushel, but the futures closing price at $2.8550 has resulted in a decline of $0.045 per bushel.
This loss of $0.045 reduces the individual’s equity per bushel from $0.2175 to $0.1725. The individual
does the math and determines that her equity is currently $8,625.00 ($0.1725 x 5,000 x 10). This
represents a loss in equity of $2,250.00 ($10,875.00 − $8,625.00). Unfortunately, the bad news doesn’t end
there. The individual has had to pay round-turn commissions of $350. This increases the present level of
loss to $2,600.00 ($2,250 + $350). Based on the amount of money the individual has deposited, her
present loss of $2,600 represents approximately a 23% total loss, including margin deposited and
commissions paid ($2,600 ÷ $11,225.00 = .2316).
The following day, the individual calls her broker because she’s concerned about her loss in equity, the
direction of the corn futures, any upcoming reports that are due, and any further deposits of equity that may
be required. Her broker is somewhat reluctant, but addresses the latter issue first. The margin requirement
for corn futures remains at $0.2175 per bushel. There’s a maintenance level of $0.1675 per bushel, which
the individual is approaching.

If her equity falls below $0.1675 per bushel, she will receive a maintenance call. This requires the contract
holder to deposit sufficient equity to bring the account equity up to the initial margin level. The individual
is nervous about this possible event.
Today, if corn futures are down by $0.01 from the previous days close of $2.8550, what happens then?
Her broker describes the unfortunate result. A loss of $.01 will mean that the market close was $2.8450.
This will represent a $0.055 decline from the individual’s established long position of $2.90. The
individual’s equity deposit of $0.2175 will have declined to $0.1625 ($0.2175 − $0.055). Since this is
below the maintenance level, the individual will then be required to deposit $2,750. This is the result of
$0.055 per bushel x 5,000 bushels x 10 contracts. The individual is less than pleased with this scenario.
She asks how much time she has to meet this maintenance call and is informed that the firm requires the
additional deposit to be made prior to the opening of the next trading session.
The individual’s broker informs her that corn did rally near the end of the last trading session; however, he
cannot predict what today will bring. The individual decides that she doesn’t want to risk additional losses at
the present time. Therefore, she places an order to liquidate the 10 corn contracts.
After the market opens, the individual contacts her broker and her contracts were liquidated at $2.8625.
The individual now calculates her loss.
She was long at: $2.9000

She sold at: $2.8625
She lost: ($0.0375) per bushel
Multiplied by: 5,000 bushels
Loss per contract: ($187.50)
Commissions paid: ($35) round-turn
Total loss per contract: ($222.50)
Multiplied by: 10 contracts
Total loss: ($2,225)
The individual is unhappy with this loss and now wants to determine the percentage of loss incurred,
based on her margin deposit. She calculates this by dividing her loss by her deposit. The individual had
deposited $0.2175 per bushel. This amounted to a deposit of $1,087.50 for each 5,000-bushel contract.
The loss incurred for each contract was $222.50. The individual could multiply both the amount of loss
and the amount of deposit by the 10-contract total. She realizes that for a percentage calculation of profit
or loss, the percentage for one contract will be the same percentage for 10-contracts (or any other
quantity of contracts).
$222.50 ÷ $1,087.50 = .2046, which is a loss of 20.46%.

Based on the previous example, it should be evident that the results of speculation require some degree of
calculation. The Series 3 Examination will require candidates to quickly and accurately derive answers to
speculation questions. Rather than engaging in a trial and error method, it’s advisable to use a model to
perform these calculations.
The model to be used is the same one the individual used to calculate her loss.
Futures position established
– Futures position liquidated
Profit (loss) per unit
x Contract size
Gross profit (loss) per contract
+/– Commissions
Net profit (loss) per contract
x Number of contracts
Total profit (loss)
A possibility of making a mistake in computation occurs when the speculator incurs a loss. The amount of
commissions paid will increase the amount of loss. This happened to the individual in the earlier case
example. Regardless of whether a person makes or loses money, a commission will still be paid. To
eliminate this potential flaw in the following examples, commissions will be shown as money out of the
customers account in the way that losses are shown.
For example, a loss of $500 per contract will be illustrated as (500). A payment of $35 in round-turn
commissions will be shown as (35).
(500) Gross loss per contract
( 35) Commissions
(535) Net loss per contract
In other examples, it will be necessary to calculate the percentage profit or loss. In these cases, once
the net profit (loss) per contract is calculated, it’s divided by the amount of margin per contract that
has been deposited.
For example, if a customer has a net profit per contract of $250 and had deposited $2,000 per contract,
what’s her profit percentage based on the margin deposited?
$250 ÷ $2,000 = .125 or 12.5%
A Case Example (Short Futures)

The same general model is used to calculate profit or loss when a speculator shorts a contract and later
covers the contract through a purchase. Futures contract prices are often expressed in cents per unit. Since
profits and losses will be expressed as a total dollar amount, it will be necessary to convert cents to dollars.
It’s advisable to convert early in the calculation process.

A client expects the price of silver futures to decline and she shorts four May silver contracts at
545.5 cents per troy ounce. Later, the customer covers the short futures at 531 cents per troy ounce
($5.31). Total commissions are $180, total margin is $3,200 ($800 per contract), and there are 5,000
troy ounces per contract.
The model will be utilized to calculate the total profit or loss, but there are two items that must be addressed.
First, it’s necessary to convert cents per troy ounce to dollars per troy ounce. Second, remember that it’s
helpful to express the commissions as round-turn, rather than as total commissions (in this case, based on the
four contracts). The calculation for commissions is $180 ÷ 4 contracts = $45 round-turn commissions. If
total commissions are used for the per contract calculation, the answer derived will be incorrect. Speed and
accuracy will be the standard needed for success on the exam.
1. Short silver at 545.5 cents per troy ounce = Short at $5.455

2. Covers the short futures at 531 cents per troy ounce = Buy at $5.310
To calculate total profit or loss:

Short at: $5.455
Buy at: $5.310
Profit per unit: $0.145
Multiplied by contract size: x 5,000
Gross profit per contact $725
Round-turn commissions: ($45)
Net profit per contract: $680
Multiplied by number of contracts: x4
Total profit: $2,720
To calculate the percentage profit, based on the margin deposit: $680 ÷ $800 = .85 or 85%. In this
example, the customer has generated a profit. However, the profit was reduced by the amount of the
commissions paid.
Example: Cattle is trading at 61.20 cents per pound ($0.6120). A client shorts
five April contracts at that price and liquidates the contracts when the price rises
to 63.17. The contract size is 40,000 pounds and round-turn commissions are $35
per contract. Margin is 7.50 cents per pound ($0.075).

The first step is to express cattle prices in dollars, and then calculate using the model.
Short cattle at: $ .6120

Buy cattle at: $ .6317
Loss per unit: ($0.0197)
Multiplied by contract size: x 40,000
Gross loss per contact ($788)
Commissions: ($35)
Net loss per contract: ($823)
To calculate the percentage loss based on the margin deposit, it’s necessary to first calculate the amount of
margin deposited per contract. The first step is to express the deposit in dollars per unit. In this case, 7.50
cents per pound = $0.0750
(500) Margin per unit: 0.0750
( 35) Contract size: x 40,000
(535) Margin per contract: $3,000
The loss per contract is divided by the margin deposited per contract.
(823) ÷ $3,000 = .274, or a loss of 27.4%.
Advanced Application
An advanced application of this model may be used to determine the answer to the following question:
A customer expects the price of gasoline to decline over the next few months. For that reason, he shorts 25
gasoline futures contracts on the New York Mercantile Exchange (NYM) at $0.5790 per gallon. The contract
size is 42,000 gallons and the commissions are $40 per contract, round-turn. When gasoline futures
decline to $0.5540, the customer closes out 10 of his contracts, but remains short on 15 contracts with the
expectation that gasoline will decline further. If gasoline futures rally instead to $0.5850 and the customer
closes out the remaining 15 contracts, what’s his profit or loss?

This question involves essentially two speculation questions. It’s necessary to determine the profit or loss
separately for each of the liquidation values used for the futures contracts.
Part 1 Part 2
Short at: $0.5790 Short at: $0.5790
Buy at: $0.5540 Buy at: $0.5850
Profit per unit $0.0250 Loss per unit: ($0.0060)
Contract size: x 42,000 Contract size: x 42,000
Gross profit per contract: $1,050 Gross loss per contract: ($252)
Commissions: (40) Commissions: (40)
Net profit per contract: $1,010 Net loss per contract: ($292)
Number of contracts: x 10 Number of contracts: x 15
Profit for Part 1: $10,100 Loss for Part 2: ($4,380)
The result of these transactions is a net profit of $5,720 ($10,100 − $4,380).
Percentage Price Change

The use of the model may not be required for some speculation questions. A question may be based on an
investor whose profit is derived from a percentage movement in the futures.
Example: A position trader at the CBT enters the pit for soybean futures and determines that
soybeans are currently bid at $6.20 and offered at $6.2075 per bushel. He takes the other side
of a market order to sell and goes long 40 contracts at $6.20. One week later, he sells the
contracts after the soybean contracts have increased by 6%. The contract size for soybeans is
5,000 bushels. The initial and maintenance margin requirements are $2,500 and $2,000 per
contract respectively. What’s this trader’s percentage profit based on the margin deposit?
Although there’s a lot of information to sort through in a question like this, much of the information will
not be used to determine the answer. In this case, the trader is long at $6.20 per bushel. To determine the
amount of profit per bushel, multiply the price by 6%. Therefore, the profit per bushel equals $0.372
($6.20 x .06). Unlike the previous examples involving speculation, this scenario contains no description of
commissions. As a position trader and a member of the exchange, commissions are not a relevant issue
(position traders may be subject to a small fee, but they don’t pay commissions). The amount of profit per
contract is determined by multiplying the profit per bushel by the contract size of 5,000 bushels. In this
case, the profit per contract is $1,860 ($0.372 x 5,000). The profit per contract divided by the margin per
contract ($2,500) will determine the trader’s percentage profit, based on the margin deposited. In this case,
the trader’s percentage profit is 74% ($1,860 ÷ $2,500).

Speculation in Financial Futures

Investors also speculate in financial futures. These futures contracts may be based on financial debt
instruments, stock indexes, and foreign currencies.
Debt Instrument Futures

Futures contracts for long-term financial debt instruments are based on Treasury notes, Treasury bonds,
and the Muni Bond Index. These futures trade on the Chicago Board of Trade (CBT). The Muni Bond
Index is based on municipal bonds and uses an index value per point of $1,000. Treasury note and
Treasury bond futures have a contract size of $100,000 and are quoted in 1/32 of-a-point increments.
Each full percentage point in value for the futures contract is equal to $1,000, while each 1/32-of-a-point
has a value of $31.25. To manage time effectively on the exam, it’s advisable to apply these values
when performing calculations.
Futures contracts are also based on short-term financial futures—Treasury bills and Eurodollars—and both
of these contracts trade on the Chicago Mercantile Exchange (CME). These futures have a contract size of
$1,000,000 and trade in basis points (one basis point equals 1/100 of 1%). Short-term instruments
underlying the futures contracts are based on the three-month maturities of these instruments (1/4 of a
year). Therefore, one percentage point in value for the T-bill or Eurodollar futures contract equals $2,500
($1,000,000 x .01 = $10,000 ÷ 4 = $2,500). For exam purposes, it will be convenient and time efficient to
realize that one basis point on a short-term financial futures contract has a value that’s equal to $25.
Remember, one percentage point of value = $2,500 and there are 100 basis points in 1%. Therefore;
$2,500 ÷ 100 = $25.
Futures contracts that are based on long-term and short-term debt instruments are price-based. If investors
expect interest rates to rise, then they believe prices will fall. The yields on newly issued and existing debt
instruments are affected by changes in interest rates. If a debt instrument pays 7% in annual interest and is
priced at 100% of its par value ($1,000 for most notes and bonds), its yield is 7.0%. However, if interest
rates rise and comparable debt instruments offer a yield of 10%, the price of the 7% instrument must be
reduced in order to make its effective yield competitive with comparable debt instruments.
An investor who expects prices to fall will speculate by going short futures contracts. For exam purposes,
questions will indicate that investors expect interest rates to rise by using the phrases, “investors believe
the rate of inflation will rise” or “the Federal Reserve Board is expected to tighten credit conditions.”
If an investor anticipates that interest rates will fall, she expects prices to rise on the debt instruments. In
this case, the investor will go long futures contracts. Exam questions will indicate that investors expect
interest rates to fall by using the phrases, “the economy is slipping into a recession” or “the Federal
Reserve Board is easing credit conditions.”
Example: A client expects interest rates to rise and shorts seven Treasury bond futures
at 105-14. The contract size is $100,000 and total commissions are $385. The futures
fall to 102-21 and the position is liquidated. What’s the client’s total profit or loss?

The first step in answering this question involves the quotation. As previously stated, long-term financial
debt futures trade in 1/32-of-a-point increments (each having a value of $31.25). In this example, since the
value of the liquidation at 102 21/32 cannot easily be subtracted from the value of the short at 105 14/32,
it’s necessary to convert the number of 32nds through the arithmetic process of borrowing. Second,
because the commissions described are for the total number of contracts, it’s necessary to convert these
commissions to a round-turn: $385 ÷ 7 = $55.
Borrowing entails reducing the whole number value by one point and increasing the fraction by the value
of one full point. For example, 101 1/4 will become 100 5/4 when adding the fractional value of one point,
and 94 1/8 will become 93 9/8. For this question, increments of 32nds of a point will be used.
Short at 105-14 = 104 46/32 (Remember, each full percentage point in value equals 32/32nds)
(32 + 14 = 46/32nds)
Short at: 104 46/32
Buy at: 102 21/32
Profit per contract: 2 25/32
Profit: 2 x $1,000 $2,000.00
+ 25 x $31.25 $ 781.25
$2,781.25
Commissions: ($55)
Net profit per contract: $2,726.25
Total profit: $19,083.75
The application of the general speculation model shows that the client has a total profit of $19,083.75.
To reduce the amount of time expended in this calculation, the contract’s components have been
converted to dollar amounts. One point in value equals $1,000, and 1/32-of-a-point equals $31.25.
When working through a speculation problem involving short-term financial futures contracts, use the
general speculation model. Remember, on a short-term financial contract, one basis point has a value
of $25 and one percentage point equals 100 basis points.

Example: An investor expects interest rates to fall and speculates by buying

20 Eurodollar futures at 93.60. He deposits margin of $5,000 per contract and
pays round-turn commissions of $40 per contract. The value of the futures
contracts rises to 94.70. What’s the total profit or loss?
Buy at: 93.60
Sell at: 94.70
Profit: 1.10
Conversion to basis points: 110
Value per basis point: $25
Profit per contract: $2,750
Commissions: ($40)
Net profit per contract: $2,710
Multiplied by number of contracts: x 20
What’s the percentage profit based on the margin deposit?

