. . . . . . . . . . . . . . . . . . . . . . . . . 223Compounding Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Chapter 23 The Interest Rate Contracts . . . . . . . . . . . . . . . . . 225Eurodollars and T-Bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225The Contract Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226Comparing a T-Bill Futures Quote with a Eurodollar Futures Quote . . . 227Spreads Between T-Bill and Eurodollar Rates—The “TED” Spread . . . 228Hedging with the T-Bill and Eurodollar Futures Contracts . . . . . . . . . . . 229Treasury Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
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Treasury Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231Cross-Hedges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232Factors Affecting Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
Chapter 24 Hedging Applications forInterest Rate Futures. . . . . . . . . . . . . . . . . . . . . . . 235To Hedge or Not to Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235Hedge Ratios—Dollar Equivalency—And the Maturity Adjustment . . . 238Hedging—Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240Applications of an Interest Rate Futures Market . . . . . . . . . . . . . . . . . . . 242Hedging Against Falling Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . 243Hedging Against Rising Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . 245Reducing Basis Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247Hedging the Prime Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248Hedging the Fed Funds Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248Prefunding a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249Hedging Long-Term Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249Corporation Hedging Sinking Fund Obligations . . . . . . . . . . . . . . . . . . . 251Bank Issuing CDs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Chapter 25 Stock Index Futures and Options. . . . . . . . . . . . . 253What’s Traded and When . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254Computing a Stock Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255Volatility in Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256Circuit Breakers and Crash Protectors . . . . . . . . . . . . . . . . . . . . . . . . . . . 256Trading the Stock Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257Hedging Illustrated. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258The Portfolio Manager and Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259Stock Index Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
Chapter 26
Commodity Options. . . . . . . . . . . . . . . . . . . . . . . . 263
The Language. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264The Greek Language and Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266Options versus Futures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267Picking an Options Broker. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269xiii
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What’s an Option Worth? Determining the Option Premium . . . . . . . . . 271Futures versus Physicals versus Financials . . . . . . . . . . . . . . . . . . . . . . . 276Are Options for You? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277Creating Synthetics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
Chapter 27 Strategies for Trading Options . . . . . . . . . . . . . . . 279Using Options in Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280Strategies for Speculating in Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . 282Using the Futures to Convert a Call to a Put . . . . . . . . . . . . . . . . . . . . . . 284Options on Financial Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285Summary of Options Strategies under Various Price Scenarios . . . . . . . 287What Option To Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290Calculating Return on Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Chapter 28 Historical Development ofCommodity Futures Trading . . . . . . . . . . . . . . . . 297Characteristics of Organized Futures Trading . . . . . . . . . . . . . . . . . . . . . 298Emergence of Organized Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299Early Futures Trading in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300Development of Futures Trading in the U.S. . . . . . . . . . . . . . . . . . . . . . . 301Midwest Grain Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302Development of Chicago Commodity Markets . . . . . . . . . . . . . . . . . . . . 303Chicago Mercantile Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304Other Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304What’s Traded and Where? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305Commodity Futures Trading and the Law . . . . . . . . . . . . . . . . . . . . . . . . 305The Commodity Futures Trading Commission . . . . . . . . . . . . . . . . . . . . 311Self-Regulation and the NFA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
Chapter 29 The Commodity Futures Exchange . . . . . . . . . . . 317Nature of the Organization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318The Trading Floor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321Execution of Trades . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321Dual Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322xiv
Contents
The Clearinghouse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
Appendix I Commodity Trader’s Scorecard . . . . . . . . . . . . . . 327Glossary of Commodity Futures Terms . . . . . . . . . . . . . . . . . . . 331Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355About the Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
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List of Figures
1.11.21.31.41.5
Leverage Illustrated. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4T-Bond Futures versus CRB Index (weekly data). . . . . . . . . . . . . . . . 11S&P 500 versus Bond Futures (weekly data) . . . . . . . . . . . . . . . . . . . 12Dollar Index versus T-bills Futures (weekly data) . . . . . . . . . . . . . . . 12Dollar versus Bonds (weekly data) . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
4.14.24.34.4
MAR Trading and Dollar Size of Qualified Universe . . . . . . . . . . . . 29MAR Fund/Pool Qualified Universe Index . . . . . . . . . . . . . . . . . . . . 30Fund Structure: Efficient Portfolios Optimal Portfolio Size. . . . . . . . 38Efficient Frontier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
9.1
The Demand and Supply Structure for Pork . . . . . . . . . . . . . . . . . . . . 89
10.110.2
Cash Seasonal Omaha Pork Seasonals . . . . . . . . . . . . . . . . . . . . . . . . 96Pork Belly Seasonals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97xvii
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List of Figures
10.310.4
Changes in Hog Prices and Pork Production . . . . . . . . . . . . . . . . . . . 98Scatter Diagram of Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
11.111.211.311.411.511.611.711.811.911.1011.11
Chicago December Wheat. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107Point and Figure Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108September Eurodollars Point and Figure 10 × 3 . . . . . . . . . . . . . . . . 110July Cotton Point and Figure 40 × 2 . . . . . . . . . . . . . . . . . . . . . . . . . 111September Soybean Oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112September Corn. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113Corn Price Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115“Head and Shoulders” Formation . . . . . . . . . . . . . . . . . . . . . . . . . . . 116Comex December Silver . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117October Soybean Meal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118July Lumber. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
