Money Talks: Commodities, Futures, Futures Contracts, Derivatives, and Options

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Commodity

traditional examples of commodities include grains, gold, beef, oil and natural gas. More recently, the definition has expanded to include financial products, such as foreign currencies and indexes. Technological advances have also led to new types of commodities being exchanged in the marketplace. For example, cell phone minutes and bandwidth.

Commodities Process

agreements to buy or sell a specific quantity of a commodity at a specified price on a particular date in the future. With limited exceptions, trading in futures contracts must be executed on the floor of a commodity exchange.

Futures Contract

A futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future.

Futures Contracts

Futures contracts are used by two categories of market participants: hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased

Commercial Hedger

A commercial hedger is an organization which uses futures contracts to lock in the price of specific commodities it uses in running its business

Speculator

A speculator utilizes strategies and typically a shorter time frame in an attempt to outperform traditional longer-term investors. Speculators take on risk, especially with respect to anticipating future price movements, in the hope of making gains that are large enough to offset the risk.

Security Futures

Security futures are among the potentially riskiest financial products available in the United States. A security futures contract is a legally binding agreement between two parties to buy or sell a specific quantity of shares of an individual stock or a narrow-based security index at a specified price, on a specified date in the future

Futures Contract

A futures contract is traded on an exchange and is settled on a daily basis until the end of the contract. Futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date. The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

Forward Contract

The agreement between two parties to buy and sell an asset at a specified price by a certain date. A forward contract is a private agreement that settles at the end of the agreement. A forward contract is used primarily by hedgers who want to cut down the volatility of an asset's price

The Commodity Futures Trading Commission (CFTC)

the federal government agency that regulates the commodity futures, commodity options, and swaps trading markets. Anyone who trades futures with the public or gives advice about futures trading must be registered with the National Futures Association (NFA), the independent regulator for anyone who trades futures with the public.

Mark to Market (MTM)

Mark to market is an accounting practice that involves recording the value of an asset to reflect its current market levels. mark to market involves recording the price or value of a security, portfolio, or account to reflect the current market value rather than book value. This is done most often in futures accounts to ensure that margin requirements are being met.

Default Risk

Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations.

Investment Counterparty Risk

the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.

Examples of Counterparty Risk

When the counterparty risk is miscalculated and a party defaults, the impending damage can be severe. For example, the default of so many collateralized debt obligations (CDO) was a major cause of the real estate collapse in 2008.

Clearing House

A clearing house acts as an intermediary between a buyer and seller and seeks to ensure that the process from trade inception to settlement is smooth. Its main role is to make certain that the buyer and seller honor their contract obligations. The clearing house enters the picture after a buyer and seller have executed a trade. Its role is to consolidate the steps that lead to settlement of the transaction. In acting as the middleman, a clearing house provides the security and efficiency that is integral for financial market stability.

Leverage

Leverage is the use of debt (borrowed capital) in order to undertake an investment or project. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out.

Margin

to use money borrowed from a broker to purchase securities. Using margin to purchase securities is effectively like using the current cash or securities already in your account as collateral for a loan.

Margin Call

occurs when the account value falls below the broker's required minimum value.

Basically, this means that one or more of the securities held in the margin account has decreased in value below a certain point. The investor must either deposit more money in the account or sell some of the assets held in the account.

The Federal Reserve Board’s Regulation T, or Reg T

mandates a limit on how much an investor can borrow, which is up to 50% of the price of the security purchased.

Federal Call

federal calls is to moderate the amount of financial risk present in the securities markets. Since borrowing money from a broker to buy securities on margin amplifies both gains and losses relative to initial investment, a broad overuse of margin has the potential to cause instability in financial markets as a whole.

House Call

a margin call by the brokerage firm for a customer whose equity has fallen below the margin maintenance requirement of that brokerage firm. If the client fails to fill the shortfall in the margin account within the time specified by the "house," positions will be liquidated without notice to the account holder until the house requirement is satisfied.

Maintenance Margin Calls

is set after the initial purchase. The Federal Reserve Regulation T sets this requirement at 25%, although many brokerage firms require more, such as 30% to 40%. A maintenance margin at 25% means a minimum equity amount must be valued at 25% or more of the margin account's total value.

Shortfall

an amount by which a financial obligation or liability exceeds the required amount of cash that is available.