$2,710 ÷ $5,000 = .542 = 54.2%
Using the value per basis point of $25.00 will prove to be a time and labor-saving shortcut.
Stock Index Futures

Futures contracts may be based on stock indexes, such as the Dow Jones Industrial Average (which trade
on the CBT), or the S&P 500 and Nasdaq 100 (which that trade on the CME). These indexes use a value
per point of the index or multiplier. For example, the S&P 500 futures index has a value per point of $250.
If an investor expects the index to rise, he will go long the index future. On the other hand, if the investor
expects the index to fall in value, he will go short the index future.
Example: An investor believes that the broad-based equity markets are due for a correction.
She shorts 11 S&P 500 June futures at 1124.72 and pays round-turn commissions of $50 per
contract. Later, when the June futures are at 1127.60, she closes the 11 contracts. The S&P
500 Futures Index uses a value of $250 times the index. What’s the investor’s gain or loss?
Short at: 1124.72
Buy at: 1127.60
Loss: ($2.88)
Multiplier: x 250
Loss per contact: ($720)
Commissions: ($50)
Net loss per contract: ($770)
Multiplied by number of contracts: x 11

Foreign Currency Futures

Finally, investors also speculate in foreign currency futures, including futures based on the British
pound, Japanese yen, Swiss franc, or the Euro (all of which trade on the CME). The value of currency
futures is expressed in U.S. dollars against the foreign currency. For example, Swiss franc futures at
.5885 have a value of $0.5885 per Swiss franc. British pounds futures (Pounds Sterling) at 1.5844 have
a U.S. dollar equivalent value of $1.5844 per pound. It’s unnecessary to perform any additional steps to
express the currency in dollar-denominated terms, except in the case of the Japanese yen, which is in
U.S. dollars per hundred yen. For that reason, a futures quotation for the Japanese yen at .7650 equals
$0.00765 dollars per yen.
The contract sizes for currency futures vary, but will be included in the question. Therefore, for test
purposes, students don’t need to commit contract sizes to memory. Movement of the U.S. dollar will have
an opposite impact on the foreign currency. In a test question, if an investor expects the U.S. dollar to rise
against the British pound, she expects the pound to decline in value. In this case, she will short British
pound futures. If the investor expects the dollar to weaken against the yen, she expects the yen to increase
in value and should go long Japanese yen futures.
Example: An investor who expects the U.S. dollar to strengthen against the
British pound goes short four British pound futures contracts at 1.4880. Later,
the contracts are closed out at 1.3870. Round-turn commissions are $55 and
there are 62,500 pounds per contract. What’s the investor’s total profit or loss?
Short at: 1.4880
Buy at: 1.3870
Profit: .1010
Contract size: x 62,500
Profit per contact: $6,312.50
Commissions: ($ 55)
Net profit per contract: $6,257.50
The speculation model has again provided a means to accurately derive the profit or loss for a futures
position.

Chapter 7 Summary
 Understand the process for calculating the total profit and loss on speculative trades
‒ Profitable positions subtract commissions
‒ Losing positions add commissions
‒ Remember to multiply by the contract size and number of contracts
‒ T-notes and T-bonds are quoted in 32nds
 Calculate the rate of return on speculative trades based on the amount invested
‒ Typically, the only investment is the original margin requirement
‒ No need to multiply by the contract size or the number of contracts for rate of return calculations


CHAPTER 8
Spreads
CHAPTER 8 – SPREADS
Introduction
If a person buys or sells a futures contract, he’s considered to have an outright long or short position.
There’s another strategy that’s used to trade the futures market and it’s referred to as spread trading.
Spread trading is the simultaneous purchase of one commodity futures contract against the sale of the
same or a related futures contract. The terms “spread” and “straddle” are synonymous. (However, please
note, in options trading, spreads and straddles are not the same.)
Types of Spreads
Intramarket (Interdelivery) Spread Involves the same commodity on the same exchange with different
contract months.
For example, buying July Sugar and selling October Sugar on the New York Coffee,
Sugar and Cocoa Exchange.
Intermarket Spread Involves the same commodity on different exchanges.

For example, buying April COMEX Gold and selling April CME Gold.
Intercommodity Spread Involves different commodities on the same or different exchanges that have
related uses.
For example, buying September Oats and selling September Corn on the
Chicago Board of Trade. Oats and corn are both used as livestock feed.
Commodity Product Spread The purchase of the raw material and the sale of the derived processed
products, or vice versa.
The Crush
Buy 50 July soybeans (10 contracts)
Sell 9 July soybean oil
Sell 12 July soybean meal
A soybean crusher is a businessperson who buys soybeans and crushes them to produce soybean oil and
soybean meal. For every 10 contracts of soybeans, 9 contracts of oil and 12 contracts of meal are produced.

The problem faced by the crusher is that he may buy soybeans and find that, once he has finished the
crushing operation, the price of oil and meal has gone down to a level where his profit disappears. In order to
protect himself, he will buy soybean futures and sell soybean oil and soybean meal futures when the margin
is favorable. The amount of oil and meal that’s sold is related to the amount of soybeans that are bought.
The Reverse Crush

Sell 50 July soybeans (10 contracts)
Buy 9 July soybean oil
Buy 12 July soybean meal
If the price difference between soybeans and soybeans products (oil and meal) is unfavorable, the crusher
cannot make a profit and will temporarily close down his operation. He may substitute a reverse crush
order in the interim, anticipating that prices will reverse themselves as shortages of oil and meal result
from a closing of the crushing operation.
Note that for the crush order and the reverse crush order, soybeans are always on one side of the market
(long in the case of the crush, but short in the case of the reverse crush) and oil and meal are always on the
opposite side of the market (short in the case of the crush, but long in the case of the reverse crush).
Another example of a commodity product spread is referred to as the petroleum crack spread. This
involves buying crude oil and selling the two refined products — heating oil and gasoline.
The Crack
Buy Crude Oil
Sell Heating Oil and Gasoline
The Reverse Crack

Buy Heating Oil and Gasoline
Sell Crude Oil
Note: The most commonly traded spread is the intramarket spread.
The Spread Market

The term “spread” refers to the difference in the price between the related contracts or, if it’s the same
commodity contract, the difference between the contract months.
Types of Orders
Spread orders can be placed as market orders, limit orders, or stop orders. Separate orders may not be
combined and executed as a spread.

If a trader entered a market spread order, the order will be written as follows:
Buy August Gold
Sell December Gold
Market
If a trader entered a limit spread order, the order will be written as follows:
Buy August Gold
Sell December Gold
December $11.00 Premium
In the case of the market order, the trader is willing to buy August and sell December at whatever spread is
currently available. In the case of the limit order, the trader is willing to buy August and sell December,
but only if he can sell December for at least $11.00 more than he pays for August.
With spread trading, the trader is not concerned with the prices are of the legs (the two contracts), but
rather with the relative differences between the legs. The following examples will clarify this point:
Buy August Gold at $451.00 and sell December Gold at $462.00.
Buy August Gold at $460.00 and sell December Gold at $471.00.
In both cases, the premium is $11.00 and the trader will accept either execution as his only interest is
selling the December contract for at least $11.00 more than he paid for the August.
Determining Whether a Spread is Profitable

Buying the More Expensive Contract As stated earlier, the two contracts are referred to as legs of the
spread. If an investor buys (goes long) the more expensive contract and sells the less expensive contract,
the net result will be a sum the investor will pay. This applies regardless of whether the market is normal
(carrying-charge market) or an inverted (discount market).
If the interval difference between the contracts increases over time, the spread had widened. This is
profitable for this investor.
The investor expects the spread to widen in the following example:
An investor places a spread on June and August corn. The June contact is sold at $2.55
and the August contract is bought at $2.70; the spread interval is $0.15.
 This indicates that the investor bought the higher leg (August). The contract price
was $0.15 higher than the June contract price.

Sell June corn at $2.55

Buy August corn at $2.70
 The investor paid $0.15 for the spread (net money per bushel paid is $0.15).
The investor will have to receive more than $0.15 per bushel when he
unwinds the spread in order to have a profit. The spread will need to widen.
In May, the June corn futures price is $2.40 while the August corn is $2.60.
To unwind the spread, the investor will liquidate the positions:

Buy June corn at $2.40
Sell August corn at $2.60
 The investor unwinds the spread and receives $0.20 per bushel. Since the
investor has already paid 15-cents, the net result is a profit of $0.05 per bushel.
Another way to evaluate the spread is to calculate the profit/loss on each leg. The investor has a $0.15
profit on the June contract and a $0.10 loss on the August contract.
Sell June corn at $2.55 Liquidate June corn at $2.40 = +.15

Buy August corn at $2.70 Liquidate August corn at $2.60 = −.10
+.05
Selling the More Expensive Contract A speculator establishes a spread by selling March T-bills
at 95.70 and buying December T-bills at 95.20. The spread was established as 50 basis points.
Buy December T-bills at 95.20
Sell March T-bills at 95.70
 The speculator has sold the higher leg and purchased the lower leg.
The speculator received the net amount.
Later, when the December T-bills are 95.95 and the March T-bills are 96.25, and the investor liquidates
the positions:
Sell December T-bills at 95.95
Buy March T-bills at 96.25
 The investor unwinds the spread and pays 30 basis points.
The net result is a profit of 20 basis points.
Another way to evaluate the spread is to calculate the profit/loss on each leg. The investor has a 75-basis
point profit on the December contract and a 55 basis point loss on the March contract.
Buy December T-bills at 95.20 Liquidate December T-bills at 95.95 =+ .75
Sell March T-bills at 95.70 Liquidate March T-bills at 96.25 = − .55
+.20

Risk in Spread Trading

Generally, risk in spread trading is less than the risk associated with outright long or short positions.
Because of the lower risk, there are lower initial margin requirements.
If a trader is long the nearby delivery month and shorts the distant delivery month, the risk is limited to the
full month carrying charges in the different months. If a trader is short the nearby delivery month and
long the distant delivery month, the risk is unlimited. Price limits don’t apply to the futures contract
nearest to delivery. Therefore, there’s no limit to the amount by which the nearby month can go above
the deferred month.
Bull and Bear Spreads

In general, if a trader is bullish or bearish in the market and is trading spreads, his market sentiment will be
reflected in his position in the near month of the spread. If a trader is bullish on the price of a commodity,
he will buy the near month and sell the deferred month. If a trader is bearish on the price of a commodity,
he will sell the near month and buy the deferred month.
As indicated below, there are two exceptions to this rule — the stock index spreads and currency spreads.
Stock Index and Currency Spreads — Bull Market

In a bull market, a trader expects that the spread will strengthen (widen). The trader anticipates that the
near month will rise more slowly than the deferred month. He will therefore sell the near future and buy
the deferred future (i.e., the opposite of a normal spread).
Stock Index and Currency Spreads — Bear Market

In a bear market, a trader expects that the spread will weaken (narrow). The trader anticipates that the near
month will fall more slowly than the deferred month. She will therefore buy the near future and sell the
deferred future (i.e., the opposite of a normal spread).

Chapter 8 Summary
 Identify the different types of spreads:
‒ Intramarket or Interdelivery – same commodity, same exchange, but different months
‒ Intermarket – same commodity, different exchange, and same month
‒ Crush spread – buy soybeans, sell soybean mean and soybean oil
‒ Crack spread – buy crude oil, sell gasoline and heating oil
‒ Reverse crush and crack spreads – reverse the buy and sell positions
 Recognize when an interdelivery spread trade will be profitable
‒ Buyers of the more expensive contract want the spread to widen (i.e., price difference to become
greater)
‒ Sellers of the more expensive contract want the spread to narrow (i.e., price difference to become
smaller)
 Recognize whether an interdelivery spread is bullish or bearish
‒ For most contracts, buying the near month is bullish
‒ For most contracts, selling the near month is bearish
‒ Stock indexes and foreign currencies are exceptions
• Buying the deferred month is bullish
• Selling the deferred month is bearish


CHAPTER 9
Hedging
CHAPTER 9 – HEDGING
Introduction
One of the principal economic functions and advantages of the futures exchanges is that they enable hedgers
to shift risks that are inherent in long or short cash positions to others who are willing to assume these
risks. Through hedging, it’s possible for trade users and producers (e.g., farmers, grain elevator operators,
flour millers and manufacturers) to pass most of the risk of price change to speculators who are willing to
accept the risk. This enables the producers and users to concentrate on growing or processing the actual
commodity without needing to take into account major price changes that could seriously affect them.
As an example, let’s consider a flour miller who purchases wheat, converts it into flour, and then sells the
flour. His profit is derived from the difference between his costs for the wheat, including both labor and
capital, and the price at which he’s able to sell the finished product. The miller may purchase all of the
wheat that he anticipates needing at the beginning of the crop year if he considers the price to be
advantageous. He will convert the wheat into flour and sell the flour during the entire year, as his
customers place orders for the flour. From the time that he purchases the wheat, until the time that he sells
the flour, he must be concerned with changes in the price of the wheat. For example, if his purchase price
is $2.00 per bushel and, after he converted the wheat into flour, the price declined to $1.50 per bushel, he
will have a loss of $0.50 per bushel, which is more than his profit margin could sustain. In fact, this result
could even force him out of business.
Through the act of hedging (which, for the situation above, would involve the act of selling futures), the
flour miller would be able to mitigate most (if not all) of the risks of ownership. Therefore, he can
concentrate on his primary business, which is the conversion of wheat into flour, and the sale of the flour at
a competitive price that’s reasonable and will allows him to cover his costs at a profit.
Let’s examine a situation to determine how hedging can eliminate most of the risk due to price change. A
grain exporter enters into a contract to sell wheat at the current price for delivery at some point in the
future. He’s committed to deliver the wheat at a fixed price. If he chooses to purchase the wheat and hold it
until such time as he’s required to export it, he will not have any risk of price change because he’s long the
actual commodity against a sale that he has already made at a fixed price (which is presumably high
enough to cover his costs and result in a profit).
For a variety of reasons that will later be examined in detail, the exporter may choose not to purchase the
wheat at the time he makes the sale. Therefore, he faces the problem that the price of wheat could rise
above his sales prices to a level that would be financially devastating. In this case, to reduce the possibility of
loss from a price change, the exporter could buy futures as a hedge to protect himself. Once he has hedged
his position, he can proceed with his primary business, which is the processing and exporting of the cash
wheat, without being concerned about rising price of the wheat.

The Hedger
A hedger is always a member of the business community who either:
 Has the actual commodity in inventory and therefore takes a futures position on the short side, or
 Has a commitment to deliver the commodity at a fixed price, but does not own the actual commodity,
and therefore takes a futures position on the long side
In other words, a hedger always takes a position in the futures market that’s opposite to his position in the
cash market. If he’s long cash, he will sell futures. On the other hand, if the hedger is short cash (i.e., he has
committed himself to the sale of the actual commodity at a fixed price, but does not have possession of the
actual commodity at the time of the sale), he will buy futures.
Hedging would be unnecessary if all purchases could simultaneously be offset by sales, and all sales could
simultaneously be offset by purchases at the time of the original cash transaction. For example, if the flour
miller who purchased wheat in July for conversion into flour could sell his flour at the same time that he
bought his wheat, he would not need to be concerned with possible price changes and, therefore, would
not need to hedge. His long position would be offset by a sale of the actual commodity at a price that’s
sufficiently high enough to enable him to make a profit. Similarly, if the grain exporter who sold wheat at
a fixed price could purchase the actual wheat at the time he made the sale, he also would not need to be
concerned with adverse price movement (in this case, that the price of wheat will rise) and would therefore
not need to hedge in the futures market.
For a variety of reasons, in the cash market, it may not be possible or desirable to make offsetting sales or
purchases at the same time that a commitment is made. However, in the futures market, it’s possible to
take a position that will temporarily serve as a substitute sale or purchase for a cash sale or purchase that
will be made later.
In the case of the flour miller, he may decide to purchase wheat in July at the beginning of the harvest if
the price is attractive. Since he may not have enough customers willing to buy the flour at the same time
that he makes his purchase, he could therefore sell futures which will stand as a substitute sale until he’s
able to sell the flour. Once he sells the flour, he will then lift his hedge by simultaneously buying an
equivalent amount of contracts in the futures market. Similarly, the grain exporter, who doesn’t have an
actual position at the time he makes his sale for later delivery, will make a substitute purchase in the form
of futures, to stand in place of the purchase of the actuals that he will make later. Once he purchases the
cash wheat, he will simultaneously sell the futures to lift the hedge that he no longer needs.
Long and Short Hedge

The determination of whether a hedger will sell futures or buy futures depends on his position in the cash
market. If he’s long the actual commodity, he will sell futures; however, if he’s short the actual
commodity, he will buy futures.

