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CHAPTER 3 :bell: PRINCIPLES OF FUTURES - Coggle Diagram
CHAPTER 3 :bell: PRINCIPLES OF FUTURES
BASIC REQUIREMENTS
DEEP MARKET
:recycle:Since the focus is on agricultural product, the commodity selected for trading has to be easily graded, and hence standardized grading.
EASY TRADING
:recycle:Prices must be free to fluctuate without any government control or monopoly power. Price's volatility leads to higher risks for buyer and seller.
FREE FLUCTUATION
:recycle:Every futures market must have sufficient number of buyers and sellers in order to provide continuous opportunity for trade.
ACTIVE PARTICIPATION
:recycle:Business communities must be ready to participate actively and regularly in order to provide sufficient liquidity in the market.
CONTRACT SPECIFICATIONS
UNDERLYING INSTRUMENT
:lock:Every futures contract has its underlying physical instrument, which is traded, in the cash market.
:lock:The price of futures contract is based on the actual price of its physical instrument.
:lock:For example, BMDB is the futures market and BMSB is the cash market.
QUALITY
:lock:The quality of the underlying instrument is specified in futures contracts to ensure that participants trade the same type and quality of underlying instrument.
:lock:Commodity futures are graded on the technical requirements of physical commodity as the underlying instrument.
:lock:Financial futures are graded on the quality of the financial requirements.
PRICE QUOTATIONS
:lock:Similar to the cash market, futures prices are quoted in the same basic unit as its underlying instrument.
:lock:For example, CPO futures prices are quoted in Ringgit Malaysia per tonne because physical palm oil is also quoted in Ringgit Malaysia per tonne.
CONTRACT SIZE
:lock:The contract size refers to the number of units or amount represented by each futures contract.
:lock:For example, the contract size of CPO futures is 25 tonnes of palm oil.
CONTRACT MONTH
:lock:Futures contract is traded based on specified contract month, which is simply the month of maturity or expiry.
:lock:For example, if it is now April 2006, April is the spot month and May, and June are the forward months available for future trades.
EXPIRY DATE
:lock:The expiry date is the last day of trading in a particular contract month, and hence, futures contract ceases to exist after the expiry date.
:lock:For example, the maturity date for CPO futures is the 15th of the contract month, which there after, ceases to exist.
OFFSETTING VS SETTLEMENT
OFFSETTING
:star:Futures contract can be closed-out simply by taking the opposite position, or a contra to the original position.
:star:Any opened contract or position can be closed-out prior to maturity by taking an offset position.
:star:A trader who has buying position can therefore offset his position by selling, and vice-versa.
SETTLEMENT
:eight_pointed_black_star:Any outstanding contract, which has not been closed-out, must be settled at maturity.
:eight_pointed_black_star:At the date of maturity, which is the last day of trading for a given contract month, a trader will be required by the exchange to settle his due contract.
:eight_pointed_black_star::The settlement of futures contract however depends on the types of futures.
TYPES OF SETTLEMENT
PHYSICAL SETTLEMENT
:arrow_forward:Settlement by delivering the physical underlying instrument
CASH SETTLEMENT
:arrow_forward:Settlement by paying the amount of cash equal to the exercise price of the futures.
COMMODITY FUTURES VS FINANCIAL FUTURES
COMMODITY FUTURES
:explode:Commodity futures is the futures which the underlying assets are the commodity products.
:explode:For example; CPO Futures and Corn Futures
:explode:Commodity futures require that the buyer and seller fulfill their obligation or close their contract either by offsetting or settlement.
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FINANCIAL FUTURES
:fire:Financial futures is a futures contracts which the underlying assets are the financial products.
:fire:Financial futures include currency futures, interest rates futures, stock index futures and single stock futures.
:fire:Financial futures also require that the buyer and seller fulfill their obligation or close their contract either by offsetting or settlement
:fire:At maturity, a buyer will be a seller and a seller will be a buyer at a settlement price determined by the clearinghouse.
:fire:Both parties are required to settle the cash price differential, that is, the difference between the opening price (when the contract was opened) and settlement price (when the contract expired)
MARKET PARTICIPANTS
HEDGER
:pushpin:Hedgers refer to the actual owners of physical commodity or financial instrument.
SPECULATOR
:key:Speculator refers to the non-owners of physical commodity or financial instrument and they are not involved in the true business but are motivated by profits based on favorable price movements within specified period.
SPREADER
:bomb:Spreader refers to a speculator who has dual positions or contracts at one time.
:bomb:Can reduce his risk because the profit from one futures position will be more than loss in another contract.
ARBITRAGEUR
:green_book:Arbitrageurs refer to investors who have dual positions at one time, that is buying futures and selling physical, and vice-versa.
:green_book:This strategy requires the establishment of one position in the futures market and at the same time opposite position in the cash market.
TRADING PRACTICALITIES
OPEN POSITION VS CLOSE OUT POSITION
:black_flag:OPEN POSITION
-When the trader hold the futures contract until the expiry date.
-The holder need to make delivery of the assets or cash settlement.
:black_flag:CLOSE OUT POSITION
-Closing out a position means entering into the opposite type of trade from the original one.
-For example, the investor who bought a July CPO futures contract on March 3 can close out the position by selling one July CPO futures contract on April 20.
LONG POSITION VS SHORT POSITION
:warning:LONG POSITION
-The long position agrees to buy the assets when the contract expires.
-In other words, he is buying today at a lower price and expects to sell later at a higher price prior to or at maturity.
:warning:SHORT POSITION
-Agrees to sell the assets when the contract expires.
-He is bearish on its underlying and expects prices to fall in the future.
MARGIN REQUIREMENT
:tada:Margin payment is a legal requirement for every participant, be it the buyer or seller.
:tada:This is to ensure that traders have sufficient funds to cover their position in the market.
:tada:Margin, by definition, is a portion (margin) of contract value, normally 5% - 10%, which represents the commitment of both contracting parties in the futures trading.
BASIS
:soccer:Basis can be defined as the difference between the cash price (spot price) of the underlying instrument (physical) and the futures price (contract).
CONVERGENCE
:basketball:Generally, cash and futures price move in tandem, that is, they are moving in the same direction, though not by the same amount.
VOLUME AND OPEN INTEREST
:smiley:VOLUME
-Like stock market, volume refers to the number contracts traded. In futures market, volume of trading must be defined further as the total of purchases or sales for a given contract month.
:smiley:OPEN INTEREST
-Unlike the stock market, open interest is applicable only in futures trading.
-Open interest refers to the number of outstanding contracts for a given contract month.