12.112.2
Elliott Wave Count Illustrated. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132Neural Network Illustrated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
15.1
Basis Relationship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
17.1
Cost-of-Carry Illustrated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
18.118.2
Crude, Heating Oil, and Gasoline Futures Prices (weekly data). . . . 180Heating Oil Less Gasoline (weekly data) . . . . . . . . . . . . . . . . . . . . . 180
19.1
2:1:1 Crack and 3:2:1 Crack Spreads (weekly data) . . . . . . . . . . . . . 196
22.122.222.322.422.522.622.7
Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218Normal Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220Flat Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220Inverted Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220Humped Yield Curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221Yield Curve Shift. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222Futures Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
23.1
TED Spread (weekly data) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
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List of Figures
26.126.2
Option Pricing Probability Diagram . . . . . . . . . . . . . . . . . . . . . . . . . 273Normal Distribution Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
27.127.227.327.427.527.627.727.827.927.1027.1127.12
Long Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293Short Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293Long Call. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293Long Put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293Short Call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293Short Put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293Short Call/Long Call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294Long Put/Short Put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294Long Call/Long Put. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294Short Call/Short Put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294Long Call/Long Put. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294Long Put/Short Call. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
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List of Tables
4.14.24.3
Comparison of Annual Returns 1989–1999 . . . . . . . . . . . . . . . . . . . . 34CTA Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36Multi-Advisor Correlation Coefficients . . . . . . . . . . . . . . . . . . . . . . . 39
6.1
Payoff or Mathematical Expectation. . . . . . . . . . . . . . . . . . . . . . . . . . 51
10.1
Building a Moving Average . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
15.1
Allowing For Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
17.117.217.317.4
Summary of Short Cattle Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169Futures versus Cash Hog Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171Worksheet for Live Hog Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172Hedging Corn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
18.1
Refiner’s Hedge of Fuel Oil Inventory . . . . . . . . . . . . . . . . . . . . . . . 181xxi
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List of Tables
19.119.2
Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192Put Ratio Back Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
22.1
The “Strip” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
24.124.224.324.424.524.624.7
Hedge Decision Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237Swiss Franc Buy Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240Canadian Dollar Sell Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241Hedging Short-Term Investment Rates . . . . . . . . . . . . . . . . . . . . . . . 245Hedging Commercial Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246Sell Hedge Eurodollar CDs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246Bank Hedge for CDs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
25.1
S&P 500 Index: An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
26.1
Adjustments for Futures, Physicals, and Financials . . . . . . . . . . . . . 276
27.127.227.3
Summary of Sell Futures—Buy Call Option . . . . . . . . . . . . . . . . . . 287Summary of Option Strategies under Various Price Scenarios . . . . . 288Summary of Bull Spread—Call Options. . . . . . . . . . . . . . . . . . . . . . 290
28.128.228.3
Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306Commodities and Instruments Traded Financials . . . . . . . . . . . . . . . 308Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
xxii
Introduction
STOCK VERSUS COMMODITIESThe late Vince Lombardi, legendary coach of the Green Bay Packers football teamduring their earlier glory years of the 1960s and early 1970s, once said, “Luck iswhat happens when preparation meets opportunity.”Lombardi was saying that, in the long run, people who are successful make theirown luck by being prepared to take advantage of favorable circumstances . . . andthose who rely on “chance luck” have very little hope of continued success.The purpose of this book is to introduce the beginner to the world of commodity futures trading, including the electronic trading aspects, and to aid in preparing one to take advantage of favorable circumstances that arise in the trading of commodity futures. Electronic tradings’ greatest impact is on the efficiency in themethod of trading and its ability to allow the trader nearly instantaneous ability toeffectuate a trade. You will still be required to do the same analyses and interpretation of data, though more of it, and to decide whether you are a buyer, a seller,xxiiiCopyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Introduction
a spreader, and so on. So, the bulk of this book will concentrate on helping you tounderstand the process of futures trading, decide whether futures trading is foryou, and, if so, help you to create a trading plan and execute it.This book will offer no sure-fire methods for making money, nor will it predictthe prices of any commodity. It makes no promises to turn you into a successful trader, because a successful trader needs more than knowledge about the market. It will,however, provide you with an understanding of many of the basic aspects of futurestrading—-knowledge without which only “chance luck” can work in your favor.The word commodity is used herein for the most part interchangeably withthe word futures. Futures contracts are now traded on many goods and services thatare not strictly commodities in the traditional sense. The concepts, ideas, anddescriptions in this book are applicable to futures whether the underlying “commodity” is agricultural, industrial, financial, foreign, or domestic.
A WORD ABOUT YOUR SUITABILITY FOR TRADINGCommodity futures trading is not for everybody. Commodity futures investmentsmanaged by others, however, have a much broader suitability to many investors.For example, you should not trade or invest unless you have money you andyour dependents can afford to lose. If you are in the proverbial “orphan or window”class, do not trade, and select your managed futures investments carefully