Selling Hedge
A selling hedge (also referred to as a short hedge) is used by hedgers who are long the actual commodity.
A buying hedge (long hedge) is used by hedgers who are short the actual commodity. The theory behind
hedging is that, if the price of the actual commodity changes either up or down, the price of futures will
also likely change up or down by a similar amount. Later, it will be shown that the amount of change in
cash and futures will not necessarily change by the same amount. However, for the sake of simplifying the
initial discussion of hedging, let’s assume that both cash and futures change by the same amount.
Let’s consider a grain elevator operator who buys 100,000 bushels of wheat at $2.00 per bushel. Unless, at
the same time, the elevator operator is able to make a sale in the cash market of the wheat that he just
purchased, he must be concerned with the fact that the price of his wheat could drop, thereby resulting in a
loss. To eliminate as much of the risk of a loss as possible prior to the sale of the wheat, the elevator
operator will immediately sell futures in an equivalent amount.
At the time that he purchased wheat at $2.00 per bushel, let’s assume that he sells 100,000 bushels of
wheat on the Chicago Board of Trade at $2.10 per bushel. He has now established a selling hedge (short
futures) and he’s long the actuals. One month later, wheat is selling for $1.80 per bushel. The elevator
operator has therefore sustained a loss of $0.20 per bushel, or $20,000 on his long position. However, at the
same time, the price of futures has gone down by the same amount, from $2.10 to $1.90. In this case, when
he sells his wheat at $1.80, he will lift his hedge by buying the futures at the same time. He will have a profit
on the futures that’s equivalent to the loss on the actuals.
The opening and closing positions will be as follows:
Cash Futures
Buy 100,000 bushels at $2.00 Sell 100,000 bushels at $2.10
Sell 100,000 bushels at $1.80 Buy 100,00 bushels at $1.90
LOSS on the actuals $0.20 PROFIT on the futures $0.20
The loss that the elevator operator sustains on his long position is offset by the profit that he made on the
futures position. If he had not been hedged, his loss would have been the full $20,000. It should be noted
that, at the time he took his futures position, the elevator operator probably did not intend to deliver the
actual grain against his futures sale (although he could if he wants to do so). The futures position was
assumed for the purposes of price protection. The operator’s sale was made at a later date in the cash
market at the current price and the hedge was lifted once the cash sale was made.
Using the same example, let’s assume that the market moved in the opposite direction, with the price
rising rather than falling. One month after buying the wheat and selling futures, the price of wheat has
advanced to $2.20 per bushel. Since the wheat has advanced by $0.20 per bushel, he now has a profit of
$20,000. However, this profit is offset by the loss in the futures market because the price of the futures also
advanced by $0.20 per bushel, to $2.30 per bushel.

Cash Futures
PROFIT on the actuals $0.20 LOSS on the futures $0.20
The gain that the elevator operator has on his long cash position is offset by the loss that he had on the
futures position. In this example, it’s apparent that the elevator operator would have been better off had he
not hedged his position because he would have realized a speculative profit of $20,000. However, his
intention in placing the hedge was to protect himself against an adverse price decline (as occurred in the first
example) by shifting his risk to others who were willing to assume the risk. By hedging his position, he
protected himself against this risk and, at the same time, eliminated the possibility of a speculative profit.
Note that if the elevator operator had been able to sell the wheat at the same time that he purchased it, there
would have been no need for a selling hedge. However, the elevator operator must purchase the wheat when
it’s available at harvest time in order to provide storage services for farmers. He will most likely not be
able to immediately sell the amount that he purchases as users of wheat are not under the same immediate
pressure to acquire it as farmers are under to sell their wheat. The farmer must sell his wheat to raise cash
to repay loans and prepare his land for the following season, but users can spread their purchases over the
course of the year.
To avoid confusion that may come up later, let’s clarify one point. In the above example, it’s stated that the
elevator operator purchased wheat at a price of $2.00 per bushel. In fact, it’s more correct to state that he
purchased wheat at a price that’s based on the price at the terminal market, which was $2.00 per bushel.
The actual price that the elevator operator paid to the farmer was $2.00 per bushel less the cost of
transporting the wheat to the terminal market and less his charges. For example, let’s assume that it costs
$0.15 per bushel to transport the wheat to the terminal market, where it’s selling for $2.00, and the
elevator operator charges $0.05 per bushel for the services that he provides. The price the farmer will
receive is $1.80 per bushel, not $2.00. The profit to the elevator operator is in the $0.05 per bushel that he
charges for handling the wheat. However, the entire $0.05 is not profit. The elevator operator has costs that
he must meet for capital and labor. Ultimately, if his costs are less than $0.05 per bushel, he will make a net
profit. It’s this profit that the elevator operator is trying to protect by hedging, which is small in relation to
the overall price that he has paid to the farmer.
Buying Hedge
Now that a selling hedge has been examined (i.e., the sale of futures to protect a long cash position), let’s
consider a buying hedge (i.e., the purchase of futures to protect a short cash position). For example, a grain
exporter sells 100,000 bushels of corn at $1.50 per bushel for delivery in six months.
One option is to purchase the corn, store it for six months, and then deliver it against the sale. In this case,
he would be required to pay the expenses of storage plus the full value of the corn, which is $150,000.
This would tie up a substantial amount of capital, perhaps more than the grain exporter has available.

A second option is to take no action at all, in which case he runs the risk that the price of the cash
commodity will rise and he will be required to buy it at a higher price.
A third option is to make a substitute purchase of the corn in the futures market. Let’s assume that, on the day
the exporter sells the corn at a fixed price for later delivery, the price of futures is $1.60 per bushel. Six months
later, when it’s time for the exporter to deliver the corn, the market price of corn has advanced by $0.10 per
bushel to $1.60. At the same time, let’s assume that the price of futures has also risen by $0.10 per bushel to
$1.70. In this case, the exporter will purchase the corn in the market at $1.60, which is a loss of $0.10 per
bushel, and he will offset his futures position by a sale at $1.70. He will lift the hedge because he has acquired
the actuals that he requires in order to meet his export commitment. Since he was short the actual commodity,
he therefore bought futures. When he offsets his futures position, he will do so by selling futures.
Cash Futures
In the above instance, the loss realized by the exporter on the actuals is offset by the profit that he realized
on the futures. By hedging his short cash position with a purchase of futures, the exporter protected
himself against the loss of $10,000 that he would have sustained on an unhedged position.
Let’s see what happens if the price moves in the opposite direction. When it’s time for the exporter to buy
the cash corn, the price has declined to $1.30 per bushel. Similarly, the price of the futures has declined to
$1.40 per bushel. The speculative profit that the exporter would have had on his short cash position (based
on his ability to buy the corn for $0.20 per bushel less than his selling price) is once again matched by the
loss that he sustained on the futures position. Although he would have profited if he had not hedged, at the
time, he did not know that the price would move down in his favor; therefore, he hedged to protect himself
against the possibility of a price increase. His initial and closing positions will appear as follows:
Cash Futures
Please note that at no time did the exporter intend to accept delivery of the corn on the futures contract. At all
times, his intention was solely to hedge in order to protect himself. The reason why the exporter would not
stand for delivery is because he has sold a definite grade of corn. For example, he may have sold #1
Yellow Corn, which commands a premium over the basis grade of #2 Yellow Corn. However, when a long
stands for delivery, he may receive (and must accept) any grade that’s delivered as long as it’s within the
grades permitted by the exchange. In the case of corn, the delivery may be the basis grade or it may be #1
Yellow Corn at a premium or even #3 Yellow Corn at a discount. Since the exporter cannot use either the
#2 or the #3 Yellow Corn, he must make his purchase in the market in order to obtain the exact grade that
he requires. The futures position was taken as a substitute position for purposes of price protection, but not for
purposes of acquiring the actual commodity.

In the above example, the purpose of the hedge was price protection. However, there are other advantages
besides price protection. By using the futures market, the exporter was able to protect himself against a
price increase without needing to purchase the actual cash commodity. This allowed the exporter to save
the expenses of storage and also the need to commit a large amount of cash to purchase the actuals. If he
had purchased the actuals, his cost would have been $150,000 plus storage for six months. Additionally,
he would have been required to pay interest on the cash commitment.
Another advantage of a selling hedge is that a hedged cash position is safer than an unhedged position.
Because of this additional safety, banks are willing to lend a larger amount than they would on an
unhedged position. For example, the grain elevator operator who’s long 100,000 bushels of wheat at $2.00
per bushel may decide to borrow from a bank to carry the wheat. Recognizing the danger of price decline on
an unhedged position, the bank may be willing to lend only 50% of the value, or $100,000. However, if the
operator is hedged, thereby reducing risk due to price decline, the bank may be willing to lend 80% or
more. For example, an individual may have $100,000 available for the purchase of cash wheat. On an
unhedged position, the hedger would be able to buy $200,000 of wheat, with the bank financing $100,000
worth of the wheat on a 50% loan. However, with a hedge in effect, the individual could buy $500,000
worth of wheat, with the bank lending $400,000 (80% of the total value) because of the added safety of the
hedge. By being hedged, the operator can buy more wheat on borrowed money than he could on an
unhedged position.
The Imperfect Hedge

In the examples above, it has been assumed that changes in the cash and futures positions are exactly the
same. However, as will be described later, it’s actually infrequent that changes in the price of cash and the
price of futures will be exactly the same. The price of cash may change more or less than the price of futures.
For example, in July, the price of wheat could be expected to decline if there’s a large harvest. However, this
doesn’t mean that the price of futures for the following May will decline by the same amount. The selling
pressure of the harvest, with farmers selling large amounts at harvest time to raise money to repay loans and
to prepare for the next planting season, will cause prices to decline. This will not be reflected in May, which
is the end of the crop year. Therefore, the price of May wheat futures may not decline as much as the price of
July wheat futures. Conversely, there may be a strong demand for a commodity (e.g., soybeans in August),
with a substantial price rise. However, the price of December soybean futures may not rise as much because
traders anticipate that the new crop (the crop year for soybeans begins September 1) will be sufficient and the
futures will reflect the new harvest and the new conditions.
There are other factors that will cause hedges to be less than perfect. For example, in all of the examples
that have been done, the position in the cash market was always offset exactly by a position in the futures
market. However, as futures always trade in round lots, it’s possible that the hedger may not be able to
hedge his exact position. If the amount of cash wheat that he owns is 118,000 bushels, the hedger will be
faced with the choice of hedging either 115,000 bushels or 120,000 bushels. If he hedges 115,000 bushels,
he’s exposed to a possible loss on the long side on 3,000 unhedged bushels. If he hedges 120,000 bushels,
he’s exposed to risk on 2,000 bushels on the short side.

With the price of the futures changing at a rate that doesn’t exactly coincide with a change in the cash
market, another reason why a hedge may be less than perfect is that futures reflect the price of the basis
grade, whereas cash market transactions may be in grades that are other than the basis grade. While it’s
generally true that the price of all grades of corn will rise or fall simultaneously, the amount of price
change in the different grades may not always be exactly the same. In the case of the grain exporter, it
was stated that he sold 100,000 bushels of corn based on a price of $1.50 and bought futures at $1.60. The
actual corn sold by the exporter did not necessarily need to be the basis grade. However, the price of
futures reflects the basis grade, with allowance for delivery of a better grade at a premium or an inferior
grade at a discount.
Let’s assume that the corn sold by the exporter required a premium of $0.01 per bushel when delivered on a
futures contract. It was stated that the price of the corn advanced to $1.60, while the price of futures
advanced to $1.70. However, the price of the specific grade of corn that the exporter sold may have advanced
$0.11 while the price of the basis grade, which is the grade of the futures on the exchange, only advanced by
$0.10. Therefore, the exporter will have a loss of $0.01 on each bushel. The fact that demand for a
particular grade of corn is stronger than for the basis grade made the hedge less than perfect. In this case,
the hedge protected him from the major loss of $0.10 per bushel, but did not protect him against the loss of
$0.01 per bushel on the particular grade of corn that he sold.
The following shows the initial position and the closing position.
Cash Futures
The exporter has a net loss of $0.01 per bushel.
At this point, the discussion has focused on hedging by primary users or producers of commodities, such as
farmers, grain elevator operators and exporters. Keep in mind, it’s also possible for secondary users of
commodities to hedge, but these hedges may not be as effective because they cannot hedge the actual
product they’re manufacturing. For example, a baker who uses wheat to manufacture bread could use the
futures market to hedge wheat. However, since his end product is bread rather than wheat, the hedge may
not be fully effective since there are factors in the manufacture of bread (e.g., labor costs) that would not
be reflected in the futures price of wheat. For this reason, the hedge may not be as effective as it would be
for a primary producer or user, although it could still provide a significant degree of protection for the
secondary user.

The following summarizes why a hedge may not always be perfect and could still result in a loss due to
price change:
 The price in the cash market and the price in the futures market may not change by the same amount,
although they will usually change in the same direction.
 The price of grades other than the basis grade may change differently than the price of the basis grade.
 The size of futures contracts is in round lots and it may not be possible to fully hedge a position.
 Secondary users cannot hedge against the product that they manufacture and must hedge against the
primary product, which may change in price at a rate that differs from the product that they
manufacture.
Basis
Understanding the term “basis” is especially important. This term was already introduced in reference to the
basis grade of the commodity, which is the grade that’s deliverable on a futures contract. Other grades are
deliverable at a premium or discount. However, the term “basis” can be used to describe other things.
Generally speaking, the term is used to describe the difference in price between the cash commodity and
the price of the nearest futures delivery month. If the price of cash is $1.50 and the price of futures is $1.60,
the basis is “$0.10 under.” If the price of the cash commodity is $2.20 and the price of futures is $2.15, the
basis is “$0.05 over.” Note that the basis is always the relationship of the price of the cash commodity to
the price of futures, but not the other way around. In other words, if the basis is “$0.10 under,” this means
that cash is $0.10 under futures. If the basis is “$0.05 over,” this means that cash is $0.05 over futures.
It’s important to note that the basis can refer to the relationship between any cash transaction or price and
any futures price. For example, a grain elevator operator may state that his basis is “$0.10 under.” In this
case, he’s indicating that the cost of the actuals when he made his particular purchase is $0.10 under the
price of the futures in the particular delivery month in which he hedged. This may be the nearest delivery
month or it may be in a deferred delivery month. In fact, this is the elevator operator’s own particular basis.
When the corn exporter (as previously referenced) bought futures to hedge a forward commitment to
deliver corn at a fixed price, he did not hedge in the nearest month, but rather in a delivery month six
months after making the cash sale, which was closest to the time when he would be buying the cash corn.
The corn exporter’s basis was “$0.10 under” as cash corn was $0.10 per bushel less than the price of
futures when the hedge was placed.
Note that it was unnecessary for the elevator operator to hedge in the month closest to the month in which
he would be making delivery. He could have hedged in a nearer month and then switched the hedge to a
more distant month if he determined that this would be more advantageous. The fact that hedged positions
can be switched from a month that’s about to expire to a more distant month means that hedgers can obtain
long-term protection despite the fact that a particular futures contract may trade only 12 months ahead.