Equity

There are various types of equity, but equity typically refers to shareholder equity, which represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debt was paid off.

Market Value

the term market value simply refers to the price of an asset in the marketplace. Pure market value is the value an asset holds on any given day in the open market.

Options

Options are contracts that give the bearer the right, but not the obligation, to either buy or sell an amount of some underlying asset at a pre-determined price at or before the contract expires. Options belong to the larger group of securities known as derivatives. As an example, wine is a derivative of grapes ketchup is a derivative of tomatoes, and a stock option is a derivative of a stock. Options are derivatives of financial securities—their value depends on the price of some other asset.

Hedge

Investors and money managers use hedging practices to reduce and control their exposure to risks. Normally, a hedge consists of taking an offsetting position in a related security.

Derivatives

The most common way of hedging in the investment world is through derivatives. Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the values of the underlying asset.

Common Forms of Derivatives

There are many different types of derivatives that can be used for risk management, for speculation, and to leverage a position. Common derivatives include futures contracts, forwards, options, and swaps.
Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset.

Stock Option

An employee stock option is a contract that grants an employee the right to buy shares in his or her employer at a specific, fixed price, known as the exercise price, after a designated date. An employee must spend his or her own money to buy the stock

Option Contract

An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date; investors use options for income, to speculate, and to hedge risk.

Premium

The total cost of an option is called the premium which is determined by factors including the stock price, strike price, and time value remaining until expiration.

Option Holder

The purchaser of an options contract.

Write (Options)

To sell an option contract. The investor who sells an option contract is called the writer. They are also considered to be short the option.

Short

A short, or a short position, is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price.

Naked Short

A naked short is when a trader sells a security without having possession of it. However, that practice is illegal in the U.S. for equities.

Covered Short

A covered short is when a trader borrows the shares from a stock loan department; in return, the trader pays a borrow-rate during the time the short position is in place.

Short Squeeze

A short-squeeze is when a heavily shorted stock suddenly begins to increase in price as traders that are short begin to cover the stock.

Call

An options contract that conveys the right to buy the underlying security at a set price (the strike price) by a designated date (the expiration date). When an investor sells (or writes) a call contract on a stock, the seller is obligated to sell stock at that price if the option is exercised.

Put

An options contract that conveys the right to sell the underlying security at a set price (strike price) by a designated date (expiration date). When an investor sells a put contract on a stock, the seller is obligated to buy stock at that price if the option is exercised.

Expiration Date

The date on which an option expires. If the purchaser of an option doesn’t exercise the contract prior to expiration, he or she loses the premium paid for the contract. The purchaser no longer has any rights and the option no longer has value.

Strike price (exercise price)

The price per share at which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the contract.

Exercise

When the buyer of the contract implements the right to buy (in the case of a call) or sell (in the case of a put) the underlying security.

Assignment

The receipt of an exercise notice by an option writer (seller) that obligates the writer to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.

At-the-money

When the market price of the underlying security is equal to the strike price of an option contract.

Out-of-the-money

When the market price of the underlying security is below the strike price of a call option, or above the strike price of a put, giving the contract no intrinsic value.

In-the-money

When the market price of the underlying security is above the strike price of a call option, or below the strike price of a put, giving the contract intrinsic value.

Open Interest

The number of outstanding contracts in a particular options market or an options contract. This information can be broken down by puts and calls, strike price and expiration date for options tied to a particular security.

Time Value

The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.

Time Decay

A term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. Time decay is referred to in trading parlance as Theta.

Volatility

In options, a measurement of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns.

Implied Volatility

A measure of the expected volatility in the price of an underlying security that is calculated from current market options prices rather than from historical data about price changes of the underlying stock.

VIX (Volatility Index)

VIX, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility.

The Greeks (Delta,Gamma,Theta,Vega,Rho)

a number of key factors that influence the price of options contracts and are called such because of their names, which are all derived from Greek letters of the alphabet

Delta

The amount an option price is expected to change based on a $1 change in the underlying stock. Technically, delta is an instantaneous measure of the option's price change

Gamma

Gamma is typically highest for at-the-money stocks near expiration.

Theta

Theta becomes larger as an option nears expiration. Theta is also known as a contract’s time value

Vega

Vega typically increases as implied volatility increases

Rho

The amount the theoretical price of an options contract is expected to change based on a one percentage-point change in interest rates. Rho typically matters most for longer-term options