INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics in Visual Studio .NET

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INTRODUCTION TO FUTURES AND OPTIONS: Understanding the Mechanics
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traders may be able to skip over the next sections, but those new to futures should read them carefully because they contain important concepts and terminology that make futures different from most other markets.
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GETTING INTO FUTURES
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For futures traders, the choice of products varies from the traditional to the exciting new trading vehicles now available. Everyone can relate to many of these markets that you use every day, from energy products such as crude oil or natural gas to agricultural markets such as meats, grains, and the socalled softs (coffee, sugar, cocoa). Prices are dictated by supply and demand functions that often are affected by weather. In addition to supply/demand influences, futures markets may provide a safe-haven security function. Precious metals such as gold may start to increase in price as investors on a global scale believe it is necessary to hold on to hard assets instead of paper assets in times of political tension or because they fear potential inflation resulting from the massive liquidity pumped into the global economy from 2001 through 2003. Financial instruments such as Treasury notes and bonds and currencies are also popular trading vehicles. In short, diversified products in all of these areas are available to futures traders and provide advantages in liquidity and leverage. Many of these markets also offer direct electronic access to traders. As long as there are products subject to supply/demand and price fluctuations that carry an element of risk, there will be a role for futures in the business world.
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THE FUTURES INSTRUMENT
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Many people, including traders, refer to commodities and futures as one and the same thing. To clarify that point first, the term commodities means an actual physical product such as corn, wheat, soybeans, cattle, gold, coffee, crude oil, cotton, and the like. The term futures refers to the instrument or the contract that is actually traded on these underlying products. Futures contracts have set standards for quantity, quality, financial requirements, and delivery points, if any (many futures contracts have cash-settlement provisions so there is no delivery). As the years have passed, futures contracts have been developed for new commodities such as foreign currencies and a number of financial instruments including interest rate products such as Treasury bonds and notes, stock indexes such as the S&P 500 index and Dow Jones Industrial Average,
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The Futures Instrument
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and, most recently, an innovative derivative product called single stock futures. Unlike equities, where stocks are quoted in dollars per share, different commodities have different contract values and different point values. The table of contract specifications for major U.S. futures markets (Table 1.1) lists the symbols and sizes of various futures contracts. For example, the contract size for corn is 5,000 bushels. If the value of one bushel is, say, $2.00, then the overall contract value is $10,000. The full-size S&P 500 index futures contract has a value of $250 times the index. If the index is at, say, 1,000, the value of the contract is $250,000, considerably larger than the value of the corn contract. Exchanges require a good-faith deposit usually called margin, although it does not have the same meaning as margin in stocks to play the game. For most futures contracts, you usually need to put up only 3 percent to 10 percent of the total contract value to trade. On the one hand, corn may have an initial margin requirement of $500 to $600 about 5 percent of the contract s value with a maintenance margin of $300. For that amount of money, you control 5,000 bushels of corn and can go long, speculating that prices will climb in the future, or sell short, speculating that the price will decline. The more volatile S&P contract, on the other hand, has a margin requirement closer to 7 percent or 8 percent or $18,000 to $20,000. The amount of money required to trade a contract may dictate what you trade if you have a small account. It has been argued that physical commodity products will find a fair value or an absolute value when they reach certain lows based on historical price comparisons and will never go to zero due to laws of supply and demand (Economics 101). Unlike stocks, commodities do not declare bankruptcy or go out of business. The reason futures will always have some value is because they do not exist solely for traders to bet on price movement. Producers and end users are also major participants in most futures markets as they use futures to reduce risk from adverse changes in price and to discover the current fair value for products they have to buy or sell to stay in business. Traders in this category are referred to as commercials or hedgers. You probably are in a second group: the individual speculator trying to capitalize on price swings created by the up and down forces in the marketplace. You may be trading from your home as a business or on the trading floor or trading as a sideline. A third category of futures traders includes the large speculators or fund managers who pool investors money together. These are sometimes referred to collectively as the commodity funds. One advantage of futures trading is that the government gives you an idea what each of these groups of traders is doing each week in the
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