As noted earlier, the term “basis” is used to describe the condition of the market. In this case, it’s referring
to the current spot (cash) price as related to the price of the nearest futures month. For example, on June
15, a news report states that the basis is $0.05 over for wheat. The report is indicating that the cash price of
wheat is currently $0.05 higher than the price of July wheat on the Chicago Board of Trade, which is the
nearest delivery month. It’s also been described that the term can be applied to a specific hedger’s price
relationship between his cash position and the price of the futures month in which he hedged. Let’s consider
an example that will clarify the relationship between these concepts.
On July 1, a grain elevator operator purchases cash wheat at $2.00 per bushel and immediately sells
September wheat futures at $2.10. At the time he establishes the hedge, the elevator operator’s basis is
$0.10 under. The general basis is also $0.10 under as the price of the cash commodity is $0.10 under the
nearest futures delivery month, which is September. A second elevator operator also purchases the cash
commodity at $2.00 per bushel. However, he hedges by selling December futures, which are trading at
$2.20 per bushel. The second elevator operator’s basis is $0.20 under.
On August 1, the cash commodity is selling for $2.05, September futures are selling at $2.13, and
December futures are selling at $2.16. The first elevator operator’s basis is now $0.08 under and the
second elevator operator’s basis is $0.11 under. Note that the basis for both elevator operators changed
because there have been changes in the price of the cash commodity and the price of futures. The basis is
always the current price of cash related to the current price of futures. Therefore, as cash is currently $2.05,
this current price is related to the price of the respective futures months in which the elevator operators
hedged their positions. If the basis is related when the hedges were first established to the current basis, it
becomes evident that the basis narrowed for both elevator operators.
Negative or Positive Basis

The basis can be negative or positive. If cash is under futures, the basis is negative; however, if cash is
over futures, the basis is positive. When evaluating the basis, a primary consideration is its strength or
weakness. The more positive the basis, the stronger it is; whereas, the more negative the basis, the weaker
it is. Therefore, a change in basis from $0.10 under to $0.09 under indicates that the basis is strengthening.
Notice that the basis, while still negative, is moving closer to the positive or becoming less negative.
As previously stated, the more positive the basis, the stronger it is. Therefore, a change in basis from $0.10
over to $0.09 over indicates that the basis is weakening. Notice that the basis, while still positive, is moving
closer to the negative or becoming less positive. Again, the more negative the basis, the weaker it is.
Changes in Basis
As will become clearer shortly, it’s changes in the basis, either by a widening or narrowing, that will
determine whether there’s a profit or a loss on a hedged position. As noted earlier, the purpose of hedging
is to protect the user of the cash commodity from major declines in the price of the cash commodity (if he’s
long) or major advances in the price of the cash commodity (if he’s short). If cash and futures prices advance
or decline by exactly the same amount (perfect hedges), the direction in which the price moves is insignificant.
Any loss on cash will be exactly offset by a matching profit on futures, or any loss on futures will be
exactly offset by a matching profit on cash.

However, if the change in the cash price is more or less than the change in the price of futures, the hedger
will have a profit or a loss that’s equal to the change in the basis. It’s the degree of change in the basis that
matters, not the dollars and cents change in the price of cash or futures. The key to whether a hedge will be
profitable (a change in the basis that’s favorable to the hedger) or unprofitable (a change in the basis that’s
unfavorable to the hedger) depends on the initial basis when the hedge is first assumed and the basis when
the position is closed out.
Examples of Hedging
Short Hedge in a Normal Market
For example, on July 1, a selling hedge (sale of futures to hedge a long cash position) is established. The
cost of the cash commodity is $1.50, and the hedge is established in December futures at a price of $1.70.
When the position is first established, the hedger’s basis is $0.20 under. The position will appear as follows:
Cash Futures Basis

Buy 100,000 bushels at $1.50 Sell 100,000 bushels at $1.70 – $0.20
On August 1, the hedger lifts his hedge by selling the cash commodity at $1.60 and buying futures at
$1.75. When the hedge is lifted, the basis has declined to $0.15 under. The price of cash is now $0.15 less
than the price of futures. Therefore, the basis has narrowed by $0.05, from $0.20 under to $0.15 under. In
order to determine whether the hedger had a profit or a loss as a result of the narrowing of the basis, the
initial position must be compared to the final position. The results of the hedge are as follows:
Cash Futures Basis

Buy 100,000 bushels at $1.50 Sell 100,000 bushels at $1.70 –$0.20
Sell 100,000 bushels at $1.60 Buy 100,000 bushels at $1.75 –$0.15
There was a profit on the cash position of $0.10 per bushel and a loss on the futures position of $0.05 per
bushel. Therefore, as a result of the narrowing of the basis, the net result of the hedge was a profit of $0.05
per bushel. The basis can also be considered to have strengthened.
For example, let’s now examine another hedge in which the basis widens. On July 1,
a grain elevator operator establishes a short hedge (sale of futures) to hedge a long
cash purchase at $2.00 per bushel. He sells futures at $2.10 per bushel. His initial
basis is $0.10 under and his initial position appears as follows:
Cash Futures Basis

Buy 100,000 bushels at $2.00 Sell 100,000 bushels at $2.10 –$0.10

On August 1, the elevator operator lifts the hedge by selling the cash commodity at $2.05 and buying
futures at $2.20. The basis has changed from $0.10 under to $0.15 under. As the following diagram shows,
this was an unfavorable basis change that resulted in a loss to the hedger. The basis can also be considered
to have weakened.
Cash Futures Basis

Sell 100,000 bushels at $2.05 Buy 100,000 bushels at $2.20 – $0.15
Considering the profit on cash and the loss on futures, the net result of the hedge is a loss of $0.05 per bushel.
For example, let’s examine one more example of a short hedge and determine how a
hedge, by contributing a profit, can reduce part of the carrying charges. The prices
of cash wheat and the May wheat futures contract on various days are as follows:
Cash May Futures

January 15 386 1/2 cents 398 1/4 cents
February 15 389 3/4 cents 401 1/2 cents
March 15 377 1/4 cents 382 1/4 cents
April 15 381 cents 383 1/2 cents
On January 15, an elevator operator buys the cash commodity and decides to hedge in
May futures. If his hedge is profitable, the amount realized will defray part of his
carrying charges. On March 15, the elevator operator sells the cash wheat and closes
out his futures position. His results are as follows:
Cash Futures Basis
Buys at $3.86 1/2 Sells at $3.98 1/4 $0.1175 under
Sells at $3.77 1/4 Buys at $3.82 1/4 $0.05 under
LOSS $0.0925 PROFIT $0.16
The net result of the hedge is a profit of 6 3/4 cents (i.e., $0.0675). The hedge not only protected the
elevator operator from sustaining a loss of 9 1/4 cents ($0.0925) on his cash position, but also contributed
6 3/4 cents toward his cost for carrying the cash commodity.

For example, as already explained, the price of cash and the price of futures must
converge during the delivery month. Therefore, in a carrying charge market (futures
prices are over cash prices), the greater the difference between cash and futures, the
more the hedge will contribute to carrying charges. Assuming that it costs $0.05 per
month to carry a commodity, the price of cash and futures are as follows:
Cash May Futures July Futures

$4.00 $4.06 $4.20
Let’s examine what would happen to a hedger who buys cash on March 1 and hedges
in May futures rather than July futures. The hedge is established on March 1, when
cash is selling at $4.00 and futures are selling at $4.06. From March 1 to May 1, it
would cost $0.10 to carry the cash commodity. Therefore, futures reflect only part of
the carrying charges. The hedger maintains his position until May 1, when the prices
of cash and futures have converged at $4.05. The results are as follows:
Cash Futures Basis
Buys at $4.00 Sells at $4.06 $0.06 under
Sells at $4.05 Buys at $4.05 $0.00
PROFIT $0.05 PROFIT $0.01
The hedge contributed $0.06 toward the carrying charges.
For example, another hedger buys cash on March 1 and sells July futures at
$4.20. There are four months between March 1 and July 1; therefore, July
futures reflect full carrying charges. The hedger maintains his position until
July 1, at which point the prices have converged at $4.12.
The results are as follows:

Cash Futures Basis
Buys at $4.00 Sells at $4.20 $0.20 under
Sells at $4.12 Buys at $4.12 $0.00
PROFIT $0.12 PROFIT $0.08
The hedge contributed $0.20 toward the carrying charges. In the first example, the hedge profit contributed
60% toward the carrying charges, whereas in the second example, the hedge profit contributed 100%
toward the carrying charges.

Long Hedge in a Normal Market

In the two examples shown above, both hedgers were long the basis. This term means that the hedger is long
the cash commodity and therefore short futures. An individual is considered to be “long the basis” if she’s
long the cash commodity and short futures. If a person has a long cash position that’s unhedged, she would
not be long the basis. If a hedger is short the basis, this means that she has contracted to sell the cash
commodity at a fixed price, but doesn’t own the cash commodity. To protect herself against a price rise,
she will buy futures. An individual is short the basis if she’s short cash and long futures. An individual
who’s short the cash commodity is not short the basis unless she has established a long futures hedge. An
example of a hedger who’s short the basis is the grain exporter who has sold corn for delivery in six
months and doesn’t own the cash corn at the time of the sale. Therefore, he buys futures to protect against
a price rise.
For example, let’s consider an example of a long hedge (purchase of futures)
with a change in the basis that’s both favorable and unfavorable. A grain
exporter sells 100,000 bushels on July 1 at $1.50 and, at the same time, buys
futures at $1.60. His initial position appears as follows:
Cash Futures Basis
Sell 100,000 bushels at $1.50 Buy 100,000 bushels at $1.60 $0.10 under
On August 1, when he buys the cash commodity at $1.40, he also sells his futures position at $1.55.
His initial basis was 10 cents under, but when he closes out the cash and futures positions, the basis
is 15 cents under.
The change in the basis resulted in a profit to the hedger, as indicated by the following:
Cash Futures Basis
Based on a favorable change in the basis, the net profit to the hedger is $0.05 per bushel.
For example, let’s assume that the sale of the actuals and the purchase of futures was
made at the same prices as in the preceding example. When the cash purchase is made
in order to make delivery, the price has dropped to $1.45 and the price of futures has
dropped to $1.50. As shown in the following table, the change in the basis—from $0.10
under to $0.05 under—is unfavorable and results in a net loss of $0.05 per bushel.
Cash Futures Basis

Taking into consideration both the profit on cash and the loss on futures, the net result of the basis change
is a loss of $0.05 per bushel.
Determining the Month to Hedge

When a hedger establishes a hedge position, he’s doing so to protect himself against adverse price
movement. If he is long the basis (long the actuals and short futures), he’s trying to protect himself against
a price decline. However, as already shown, the degree of protection will depend on changes in the basis.
Although the hedger will be able to protect himself against major price movements, he cannot protect
against changes in the basis. The hedger will try to assess all of the factors to the best of his ability to
ensure (as much as possible) that changes in the basis will be in his favor; therefore, not only protecting
himself against major price movements, but also against basis changes. He will do this by assessing all
factors at the time that he establishes the hedge. He will examine the price relationships of the different
futures months to determine which month will provide the most advantageous hedge and where the change
in the basis is most likely to be in his favor.
If the hedger is long the basis and anticipates that the price of near futures will advance more than the
price of deferred futures, he will establish his hedge in the deferred futures because the change in the basis
will be more favorable. For example, if the price of cash advances and a hedger who’s long the basis
anticipates that the price of September futures will advance more than the price of December futures, he
will hedge in December.
The following example will clarify this point. On March 1, a hedger who’s long the
basis (long the cash commodity) has the option of selling futures in September at
$2.10 or in December at $2.20. He anticipates that the price of September futures will
likely advance more than the price of December futures if there’s an advance in the
price of the commodity. He hedges with December futures, rather than September
futures. On May 1, when he sells the cash commodity at $2.05, September futures are
at $2.20, while December futures are at $2.25. December futures advanced less than
September futures and the hedger anticipated the price movement correctly. When he
lifted the hedge on May 1, he had a profit of $0.05 on the actuals. However, his loss
on December futures was also $0.05 and therefore his net result was flat. If he had
hedged in September, his loss would have been $0.10 on the futures versus a profit of
$0.05 on the actuals, resulting in a net loss of $0.05.
The following shows how the change in prices would have affected the hedger:
Cash September Futures December Futures
Buy at $2.00 Sell at $2.10 Sell at $2.20
Sell at $2.05 Buy at $2.20 Buy at $2.25
PROFIT $0.05 LOSS $0.10 LOSS $0.05

Along with the best month in which to hedge, there are other factors that the hedger will consider. He will
be concerned as to whether the price at which he buys the cash commodity is the best price that he can
obtain. If the price at which he buys or sells is better than the general level of prices, then his own
particular basis (the relationship between his particular cash position and his particular futures position)
will be more favorable than the general basis and thereby more likely to yield a profit. For the same
reason, he will try to close out his cash position at the most favorable price possible.
For example, let’s assume that the general level of cash prices on a particular
day is $2.00. The price of September futures is $2.20 and the price of December
futures is $2.30. An elevator operator is able to buy the cash commodity at
$1.95, which is $0.05 below the general price level. The elevator operator has
established his particular basis at $0.25 under, whereas the general level of
prices is $0.20 under. He has also determined that the price of September futures
is relatively high and is likely to decline more than the price of December futures
if there’s a decline in the price of the commodity. In this case, he will hedge in
September futures rather than December futures. His estimate is based on the
historical relationship between cash and futures prices in previous years, his
anticipation of the supply and demand factors that are likely in the different
months, and other fundamental factors.
To summarize, the hedger will consider the following factors to determine the best month in which to
hedge:
1. The best time in which to hedge is when the relationship between cash and futures is at the most
favorable basis.
2. The choice of the month in which to hedge is based on his determination of the probable price
changes that may occur and then selecting the month in which price changes will be most favorable.
If the hedger is long the basis (long cash and short futures), he will try to hedge at a time when the
price of cash is relatively low and the price of futures is relatively high. In this case, he’s anticipating
that the price of cash will advance relatively more than futures, or that the price of futures will
decline relatively more than cash. If he’s short the basis (short cash and long futures), he will seek the
opposite relationship between the price of cash and the price of futures.
3. The hedger will attempt to buy the cash commodity at the lowest possible price, or sell the cash
commodity at the highest possible price, when he establishes his cash position, thereby affording him
the best basis possible. Likewise, he will attempt to close out his position at the best possible price.
Practical Applications of Hedging

Up to this point, the concern has been with changes in the basis and whether the change in the price
relationship yields a profit or a loss on the hedge. Now let’s examine some hedging situations to determine
how hedging works in practice.

Plumbing Contractor
On October 1, a plumbing contractor is awarded a contract at a fixed price for the installation of plumbing
fixtures for an industrial complex. The installation is scheduled to begin in December and will require
200,000 pounds of copper tubing. On the day that the contract is awarded, the cash price of copper is $0.8370
per pound and the price of December copper futures is $0.8550 per pound.
The first point that must be determined is the type of hedge that will be placed. In this example, the
contractor has agreed to supply 200,000 pounds of copper. Since he doesn’t currently own the copper, he’s
concerned about the potential rise in price. If the price does rise, he will be required to buy the cash copper at
the higher price and could lose a substantial amount on the order. Again, since the contractor doesn’t own
the cash copper that he’s required to deliver, he’s short the basis (short the cash commodity) and will
therefore buy futures. Because copper futures trade in units of 25,000 pounds, the contractor will buy eight
December copper contracts. When the position was first assumed, the contractor’s basis was $0.018 cents
under due to the fact that cash is $0.018 under futures ($0.8370 – $0.8550).
On December 1, the contractor purchases 200,000 pounds of copper in the cash market and, at the same
time, lifts his hedge. The price of the cash copper is $0.9190 per pound and the price of December copper
futures is $0.9345 per pound. In the interim, the basis has changed and is now $0.0155 under ($0.9190 –
$0.9345).
The result of the hedge is as follows:

Cash Futures Basis
Sell at 83.70 cents Buy at 85.50 cents 1.8 cents under
Buy at 91.90 cents Sell at 93.45 cents 1.55 cents under
LOSS 8.20 cents PROFIT 7.95 cents
When the initial position was taken, the firm sold the cash copper at $0.8370 per pound and bought futures
at $0.8550 per pound. When the hedge is lifted, cash is bought at $0.9190 per pound and futures are sold at
$0.9345 per pound. There’s a loss of $0.82 per pound on cash and a profit of $0.795 cents per pound on
futures. Due to the adverse change in the basis, the net result of the hedge is a loss of $0.25 per pound.
Does this mean that the hedge was unsuccessful? No; as a matter of fact, the hedge was very successful and
held down the additional cost that the contractor was required to pay for the cash copper to only $0.25 per
pound rather than $0.82 per pound, which would have been his added cost had he not hedged. If the
contractor had not hedged his position, his cost for the cash copper would have been the full $0.9190 cents
per pound and his loss on an unhedged position would have been the full $0.82 per pound.

When the contractor bought the cash copper, he paid a total of $183,800 (200,000 pounds times the current
cash price of $0.9190). His selling price for the copper was only $167,400 (the price of copper when he won
the contract was $0.8370 per pound for 200,000 pounds). Therefore, his additional cost for the copper was
$16,400. However, his futures position contributed $0.795 per pound profit on 200,000 pounds, for a total of
$15,900. This profit on futures reduced the net cost for the cash copper by $15,900. Therefore, his total cost
for the copper was $167,900 ($183,800 cost for the copper in the cash market minus $15,900 profit on the
futures). This compares very favorably with the cost of $167,400 that the copper would have cost (200,000
pounds x $0.8370 per pound) had the contractor bought the copper when he won the contract on October 1.
His additional cost for the copper was only $500, compared to $16,400 for an unhedged position.
Cattle Raiser
Now, let’s examine a hedge by a cattle raiser who wants to protect the value of his long cash position. In
January, a cattle raiser estimates that he will have 800,000 pounds of live cattle which he will be able to
market in six months. He estimates that it will cost $56.00 per hundredweight to raise and market the
cattle. The current cash price for live cattle is $65.50 and June cattle futures are selling at $72.20.
The first point that must be determined is the type of hedge that the farmer will establish. In this case, he’s
long the cash cattle and wants to protect himself against the possibility that prices will decline from the
present level when he’s ready to market the cattle. He’s long the basis and will therefore sell live cattle
futures. Since the live cattle contract is for 40,000 pounds, the hedger will sell 20 contracts (800,000 ÷
40,000). When the farmer sets up his hedge, his basis is $6.70 under (cash is 6.70 under futures).
In June, when the farmer is ready to market the cattle, the price of cash has fallen to $64.15 per
hundredweight and the price of futures has fallen to $70.55. The farmer’s basis has dropped from $6.70
under to $6.40 under. The $0.30 change in the basis has resulted in a profit of $0.30 per hundredweight on
the hedge, as indicated by the following diagram of the initial and closing positions:
Cash Futures Basis
Long at $65.50 Sell at $72.20 $6.70 under
Sell at $64.15 Buy at $70.55 $6.40 under
LOSS $ 1.35 PROFIT $ 1.65
Note that, as the farmer feared, the price of cattle dropped from $65.50 per hundredweight in January to
$64.15 when the farmer sold the cattle. How did this drop in price affect the farmer? Did it result in his
earning less than he would have earned had he been able to sell the cattle in January at the higher cash
market price? The end result was that the farmer was able to market the cattle at a higher net price because
of the hedge, even though the cash market price dropped. When the cattle are sold, the farmer realized a
total of $64.15 per hundredweight. In addition, he had a profit of $1.65 per hundredweight on his futures
position. Therefore, the total price realized on the cattle was $65.80 ($64.15 selling price + $1.65 profit on
futures), which is $0.30 higher than the cash price in January. The total amount received on the sale of the
cattle was $526,400 ($65.80 per hundredweight on 800,000 pounds). The farmer’s cost for raising and
marketing the cattle was $448,000 ($56.00 per hundredweight on 800,000 pounds). Therefore, his net profit
was $78,400 ($526,400 – $448,000).

Sugar Exporter
The next example of hedging involves a sugar exporter who enters into an agreement on February 15 to
sell sugar at a fixed price of 16.30 cents per pound. The sugar is to be delivered in July. On the day the
sale is made, July futures are selling at 17.45 cents per pound. The exporter doesn’t own the cash sugar
and he intends to make the purchase immediately prior to delivery. Therefore, the exporter is short the
cash commodity and is concerned that the price will rise in the interim. To protect against a price rise on a
short cash position, he will buy July futures.
In July, when it’s time to make delivery on the cash sugar, the price has risen substantially to 19.60 cents
per pound. The price of July futures is 20.05 cents per pound. Let’s determine the net result of the hedge and
also the net selling price that’s realized by the hedger on his cash sugar. The net result of the hedge is as
follows:
Cash Futures Basis
Sell at 16.30 cents Buy at 17.45 cents 1.15 cents under
Buy at 19.60 cents Sell at 20.05 cents .45 cents under
LOSS 3.30 cents PROFIT 2.60 cents
The net result of the hedge was unfavorable. The basis change from 1.15 cents under to .45 cents under
resulted in a net loss on the hedge of 0.7 cents per pound. However, the fact that the basis changed
unfavorably doesn’t mean that the hedge was ineffective. Note that the cash price of the sugar advanced by
3.3 cents. Had the exporter not hedged, he would have been forced to absorb this entire price increase. As a
result of hedging his position, he was able to defray 2.6 cents of the price increase through his profit on
futures. Taking into consideration the profit on the hedge, his net selling price for the sugar is therefore 18.90
cents per pound. This is the amount of the actual selling price (16.30) plus the profit on the hedge (2.60).
The exporter’s situation can also be viewed from another standpoint to determine his net cost for the sugar.
When he bought the sugar in the cash market, he had to pay 19.60 cents per pound. His cost was reduced by
the amount of profit that he made on futures (2.60 cents), and therefore, his net cost for the sugar was
17.00 cents per pound.
Note that the hedger did indeed lose money on his overall transaction. He realized a net selling price of
18.90 cents per pound, but he had to purchase the cash sugar at 19.60 cents per pound. Therefore, his
overall loss on the transaction was .7 cents per pound. Had he not hedged, he would have paid 19.60 for
the cash sugar and would not have realized any profit on futures to defray this cost. Therefore, his overall
loss would have been 3.3 cents per pound. Of course the results are the same if the problem is viewed from
the standpoint of his net cost of 17.00 cents per pound (cost of cash sugar is 19.60 minus profit on futures
of 2.60). Since his selling price was 16.30 cents per pound and his cost was 17.00 cents per pound, his net
loss was 0.7 cents per pound.

Meat Packer
In this situation, a businessman is neither long nor short the cash commodity, yet still uses the futures market
advantageously. On February 15, a meat packer observes that the price of cash hogs is $19.35 and the
price of August hog futures is $19.45. Both prices are attractive to the packer. He doesn’t currently require
the hogs; instead, he anticipates that he will need hogs in August. However, he has no commitments at the
present time and therefore is not short cash hogs. The meat packer’s options are as follows:
1. Buy the cash hogs on February 15 at $19.35 and hold them until August. In this cash, the packer will
have carrying charges for the hogs.
2. Wait until August and then buy the hogs. In this case, there will be no carrying charges. However, the
meat packer finds today’s price attractive and thinks that the price will rise by August.
3. Buy hog futures. The hog futures will serve as a temporary substitute for the later cash market
purchase of the hogs.
The meat packer elects to buy hog futures at $19.45. On August 1, cash hogs are selling for $19.87 and
hog futures are at $19.90. The meat packer buys the cash hogs and sells the futures. Note that the price of
hogs rose $0.52 per hundredweight. The profit on futures was $0.45. This $0.45 profit defrays part of the
cost of the cash hogs; therefore, the meat packer’s net cost is $19.42 (cash price of $19.87 – $0.45 profit
on futures). In this case, the profit on futures results in a lower net cost for the cash hogs.
Hedging in Financial Instruments

There are two basic reasons why individuals hedge in financial instruments. One is to protect the value of
currencies that are owned by or owed by them against price change. The second is to protect against
adverse changes in interest rates. Let’s first examine hedging in currencies.
Foreign Currency Hedging

Decreases If an individual owns a foreign currency, or is owed a foreign currency that will be paid to
him at a later date, he’s concerned that the value of the currency will decrease. For example, let’s assume
that an American manufacturer has entered into a contract which calls for delivery of electronic
equipment to a British company in six months. The American firm wants a price of $3,000,000 for the
equipment. The British importing firm agrees to this price and states that it will pay the equivalent of
$3,000,000 in British pounds on delivery. At the time the order is signed, the British pound is worth
$2.0510. Therefore, the contract is written for the payment of 1,462,701 pounds ($3,000,000 ÷ $2.0510).
Note that payment will be made in pounds, not dollars. When the pounds are received, the American firm
will of course convert the pounds into dollars. The American exporter is concerned that the pound will
become devalued in relation to the dollar. If this occurs, the exporter will receive fewer dollars when he
converts the pounds into dollars. For example, when delivery is made, let’s assume that the pound
decreases in value to $1.9850. The American exporter will receive 1,462,701 pounds worth only $1.985
each, which he could convert into $2,903,461. Therefore, he would receive $96,539 less than the price he
expected when he sold the equipment.

In order to hedge against a devaluation of a foreign currency, the exporter would sell the currency futures
on the exchange. If the foreign currency is devalued, the loss that he realizes on the cash trade would be
offset by a profit on the futures. Let’s assume that, at the time the contract is signed, the pound is selling
on the futures market at $2.083. To protect his cash position, the exporter will sell futures. When the
electronic equipment is delivered, the cash price has dropped to $1.9850 and the price of futures has
dropped to $2.0170. The net result is as follows:
Cash Futures Basis
Long at $2.0510 Sell at $2.0830 $0.032 under
Sell at $1.9850 Buy at $1.0710 $0.032 under
LOSS $0.066 PROFIT $0.660
There was no change in the basis between the opening and closing positions. The loss of $0.066 on the
cash position was exactly offset by the profit on futures and, therefore, the hedge provided full protection
against the devaluation of the pound.
Increases In the preceding example, the businessman sold futures to protect against a devaluation of
a foreign currency. Now, let’s examine an example of a hedger who’s short a foreign currency and
therefore hedges to protect himself against a revaluation (increase) in the value of the currency. For
example, an American firm agrees to import a product from Germany. The price required by the German
exporter is 100,000 Euros. At the time the order is signed, the Euro is selling at .8616. This means that it
would cost the American importer $0.8616 to acquire each Euro. As the order calls for 100,000 Euros, the
total cost to the American importer is $86,160 ($0.8616 x 100,000). The importer is short the Euro and
is concerned with an increase in its value. If the Euro increases to $0.89, the cost to the importer will be
$89,000 to acquire 100,000 Euros. To hedge against an increase in the value of the Euro, the importer
will buy futures on the Euro.
At the time the order is signed, let’s assume that the June futures are selling at $0.8688 and the importer buys
the contract. When delivery is made, the cash price of the Euro has increased to $0.8988 and the price of
futures has increase to $0.9076. The results of the hedge are as follows:
Cash Futures Basis
Short at $0.8616 Buy at $0.8688 $0.0072 under
Buy at $0.8988 Sell at $0.9076 $0.0088 under
LOSS $0.0372 PROFIT $0.0388
The net result of the hedge was profitable because of a favorable basis change. The price of the Euro
increased, as the importer feared. However, the price of futures increased even more, and the net result of
the hedge was a profit of $0.0016. (profit .0388 − loss .0372)
Let’s look in depth at one more example of hedging in currency futures. On February 15, an American
importer places an order with a Swiss watch manufacturer for the delivery of watches in September. The
value of the contract (to be paid in the Swiss franc) is 500,000 francs. At the time the order is placed, the
Swiss franc is worth $0.6167 and September futures are trading at $0.6572.

On the day the order is placed, the total value of the order is $308,350. It would cost the American
importer this amount of dollars to acquire 500,000 Swiss francs (500,000 x $0.6167). The importer is
concerned that the price of the franc will increase with a corresponding increase in the dollar cost to buy
the francs. In order to hedge against a price increase, he could buy September futures. Since the contract
size for the Swiss franc is 125,000, he would buy four contracts.
On the day that the watches are delivered and payment is due, the price of the Swiss franc has increased.
The cash price for the franc is $0.6377 and the price of September futures has increased to $0.6752. If the
importer had chosen not to hedge, his cost for the watches would be $318,850 (500,000 x $0.6377), an
increase of $10,500. However, because of the hedge, the price increase to the importer is substantially less.
The results of the hedge are as follows:

Cash Futures Basis
Short at $0.6167 Buy at $0.6572 $0.0405 under
Buy at $0.6377 Sell at $0.6752 $0.0375 under
LOSS $0.0210 PROFIT $0.0180
Because of an unfavorable basis change, the net result of the hedge was a loss of $0.003 (3/10th of one cent).
However, because of the hedge, the additional cost to the importer was only $1,500 rather than $10,500,
which would have been the case if the position had been unhedged. When the watches were delivered,
the importer bought Swiss francs at a cost of $318,850 (500,000 x $0.6377) and closed out his futures
position at a profit of $9,000 (500,000 x $0.018). This profit reduced his net cost for the watches to
$309,850 ($318,850 – $9,000), which is $1,500 over the original cost projection of $308,350 when the
order was placed.
Treasury Bond Hedging

Now let’s focus on hedging to protect against changes in interest rates. In order to understand how these
hedges operate, it’s first necessary to understand the relationship between changes in interest rates and the
prices for bonds that are outstanding in the market. The first point to note is that interest rates and bond
prices change in an inverse relationship. If interest rates increase, prices for bonds that are already
outstanding will decrease; however, if interest rates decrease, prices for bonds that are already outstanding
will increase. To understand this relationship, let’s examine a bond that’s currently outstanding.
A bond that’s currently outstanding is paying 8% interest annually. Interest rates for comparable bonds
being issued today are currently 9%. An individual who’s interested in acquiring a comparable bond would
be willing to buy either bond provided that his net yield on the bond is the same. The individual could buy
a new bond by paying the principal amount of $1,000 and would receive interest payments of $90 annually
(9% of $1,000). However, the individual would certainly not buy the 89% bond that’s already outstanding
because his return would only be $80 annually (8% of $1,000).

If a holder of the 8% bond wants to dispose of it, he could only do so by selling the bond at a lower
principal amount, which would make the net yield to the new buyer equal to 9%. For example, if the 8%
bond has one year remaining until maturity, its price will drop to approximately $990. If the bond has 10
years remaining to maturity, its price will drop to approximately $935. The amount that the price must fall
to offset an increase in interest rates is based on a complicated formula that is not required for test purposes.
One other point should be noted. Bonds are quoted at a percentage of the par value. Therefore, if a bond
price drops to $990, it will be quoted at 99, which is 99% of the par value of $1,000. If the price drops to
$935, it will be quoted at 93.5, which means 93.5% of the par value of $1,000.
Let’s first examine a hedge that’s established to protect against falling interest rates. An individual is in the
process of selling his business for $500,000. He intends to use the proceeds of the sale to invest in bonds
and the proceeds will be available to him in three months. The current rate of interest is attractive to him,
but he doesn’t yet have the funds available to purchase the bonds. He’s concerned that if he waits until the
proceeds are available, interest rates will decline and his yield will therefore be lower. To protect himself
against falling interest rates, the individual decides to hedge in the futures market.
The first point to determine is the type of hedge he will establish. Since the investor is concerned with falling
interest rates, he will buy futures. Remember, the price of fixed income securities moves in an inverse
relationship to interest rates. If interest rates fall, bond price will increase. Any loss of income he may realize
based on a decrease in interest income will be offset by a profit on the eventual sale of the futures.
Long Hedge Let’s assume that the current interest rate on high-grade corporate bonds is 8.7%, which is
a satisfactory yield for the investor. He will eventually be buying bonds with an 8% interest rate; therefore,
the bonds are currently selling in the market at 95 00/32nds. He decides to secure this yield by buying U.S.
Government bond futures. The current price of the futures is 92-24/32nds. The initial position will appear
as follows:
Cash Futures
Current Price 95-00 Buy 5 Treasury bond contracts at 92-24
When the investor finally realizes the $500,000 from the sale of his business, interest rates have decreased.
Therefore, he will need to pay a higher price to purchase the same 8% bonds, which are currently selling at
98-16/32nds. Remember, the price of bonds that are already outstanding increases if interest rates decrease.
This means that the bonds he could have purchased at 95-00/32nds (95% of the face value) are now selling at
98-16/32nds (98.5% of face value). Therefore, it would cost him 3 1/2% more to purchase $500,000 of
bonds, for a total of $17,500 ($500,000 x .035). As a result of the change in interest rates, the price of the
Treasury bond futures that he purchased have also gone up and are now selling at 96-8/32nds.

The net results are as follows:

Cash Futures
Current Price 95-00 Buy 5 Treasury bond contracts at 92-24
Buy bonds at a current price of 98-16 Sell 5 Treasury bond contracts at 96-08
Increased cost of bonds 3-16 PROFIT on futures 3-16
As a result of hedging, the increased cost to the investor to purchase the bonds is exactly offset by the
profit on the futures.
Short Hedge The last hedging example to consider will deal with a corporation that intends to issue
$10 million of bonds in six months. The corporation is concerned that interest rates will rise and that it will
be required to pay a higher rate of interest on the bonds that it eventually issues. In order to hedge against
rising interest rates, the corporation will sell Treasury bond futures. If interest rates go up, the price of the
futures will fall. The increased cost to issue the bonds will be offset by a profit on the futures.
At the time that the corporation makes plans to issue bonds, comparable bonds are selling at a price of 96-
16/32nds and Treasury bond futures at trading at 98-22/32nds. In order to hedge against rising interest
rates, the corporation will sell 100 Treasury bond contracts. The initial position appears as follows:
Cash Futures
Current Price 96-16 Sell 100 Treasury bond contracts at 98-22
When the corporation issues the bonds, interest rates have risen and the price of fixed income securities
that are already outstanding has fallen. Bonds that are equivalent to the grade that the corporation will issue
are selling at 92-2/32nds and the price of the Treasury bond futures has dropped to 93-10/32nds.
The results of the hedge are as follows:

Cash Futures
Current Price 96-16 Sell 100 Treasury bond contracts at 98-22
Issues bonds at a price of 92-02 Buy 100 Treasury bond contracts at 93-10
Increased cost of issue 4-14 PROFIT on futures 5-12
In this example, note that there was a favorable change in the corporation’s basis. The basis went from 2-
6/32nds under to 1-8/32nds under. This change in the basis resulted in a net profit on the hedge of
30/32nds on the hedge (5-12/32 – 4-14/32).
If the futures position is examined, it’s evident that there was a profit of 5-12/32nds. Keep in mind, each full
point represents 32/32nds. Since there are 5 points, this equals 160 (5 x 32). By adding the additional
12/32nds to the 160, the result is a total profit of 172/32nds. In a Treasury bond futures contract, each 32nd
of one point is equal to $31.25. Therefore, with 100 contracts involved in the hedge, the total profit is
$537,500 (172 x $31.25 x 100 contracts).

This profit helps to defray the added interest costs that the corporation will sustain over the life of the bond
as a result of increased interest rates. The hedge itself not only defrayed the added cost due to rising
interest rates, but also yielded a net profit. Note that, due to a favorable basis change, the hedge
contributed a profit of 30/32nds. Since each 32nd is worth $31.25, the total profit on the hedge was
$93,750 (30 x $31.25 x 100 contracts).
The corporation issued the bonds at the current rate of 92-2/32nds. However, this was not the net issue
price because the futures hedge contributed a profit of 5-12/32nds. In order to determine the final issue
price of the bonds, taking into consideration the profit on the futures, the profit on the futures is added to
the issue price. The effective issue price is therefore 97-14/32nds (92-2/32nds issue price + 5-12/32nds
profit on futures.)

Chapter 9 Summary
 Understand the two types of hedgers
‒ Producers are long the cash commodity and hedge by selling futures
‒ Users are short the cash commodity and hedge by purchasing futures
 Recognize the basis and how changes in the basis will impact hedgers
‒ Producers are long the basis and will profit when the basis strengthens
‒ Users are short the basis and will profit when the basis weakens
‒ In a normal market, a strengthening basis is narrowing and a weakening basis is widening
‒ In an inverted market, a strengthening basis is widening and a weakening basis is narrowing
 Recognize which expiration month to use
‒ Since hedgers want protection, they always choose the first expiration month after the cash
position is lifted
 Understand how to calculate total profit and loss from hedged positions
 Recognize how to calculate the effective selling price or effective cost
‒ Producer’s Effective Selling Price = Cash Now Price +/‒ Gains or Losses on Hedge
• Producers will add gains and subtract losses to find their effective selling price
‒ User’s Effective Cost = Cash Now Price +/‒ Losses or Gains on Hedge
• Users will add losses and subtract gains to find their effective cost


CHAPTER 10
Stock Index Futures

CHAPTER 10 – STOCK INDEX F UTURES
Introduction
With the introduction of stock index futures, it allowed the stock market as a whole to be traded. Before
examining the features and benefits of these major contracts, let’s list some of the underlying stock index
futures and the appropriate exchange on which they’re traded.
Futures Contract Exchange

Dow Jones Industrial Average Chicago Board of Trade
S&P 500 Index Chicago Mercantile Exchange
Nasdaq 100 Index Chicago Mercantile Exchange
Russell 2000 Index Chicago Mercantile Exchange
Nikkei 225 Stock Average Chicago Mercantile Exchange
NYSE Composite Index New York Futures Exchange
Non-Systematic Risk
For years, investors were required to purchase mutual fund shares or carry large portfolios if they wanted
to trade the market. Today, stock index futures have changed that. Through the use of stock index futures,
much of the market risk exposure has been eliminated. Modern Portfolio Theory (MPT) defines the risks
inherent in common stocks to be individual stock risk (also referred to as non-systematic risk). Non-
systematic risk is a combination of industry risk and company risk. Factors that create industry risk include
changing growth rates, technologies, production cost, and earnings.
Systematic Risk
Individual stock risk can be reduced through diversification. The result is that market risk (also referred to as
systematic risk) then dominates the return on the stock or the portfolio. Systematic risk is created by the
volatility of the overall market. Ever changing technical forces in the money and capital markets, as well as
the general economic environment (e.g., inflation, employment, investment, and government policy),
impact the general stock market.
Individuals and institutional investors can use stock index futures to hedge their portfolios from adverse
market risk. Stock index futures can be used to separate market-related risk from individual stock risk.
These index contracts can also enable traders to trade the general direction of the overall stock market. As
a result, stock index futures have enormous appeal to investors and traders alike.
Stock index futures represent an important innovation in futures trading as well as in modern finance.
Essentially, these contracts are agreements to buy or sell the market value of stocks included in one of the
stock market indexes.

They’re not based on any underlying product (e.g., corn, pork bellies or T-bills), but rather on the changes
in the computed average of stock prices. Although stock index futures are futures contracts, they nevertheless
possess important attributes of the equity market. In particular, their value is determined by the price of the
component stocks in the index.
Futures Contracts
Size of Contracts
Index futures contracts are traded and quoted using the same terms as the actual index. Each contract is
assigned a multiplier or value per point by the exchange on which the contract is traded.
For example, if the contract size is equal to $250 times the index, each full index point (i.e., 1.00) is
equal to $250. If the S&P 500 Index is trading at 914.00, the value of one contract equals $250 x 914.00
= $228,500. For most stock index futures, the minimum tick is .05, rather than .01 as the index is
computed. In the example above, the dollar value of one tick (.05) is equal to $12.50 (.05 x $250).
Therefore, a change of 1.25 in the index futures contract is equal to $312.50 ($250 x 1.25 = $312.50).
For several indexes, there are both standard and E-mini contracts. The standard contract has a larger
multiplier (e.g., $250 for the S&P 500) and a smaller multiplier for the E-mini contract (e.g., $50 for the
S&P 500 E-mini). In some cases, investors can actually offset the standard contract with an equivalent
amount of the E-mini contracts.
Contract Months
As with most commodity futures, there are standard contract months, which are March, June, September,
or December.
Cash Settlement
Unlike traditional commodities, stock index futures don’t have physical delivery at settlement. Instead, at
contract expiration, all open stock index future positions are settled in cash. The cash settlement feature
eliminates the prohibitively expensive cost of delivering fractional amounts of the individual stocks.
Therefore, there’s no physical delivery of securities and no transfer of the full value of the contract.
For most futures contracts, the final settlement is determined at the close of the trading on the contract’s
expiration date. For S&P 500 Index futures, the final settlement is calculated based on the opening value
on the day after the S&P 500 futures contract expires. However, for the E-Mini S&P 500 Index futures, the
final settlement is based on the opening value on the same day that the futures contact expires.

Market Participants
Stock index futures represent an effective proxy for the general stock market, and consequently, enable
investors to separate market risk from individual stock risk. For that reason, they have become an important
means of hedging the market risk component of stock prices. Therefore, stock index futures offer investors
the opportunity to trade the direction of the market as well as the flexibility to hedge a portfolio against
adverse market risk.
Market makers, individual investors, institutions, specialists, new issue underwriters, block positioners,
and risk arbitrageurs use stock index futures to transfer all or part of their risk to another person who’s
willing to assume it. The speculator's assumption of risk is taken in the hope of substantial speculative
profit. The hedger executes a position in the futures market which is equal, but opposite, to his position in
the cash market. His purpose is to offset losses in the cash market with gains in the futures market.
Therefore, the purpose of any hedge is not to generate a profit, but rather to protect against a loss.
Trading
As a concept, stock index futures are relatively simple. If a person expects the stock market to rally, she
could buy (go long) stock index futures, which is referred to as a bull trade. If a person anticipates a stock
market decline or “sell-off”, she could sell (go short) stock index futures, which is referred to as a bear
trade. Once a position is established, the trader can hold his position for as long as she wants, until the
contract expires. For example, a trader expects the market will move up in late August. On August 19, the
trader buys one September NYSE Index contract at 168.30 (168.30 x $500 = $84,150). On September 4, the
trader sells the contract and closes out the position at a price of 171.20 (171.20 x $500 = $85,600). The
gain on the trade is $1,450, excluding round turn commission costs. If the trader placed a switch order, her
position would be rolled over into another contract month.
Index versus Trading

Trading stock index futures differs significantly from stocks. Index futures are traded by open outcry on a
regulated futures exchange. By contrast, stocks are traded by a specialist system, with each stock located at a
specific post. Additionally, unlike stocks, index futures don’t offer priority as to time or size of the trade;
instead, bids and offers compete equally. Since index futures don’t typically have a single opening or closing
price for market orders, there’s generally is an opening and closing range.
Traders who want to sell short in the futures market have none of the restrictions that their counterparts in
the stock market face. To sell short in the futures market, there’s no need to wait for an up-tick. An up-tick
is a term that’s used to designate a transaction made at a price higher than the preceding transaction. A
trader can sell short at any time and there’s no need to borrow stock in order to sell futures short.

Spreading Stock Index Futures

The risk in spreading is less than taking outright long or short positions. At the same time, while the risk is
reduced, so too is the potential for profit.
With spreading, the price differential should either widen or narrow and then return to normal. In the case of
stock index futures, when spreads are considered normal, the nearby months trade at prices above the cash
index and below the deferred months. In a bull market, where prices are rising, the deferred months should
rise faster than the nearby months and the spread should strengthen or widen (i.e., become more positive).
Similarly, during a bear market, the deferred months should lead the nearby months on the downside and
the spread should weaken or narrow, i.e., become more negative. Therefore, in stock index futures, a bull
spread is when the trader buys the deferred month and sells the nearby month. Likewise, in a bear spread
the trader would sell the deferred month and buy the nearby month.
Strategies
Stock index futures offer attractive possibilities on two basic strategies—the long hedge and short hedge.
Long Hedge
The investor or portfolio manager can use a long hedge to lock in a broad market component for the price
of stocks to be purchased at a later date. Essentially, the long hedger seeks to reduce the risk of paying
higher prices due to a rising stock market while awaiting future cash flow intended for equity purchases at
a later date.
For example, if a portfolio manager is unsure of what stocks he will buy, but
wants to protect the buying power of his funds, he can buy a dollar equivalent
amount of stock index futures or in-the-money calls. If the stock market rallies,
profits from either the long futures position or long call position will offset the
higher stock prices that the manager pays when he buys the actual stocks.
Short Hedge
The investors, pension funds, and mutual fund managers that hold substantial equity positions can
implement the short hedge to protect their long positions. Institutional portfolio managers have often found
themselves forced to liquidate long positions in stocks with promising long-term prospects simply to avoid
losses resulting from overall declining stock prices. For these investors or managers, the hedge potential of
the contract improves with the scope of portfolio diversification.
For example, if a portfolio manager believes the stock market is weak, he can sell a
dollar equivalent amount of stock index futures or buy in-the-money puts to offset the
exposure of his portfolio. If there’s a price decline in the stock market, the loss on the
value of the portfolio will be offset by gains in the futures position or long put position.

Calculating the Number of Contracts

Typically, calculating the number of contracts needed to hedge is quite straightforward. However, since
index futures don’t have a traditional contract size, it can more difficult when hedging a stock portfolio
using index futures. In order to determine the number of contracts needed to hedge, an investor will need
to take the value of an index futures contract and divide it into the size of the portfolio being hedged.
For example, an index mutual fund manager wants to hedge a stock portfolio which
tracks the S&P 500 Index. Currently, the stock portfolio is worth $500 million.
Yesterday, the June S&P 500 index futures contract settled at 3022.30 and the contract
multiplier is $250. How many futures contracts will the manager need to sell?
Number of Contracts = Portfolio Value ÷ Futures Value

Number of Contracts = $500,000,000 ÷ (3022.30 x $250)
Number of Contracts = $500,000,000 ÷ $755,575
Number of Contracts = 661.747
The manager will need to sell 661 contracts. For this problem, round down to the nearest
whole number.
Chapter 10 Summary
 Understand the different types of risk that stock index futures can hedge
‒ Non-systematic risk is diversified
‒ Systematic risk is hedged using stock index futures
 Recognize that stock index futures have a multiplier rather than a delivery size
 Recognize that stock index futures are cash settled and don’t require the delivery of the underlying
shares
 Understand how to calculate the number of futures contracts that are needed to hedge a portfolio
‒ Number of Contracts = Portfolio Market Value ÷ (Futures Price x Contract Multiplier)
‒ Always round down to nearest whole number of contracts


CHAPTER 11
Commodity Options
CHAPTER 11 – COMMODITY OPTIONS
Introduction
An option is an agreement which gives the buyer of the option the right to exercise the option and require
the seller (writer) of the option to perform according to the stated provisions of the contract. There are two
classes of options—call options and put options. Both types are traded in the same delivery months as the
underlying futures contract. The price that’s paid for a put or call option is referred to as the premium and
is established in open competitive trading on the floor of the exchanges on which the options trade.
A call is an option contract in which the buyer pays a premium for the right, but not the obligation, to buy
(go long) a commodity futures contract from the seller at an agreed upon price (strike or exercise price).
A put is an option contract in which the buyer pays a premium for the right, but not the obligation, to sell
(go short) a commodity futures contract at an agreed price (strike or exercise price). The put and call
options can be exercised at any time before the expiration date. Options will be traded on an expiration
cycle based on the expiration cycle of the underlying futures contract.
Classification
Options may be grouped into three basic classifications:
1. Type – which refers to an option as being either a call or a put.
2. Class – which refers to all option contracts of the same type and covering the same underlying futures
contract. For example, all T-bond call options (regardless of their exercise price or expiration date).
3. Series – which refers to all option contracts of the same class, with the same exercise price, and the
same expiration date. For example, a Comex gold April 400 call.
Buyer’s Rights versus Seller’s Obligations

As in any market, for every buyer there must be a seller. In options trading, an option seller must be
prepared to enter an appropriate futures position that’s opposite to the option buyer if and when the option
is exercised. This is illustrated by the following table:
Seller Buyer
(also referred to as the Grantor, (also referred to as the Purchaser
Writer, or Short the Option) or Long the Option)
If the buyer decides to exercise, he will
The writer will be assigned a short futures
CALL assume a long position in the underlying
position if the buyer exercises the option.
futures contract.
If the buyer decides to exercise, he will
The writer will be assigned a long futures
PUT assume a short position in the underlying
position if the buyer exercises the option.
futures contract.

Introduction of New Options

When a new option is introduced, the initial exercise price will bracket the current price of the underlying
futures contract of the same expiration month. As the futures price fluctuates, additional exercise prices
will be opened for trading by the appropriate exchange.
Opening and Closing Transactions

All options transactions are either opening or closing transactions. An opening transaction is one in which
a trader establishes or increases a position in an option. On the other hand, a closing transaction is one
which decreases or eliminates an existing option position.
For example, a trader who has sold a call (opening sale) may later buy a call
(closing purchase) on the futures contract with the same striking price, thereby
offsetting the short call position and terminating his obligations as an option writer.
Note: It’s important to remember that the purchase of a call cannot be offset with the sale of a put.
Likewise, the sale of a call option cannot be offset with the purchase of a put.
Option Premiums
The key to options trading is the premium. An option is considered a wasting asset (i.e., when it expires, it
becomes worthless). For both puts and calls, it’s the buyer’s right (not obligation) to exercise the option to
acquire a futures market position. The decision of whether the exercise the option is entirely in the hands
of the buyer (not the seller).
Since the premium is actually the market price of an option at a particular time, it’s important to have a
fundamental understanding of how option premiums are determined and the principal factors that impact
them. The first thing to remember about option premiums is that they’re determined by supply and demand
between buyers and sellers. The exact price that buyers and sellers are willing to accept at a particular time
is influenced by two primary factors—the intrinsic value and the time value of the option.
Option Premium = Intrinsic Value + Time Value
Intrinsic Value
For a call option, the intrinsic value portion of the premium represents the amount by which the futures
price is above the option’s strike price (exercise price). An option that has intrinsic value is considered to
be in-the money. If the futures price is the same as the option’s strike price, the option is at-the-money. If
the futures price is below the strike price, the option is out-of-the-money. A call option that’s either at-the-
money or out-of-the-money has no intrinsic value. Conversely, the intrinsic value for a put option
represents the amount by which the current futures price is below the option’s strike price.

Note: When determining whether a put or call option is in-the-money or out-of-the-money, it’s always
based on the buyer’s option.
Below is a chart that outlines whether an option is in-the-money, at-the-money, or out-of-the-money:
Buy 1 Dec 1720 Gold

Call Market Price Put
In-the-money 1728 Out-of-the-money
At-the-money 1720 At-the-money
Out-of-the-money 1714 In-the-money
Time Value
The portion of an option’s premium that exceeds its intrinsic value is referred to as time value (i.e., Time
Value = Option’s Premium – Intrinsic Value). If an option’s premium consists entirely of time value, it’s
either at-the-money or out-of-the-money. In an option’s premium, the amount of time value is dependent on
how much time is left until the option expires. The longer the time to expiration, the greater the time value. For
example, a six-month option will typically trade at a higher price than a three-month option with the same
exercise price. To put it another way, the time value of an option will typically decline or decay, since the
expiration of the option is always getting closer. Volatility of the underlying futures contract also impacts
time value. The more volatile the underlying futures contract, the more time value an option will have.
Also, at-the-money options have more time value than either out-of-the-money or in-the-money options.
Option Premiums for Treasury Bond Futures

U.S. Treasury bond futures are quoted in points and 32nds of a point (each 32nd of a point = $31.25).
Premiums for options on U.S. Treasury bond futures are quoted in points and 64ths of a point (each 64th
of a point = $15.625). This is the minimum tick for options on T-bond futures.
To determine the premium for options on T-bond futures, the number of 64ths is multiplied by
$15.625 and rounded up to the nearest $.01. Therefore, an option premium of 1-32 equals 1 and 32/64
points, or $1,500.
Strike (Exercise) Price

Th strike price represents the price at which the buyer of the call may exercise his right to purchase the
underlying futures contract. For put options, the strike price is the price at which the buyer of the put may
exercise his right to sell the underlying futures contract.
Expiration Date
The expiration date represents the last day that the option may be exercised.

Buying Calls
Investors buy calls for many reasons, but the basic objective is to take advantage of an anticipated
increase in the price of an underlying futures contract. By purchasing a call, the investor hopes for an
increase in the value of both the underlying futures and the call premium so that he’s able to sell that call
at the higher premium for a profit. The following section describes the major applications.
Calls for Limited Speculation in Rising Markets If futures are rising, the purchase of calls
presents a method of entering markets with a limited risk. If the market continues to rise, the calls can
be resold or exercised at a profit. If the market declines instead, there’s never a margin call and the
entire risk is the premium.
Calls to Lock in Planned Purchases (User Hedging) Call options have a variety of potential uses for
both commercial and institutional users. These participants can use options as insurance (protection) to
reduce market exposure when planning large purchases of specific commodities or financial instruments.
Calls to Hedge Short Futures Positions A trader can purchase calls to protect favorable or adverse
short futures positions.
Buying Puts
Put options are essentially the opposite of calls. While calls give the buyer the right to purchase an underlying
futures contract, puts give the buyer the right to sell a futures contract at a specified price at any time up to the
expiration date. The buyer of a put option anticipates a decline in the underlying futures contract which will
increase the value of the premium. The following section describes the major applications.
Puts for Limited Speculation in Declining Markets The purchase of puts presents a method of
participating in the market with a limited risk. If the market declines, the puts can be resold or exercised at a
profit. However, if the market rises, there’s never a margin call and the entire risk is limited to the premium.
Puts to Lock in Planned Sales (Producer Hedging) Puts are useful in pre-positioning or establishing
a sales price in advance of an actual sale. By purchasing puts, the producer has hedged output in falling
markets, but has not been locked-in and is still able to take advantage of rising markets by getting higher
prices for the actuals.
Puts to Hedge Long Futures Positions For investors or hedgers with long futures positions in their
portfolios, buying put options can act as insurance against the depreciation of a long futures position
because a futures loss can be offset by a gain on the put.
Writing (Selling) Calls

A call writer (seller) enters into an agreement to sell a given futures contract at the specific strike (exercise)
price at any time prior to expiration if he’s notified that the call has been exercised. To compensate the call
writer for taking on this obligation, he receives compensation from the call buyer in the form of the premium.
Therefore, it’s the premium that motivates call writers to participate in the market.

The risks involved in writing calls are greater than the risks associated with buying calls. Also, it’s
important to remember that call sellers, like call buyers, can offset their positions at any time and be
completely relieved of their market obligations.
Covered Call Writers Persons who own the underlying futures are covered call writers. These covered
call writers often employ this conservative strategy as a means of reducing the risk of their existing long
futures positions or gaining another source of income. Therefore, a covered call writer has a long futures
contract in his portfolio that can serve as a cover if the option is exercised by a call buyer.
If a call option is exercised by the buyer, the exercise serves to liquidate the covered writer’s offsetting
futures position at the option’s strike price.
Uncovered (Naked) Call Writers Persons who have no underlying futures position are uncovered call
writers. Uncovered call writers seek to gain from an expected weakening of the underlying futures. The
risk of naked call writing stems from the possibility that, if the futures price increases significantly and the
call is assigned, a large net loss could result. If the call option is exercised by the buyer, the writer is
assigned a short futures position at the strike price of the option.
Writing (Selling) Puts

A put writer (seller) enters into an agreement to buy an underlying futures contract at the stated strike
(exercise) price at any time prior to expiration if he’s notified that the put has been exercised. The put
writer’s compensation for taking this position is the option’s premium.
Covered Put Writers Persons who have short positions in the underlying futures are covered put
writers. Covered put writers employ this strategy to protect a short position by the amount of the premium
received from the sale of a put. If a put option is exercised by the buyer, the exercise serves to liquidate the
covered writer’s offsetting futures position at the strike price.
Uncovered (Naked) Put Writers Persons who have no underlying futures position are uncovered put
writers. The strategy for uncovered put writers is the opposite of writing naked (uncovered) calls. The
potential reward is the opportunity to retain the option premium if the option is not exercised. However,
there’s a risk if the futures price declines below the option exercise price by more than the option
premium, which will result in a net loss. If the put option is exercised by the buyer, the writer is assigned a
long futures position at the strike price of the option.
Hedging with Options

Hedgers can use options to hedge their positions in the cash commodity. Typically, hedgers will buy
options since it gives them the control over exercise. Producers will buy puts, which will generate a profit
when the futures price decreases, just like a short hedge. Similarly, users will buy calls, which will
generate a profit when the price rises, just like buying futures.

However, option premiums will not rise and fall as much as futures prices, which means that buying only
one option will not typically create an effective hedge.
Delta
Delta is an estimate of how much an option premium will increase or decrease for a $1.00 change in the
underlying futures. For example, a call option with a delta of .50 (or 50%) will rise by $0.50 if the
underlying futures price rises by $1.00. Bullish option positions (i.e., long calls and short puts) will have
positive deltas. The premium on a bullish option position will rise as the futures’ price rises, but the
premium will fall when the futures price falls. Bearish option positions (i.e., long puts and short calls) will
have negative deltas. The premium on a bearish position will fall as the futures’ price rises, but the
premium will rise when the futures price falls. Options that are in-the-money will have deltas close to 1 (or
100%), while options that are out-of-the-money will have deltas approaching zero.
In summary:
Bullish
 In-the-Money = Close to +1.0 or 100%
 At-the-Money = Close to +.50 or 50%
 Out-of-the-Money = Close to 0 or 0%
Bearish
 In-the-Money = Close to –1.0 or –100%
 At-the-Money = Close to –.50 or –50%
 Out-of-the-Money = Close to 0 or 0%
Estimating the Premium With an option’s delta, traders can predict the change in the premium using
an expected change in the futures price. After estimating the change in the option’s premium, they can
then calculate the new premium.
For example, the 300 March corn call is currently trading at $1.10 and has a delta of 75.
What’s the expected premium on the 300 March corn call if futures rise by $0.80?
Change in Premium = Change in Futures x Option’s Delta

Change in Premium = $0.80 change in futures x .75 delta = $0.60
New Premium = Old Premium +/- Change in Premium

New Premium = $1.10 premium + $0.60 = $1.70

Effective Hedging In order to create an effective hedge, producers and users will need a greater number
of options than futures to compensate for the option’s delta. To calculate the number of option contracts
needed to effectively hedge, hedgers will simply divide the number of futures they would use by the delta
of the option.
For example, a farmer anticipates she would need 20 futures contracts to

hedge this year’s crop. If she wants to buy a September 875 put option with a
delta of 50, how many put contracts will she need?
Number of Options Needed = Number of Futures ÷ Option’s Delta

Number of Options Needed = 20 futures ÷ .50 delta = 40 put contracts
If the option has a delta of 10?

Number of Options Needed = 20 futures ÷ .10 delta = 200 put contracts
If the option has a delta of 90?

Number of Options Needed = 20 futures ÷ .90 delta = 22.2 or 22 put contracts
At first glance, it seems like buying options with higher deltas is better, since fewer options are needed.
However, options with higher deltas will be in-the-money and have larger premiums. While options with
lower deltas require more contracts, they may be a cheaper way to hedge because of their lower premiums.
Constructing Synthetic Positions

A synthetic long position is the use of an options position and a futures position that has the same effect of
one long option position.
1 synthetic long option position = 1 futures position + 1 long option position
Synthetic Long Call

Let’s assume that the T-bond market is at 78-00. An investor is bullish and can buy a 76 T-bond call
option at 3-00. The investor’s position would be long a 76 T-bond call option at 3-00.
 Breakeven = 79-00 (76-00 + 3-00)
 Maximum profit = unlimited
 Maximum risk = $3,000.00 (price of the option)
To assume the same position using a synthetic position (which is a futures position and an option
position), the investor can buy one T-bond futures contract at 78-00 and buy one 76 T-bond put option at a
premium of 1-00 (1,000.00).

 Breakeven = 79-00 (futures price + cost of option)

 Maximum profit = unlimited
 Maximum risk = $3,000.00 (2,000.00 in the futures market and
$1,000.00 for the cost of the long put)
A synthetic long call has been constructed (synthetic long call = long put + long futures).
Synthetic Long Put

Let’s assume the crude oil market is at 78.00. An individual is bearish and can buy an 80 crude oil put
option at 3.00. His position would be long an 80 T-bond put option at 3.00.
 Breakeven = $77.00 (80.00 – 3.00)
 Maximum profit = $77,000
 Maximum risk = $3,000 (price of the option)
To assume the same position using a synthetic position, the individual can sell one crude oil futures
contract at 78.00 and buy one 80 crude oil call at 1.00.
 Breakeven = $77.00- (futures price - cost of the long call)
 Maximum profit = $77,000 (futures price – cost of the call)
 Maximum risk = $3,000 ($2,000 in the futures market and
$1,000 for the cost of the long call)
A synthetic long put has been constructed (synthetic long put = long call + short futures).
Synthetic Short Call

A synthetic short call is a short put option and a short futures contract.
In this situation, a trader is employing a strategy to obtain limited protection on a short futures contract
position and obtain a limited reward (premium) if the option is not exercised.
Synthetic Short Put

A synthetic short put is a short futures call option and a long futures contract.
In this situation, a trader is employing a strategy to obtain limited protection on a long futures contract
position and obtain a limited reward (premium) if the option is not exercised.
Note: Synthetic short calls and synthetic short puts are both considered covered options.

Synthetic Futures
A synthetic futures position is an option position that’s equivalent to a long or short position in the
futures market.
Synthetic long futures position = a long call option + a short put option
Synthetic short futures position = a long put option + a short call option
Spreading with Options

Now let’s examine strategies involved in purchases and sales of spreads. An option spread is the
simultaneous purchase of one or more option contract and sale of an equivalent number of option contracts
in a different series of the same class of options. A spread may involve buying and selling calls, or buying
and selling puts, on the same underlying commodity.
The term “spread” refers to the difference in premiums between the purchase and the sale. If the long position
has a higher premium than the short position, the investor will be required to deposit the difference in
premiums. This position is referred to as a debit spread. On the other hand, if the long position has a lower
price than the short position, the investor will be allowed to withdraw the difference in premiums. This position
is referred to as a credit spread. If the premiums on each side are the same, the spread is considered even.
Calendar Spreads
A calendar spread is the simultaneous purchase and sale of options of the same class, with the same
exercise prices, but with different expiration dates. This type of spread is also referred to as a time or
horizontal spread. The following is an example of a calendar spread:
Buy March 78 T-bond call
Sell December 78 T-bond call
Note: A calendar spread has the same exercise price, but different expiration dates.
Vertical Spreads
A vertical spread is the simultaneous purchase and sale of options of the same class, with the same
expiration date, but with different exercise prices. This type of spread is also referred to as a money or
price spread. The following is an example of a vertical spread:
Buy December 78 T-bond Call
Sell December 80 T-bond Call
Note: A vertical spread has different exercise prices, but the same expiration date.

Bull Call Spread

A bull call spread is a type of vertical spread that involves the purchase of a call option with a lower
exercise price and the sale of a call option with a higher exercise price. The net result is will be a debit
transaction because the lower exercise price will have the higher premium. This spread is also referred to
as a buy call spread.
 Breakeven = lower strike price + net debit

 Maximum profit = difference in strike prices – net debit
 Maximum risk = net debit (long option premium – short option premium)
For example, in October, the December T-bond contract is trading at 78-00.
Buy December 78 Call at 1-00 (1,000.00)

Sell December 80 Call at 0-32 ( 500.00)
Net Debit (Initial Debit) (0-32) ( 500.00)
BE = 78 + 0-32 = 78-32 (T-bond option price in 64ths)

or
= 78-16 (T-bond futures price in 32nds)
MP = 80 – 78 = 2 x $1,000 – $500 = $1,500.00
MR = $1,000 – $500 = $500
The trader will buy a vertical bull call (debit) spread because he’s mildly bullish. By doing so, the
trader gives up unlimited profit potential in return for reducing his risk. In a vertical bull call (debit)
spread, the trader is expecting the spread premium to widen because the lower strike price call will
become in-the-money first.
Bull Put Spread

The bull put spread is a type of vertical spread that involves the purchase of a put option with a lower
exercise price and the sale of a put option with a higher exercise price. Although this is the same action
that a bull call spreader will take, the difference between a call spread and a put spread is that the net result
will be a credit transaction because the higher exercise price will have the higher premium. This spread is
also referred to as a sell put spread.
 Breakeven = higher strike price – net credit

 Maximum profit = net credit
 Maximum risk = difference in strike prices – net credit
Buy December 76 Put at 0-32 ($ 500)

Sell December 78 Put at 1-00 ($1,000)
Net Credit 0-32 ($ 500)

BE = 78 - 0-32 = 77-32 (T-bond option price in 64ths)

or
MP = $500
MR = 78-76 = 2 x ($1,000) – $500 = $1,500
A trader will sell a vertical bull put (credit) spread to generate income (net credit) and because he’s
moderately bullish. The trader expects the spread premium to narrow because a decrease in time value will
decrease the option’s premium.
Bear Call Spread

The bear call spread involves the sale of a call option with a lower exercise price and the purchase of a call
option with a higher exercise price. The net result is a credit transaction because the lower exercise price
will have the higher premium. This spread is also referred to as a sell call spread.
Breakeven = lower strike price + initial credit

Maximum profit = net credit
Maximum risk = difference in strike prices – net credit
Buy December 80 Call at 0-32 ($ 500)

Sell December 78 Call at 1-00 ( 1,000)
Net Credit 0-32 ($ 500)
BE = 78 + 0-32 = 78-32 (T-bond option price in 64ths)

or
MP = $500
MR = 80 – 78 = 2 x ($1,000) – $500 = $1,500
A trader will sell a vertical bear call (credit) spread to generate income (net credit) and because he’s
moderately bearish. The trader expects the spread premium to narrow because a decrease in time value
will decrease the option’s premium.
Bear Put Spread

The bear put spread involves the sale of a put option with a lower exercise price and the purchase of a put
option with a higher exercise price. Note that this is the same action that a bear call spreader will take;
however, the difference between a call spread and a put spread is that the net result will be a debit
transaction because the higher exercise price will have the higher premium. This spread is also referred to
as a buy put spread.

Breakeven = higher strike price – net debit

Maximum profit = difference in strike prices – net debit
Maximum risk = net debit
Buy December 78 Put at 1-00 ($1,000)

Sell December 76 Put at 0-32 ($ 500)
Net Debit (0-32) ($ 500)
BE = 78 - 0-32 = 77-32 (T-bond option price in 64ths)

or
MP = 78 – 76 = 2 x ($1,000) – $500 = $1,500
MR = $500
The trader will buy a vertical bear put (debit) spread because he’s moderately bearish. The trader gives up
unlimited profit potential in return for reducing his risk. In a vertical bear put (debit) spread, the trader
expects the spread premium to widen because the higher strike price put becomes in-the-money first.
Opposite Spreads
Vertical bull (debit) call spread ----------------- Vertical bear (credit) call spread
Vertical bull (credit) put spread ----------------- Vertical bear (debit) put spread
A trader buys vertical debit spreads and sells vertical credit spreads.
Buy Sell
Vertical bull (D) call spread Vertical bear (C) call spread
Vertical bear (D) put spread Vertical bull (C) put spread
Summary
Traders who are bullish on the market will either buy a bull call spread or sell a bull put spread.
Bull Call Spread

Buy a call with a lower exercise price and sell a call with a higher exercise price. The net result is a
DEBIT spread.
Bull Put Spread

Buy a put with a lower exercise price and sell a put with a higher exercise price. The net result is a
CREDIT spread.

Traders who are bearish on the market will either buy a bear put spread or sell a bear call spread.
Bear Put Spread

Sell a put with a lower exercise price and buy a put with a higher exercise price. The net result is a
DEBIT spread.
Bear Call Spread

Sell a call with a lower exercise price and buy a call with a higher exercise price. The net result is a
CREDIT spread.
Straddles
A straddle consists of the purchase or the sale of both a call and a put on the same underlying futures
contract, with the same expiration date, and the same exercise price. In other words, it’s a call and a put
with all of the same elements.
Long Straddle
A trader may purchase a straddle if he believes that the underlying futures contract will make a sizeable
move, but he’s unsure of the specific direction in which it will move. Therefore, by purchasing both a call
and a put, the trader could make money regardless of the direction in which it moves.
For example, a trader creates a long straddle:

Buy December 78 Call at 3-16
Buy December 78 Put at 0-16
Combined Premium 4-00
The trader will profit if the futures contract moves by more than four points in either direction. However, a
loss is experienced at prices between 74-00 and 82-00. In fact, at 78-00, the entire amount of the
investment will be lost.
Short Straddle
A trader may write a straddle if expects little or no movement in the price of the underlying futures contract.
For example, a trader creates a short straddle:

Sell December 78 Call at 3-16
Sell December 78 Put at 0-16
Combined Premium 4-00
The trader will profit if the futures contract price is between 74-00 and 82-00. However, any price outside of
that range will result in a loss if either the put or call is exercised.

Strangles
A strangle consists of the purchase or the sale of both a put and a call on the same underlying futures
contract, with the same expiration date, but different exercise prices. The exercise prices should bracket
the market. For that reason, the call is above the market and the put is below the market.
Long Strangle
A trader will purchase a strangle if he believes the underlying futures contract will make a sizeable move, but
is unsure of the exact direction. The breakeven point is determined by adding the premiums paid to the
exercise price of the call and subtracting it from the exercise price of the put. The buyer’s potential profit is
unlimited, while his risk is limited to the total premiums paid and he will be negatively impacted by time
delay in a non-volatile or stable market.
Short Strangle
A trader will sell a strangle if he believes there will be little or no movement in the price of the underlying
futures contract. The breakeven point is determined by adding the premiums received to the exercise price
of the call and subtracting it from the exercise price of the put. The seller’s maximum profit is limited to
the premium collected, but his risk is unlimited.
Margins on Options
As with futures contracts, options have margin requirements. When an investor purchases an option, the
margin requirement is simply 100% of the option’s premium. However, for option writers, the margin
requirements are more complicated. For in-the-money option contracts, a writer’s margin requirement is
the option’s premium plus the margin on the underlying futures contract. On the other hand, if the option
is out-of-the money, the margin requirement is reduced by 50% of the out-of-the-money amount.
Simple Option Margin Requirements

Long Options: 100% of the premium
Example: A trader buys a June copper 2.5000 call for a premium of $0.0500. If the
copper contract size is 25,000 pounds, what’s the margin deposit?
Margin = $0.05 premium x 25,000 lbs. = $1,250 margin requirement
Short Options:
 In-the-money: Option Premium + Futures Margin
 Out-of-the-money: Option Premium + Futures Margin – 50% of the out-of-the-money amount

Example: July corn futures are trading at $6.70 and the initial margin for the futures
contract is $0.50 per bushel. A customer sells a July $6.60 put at $0.25. If corn futures
have a 5,000-bushel delivery size, what’s the margin deposit?
Futures margin = $2,500 futures margin ($0.50 x 5,000 bushels)
Option Premium = $1,250 option premium ($0.25 x 5,000 bushels)
Out-of-the-money Amount = $6.70 futures price - $6.60 strike price = $0.10 out-of-the-money
Margin Deduction = $0.10 out-of-the-money x 50% x 5,000 bushels = $250 deduction
Total Margin for Short Option = $2,500 futures margin + $1,250 premium – $250 out-of-the-money
Total Margin for Short Option = $3,500 margin requirement
Option Spread Margin Requirements

An option spread involves the simultaneous purchase and sale of two different put or call options. When
more is paid for the long option than received in premium for the short option, the spread is a debit
transaction. Conversely, when more is received than paid, the spread is a credit transaction. In general, a
credit spread will require a margin deposit.
The potential loss in an option spread is determined by two factors—the strike price and expiration date.
With this in mind, the following two basic rules may be used for quickly estimating whether margin will
be required for specific spreads:
1. If the strike price of the long call is greater than the strike price of the short call, or if the strike price
of the long put is less than the strike price of the short put, margin is required. (An adverse market
move can cause the short option to suffer a loss before the long option can show a profit.)
2. If the long option expires before the short option, margin is required. (Once the long option expires,
the trader holds an unhedged short position.)

Chapter 11 Summary
 Understand the basic option positions
‒ Long call is the right to buy a futures contract
‒ Short call creates an obligation to sell a futures contract
‒ Long put is the right to sell a futures contract
‒ Short put creates an obligation to buy a futures contract
 Recognize that options are based on the futures contracts, not the cash position
 Recognize the fundamentals of an option’s premium
‒ Intrinsic value is the amount by which the option is in-the-money
‒ Time value is based on the underlying market risk and time remaining until the option expires
‒ T-note and T-bond option premiums are quoted in 64ths
 Understand the basics of straddle
‒ Long Straddle = Long Call + Long Put (seeks volatility)
‒ Short Straddle = Short Call + Short Put (expects stability)
 Understand the fundamentals of option spreads
‒ Spreads can be bullish or bearish
‒ Spreads limit both gains and losses
 Recognize the synthetic options positions
‒ Long Call = Long Put + Long Futures Contract
‒ Short Call = Short Put + Short Futures Contract
‒ Long Put = Long Call + Short Futures Contract
‒ Short Put = Short Call + Long Futures Contract
‒ Long Futures Contract = Long Call + Short Put
‒ Short Futures Contract = Short Call + Long Put
 Understand the basics of an option’s delta and how to use delta for hedging
‒ Option’s Delta = Change in Option Premium ÷ Change in Futures Price
‒ Number of Options Needed to Hedge = Number of Futures Needed to Hedge ÷ Option’s Delta


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SERIES 3

National Commodity Futures Examination

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Anti-Money Laundering ...............................................................................2-22

CHAPTER 3 PRICE FORECASTING

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Sell Stop Order .............................................................................................5-3

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Stock Index Futures .....................................................................................7-10

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Hedging in Financial Instruments .....................................................................9-19

CHAPTER 10 STOCK INDEX FUTURES

CHAPTER 11 COMMODITY OPTIONS

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Expiration Date .............................................................................................11-3

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About the Series 3 Examination

Part I General Industry Knowledge 85 questions

The minimum required passing score is 70% for each part.

Taking the Exam

About the Study Program

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Standardized Test-taking Tips

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Series 3 – Three-Week Training

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY

1A and 1B 2A and 2B 3A and 3B

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PASS THE SERIES 3!

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY

Complete Chapters 3 – 4 (Review incorrect answers)

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Review Crunch Time Facts

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Cash Forward Transactions

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Commodity Futures Contract

Long and Short Positions

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Benefits Provided by the Futures Exchange

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1. The CME Group, which includes:

2. The Intercontinental Exchange (ICE), which includes:

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Successful Exchange Markets

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Responsibilities of the Exchange

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Clearing Commodity Transactions

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