Futures and Options on Futures
Farming is a risky venture. A lot of money, time, and effort is needed to produce farm products, with many risks, such as weather or price fluctuations in the market, which can result in high or low prices in the spot market (aka cash market), which is the market where the buyer pays cash to the seller for the immediate delivery of the commodity. Since the farmer can only sell in the spot market when the product is ready for delivery, there is no way to know beforehand what the price will be, and the same is true for the buyer—both have price risk.
The spot market is a zero-sum trade—if prices are too high or too low, either the buyer or the seller profits at the expense of the other. Thus, if grain prices rise, farmers benefit, but millers suffer because they have to pay higher prices for their grain. If prices fall, then farmers suffer, but millers benefit. Forward contracts became common in the 1800's to protect both the buyer and the seller by agreeing to a set price ahead of time.
A forward contract (sometimes called a cash forward sale) is a contract to supply a commodity at a given date for a specified price. No money is paid until the date of delivery. Before the organized exchanges, forward contracts were signed where farmers happened to be selling their goods, such as farmer's markets, public squares, and street curbs. But there were 3 main problems with individual forward contracts:
- there was a risk of default by the other party, especially if prices were either extremely high or low by the delivery date, which negated the main value of a forward contract—price certainty;
- the only way to legally terminate a contract was by mutual agreement, which would be unlikely when the market price was significantly different from the delivery price;
- there was no easy way to resell the contract, because it had customized terms that specifically suited the seller and buyer—hence, forward contracts were highly illiquid.
Eventually, organized exchanges developed that solved these basic problems. To lower the risk of default, the exchanges required that money be deposited with a 3rd party to ensure the performance of the contract.
The exchanges also standardized the contracts by stipulating the types of contracts that they would sell, including its terms. Standardized contracts were easier to sell or to offset with another contract that eliminated the liability of the original contract. Standard specifications include the amount of the commodity, the grade, and delivery dates. These standard forward contracts were called futures, and the exchanges developed listings for these contracts that greatly increased their liquidity.
More recently, futures were created based on assets completely different from agricultural products, such as stock indexes, interest rates, and even the weather, and provided more investment opportunities for many more investors. They became great tools to hedge portfolios or to simply profit from speculation.
The buyers and sellers of futures can be classified as hedgers or speculators. Hedgers use futures to minimize risk, like the farmers who use futures to guarantee a price for their product, or a miller who wants a set price for grain when it is harvested. Futures can also be used to hedge investment portfolios. Thus, futures is a significant means of price risk transfer—transferring price risk to someone with an opposite risk, or to a speculator who is willing to accept risk to make a profit.
Speculators use futures to make a profit, by buying low and selling high (not necessarily in that order). The speculator has no intention of making or taking delivery. A speculator is making a bet on the future price of a commodity. If he thinks the price of the commodity will drop, he takes a short position by selling a futures contract. If he thinks that the price of the commodity will increase, then he takes a long position by buying a futures contract. Later, he will close out his position by offsetting the contract. If he sold short, he will buy back the contract, and if he bought long, then he will sell the contract.
The buying and selling of futures contracts is a zero sum gain, because it is basically a contract between 2 traders. It is not an investment in a company that creates wealth, where every shareholder can win—or lose. If the short side profits, the long side loses an equal amount, and vice versa.
The number of assets on which futures are based has greatly increased. In fact, most futures contracts today are financial futures, which have nothing to do with farming or agricultural products, and futures continue to expand in diversity.
|Agricultural Futures||Petroleum Futures||Interest Rate Futures|
|cattle-feeder||crude oil, light sweet||Treasury bonds|
|cattle-live||gasoline-New York RBOB||Treasury notes|
|cocoa||unleaded gasoline-New York||5 yr. Treasury notes|
|coffee||heating oil No. 2||2 yr. Treasury notes|
|corn||natural gas||30 day Federal Funds|
|cotton||Metal Futures||1 month LIBOR|
|orange juice||Index Futures||Canadian Dollar|
|pork bellies||DJ Industrial Average||Euro|
|rough rice||Mini DJ Industrial Average||Japanese Yen|
|soybean meal||S&P 500 Index||Mexican Peso|
|soybean oil||Mini S&P 500 Index||Swiss Franc|
|sugar-domestic||Mini NASDA 100|
|wheat||U.S. Dollar Index|
The 1st exchange was organized in Chicago, because the Midwest was a major producer of agricultural products, and, thus, Chicago was a major center for trading agricultural products, with many processing plants and warehouses for agricultural products located there.
The Chicago Board of Trade (CBOT) was the 1st organized exchange for grain. The Chicago Mercantile Exchange (CME) started in 1874 as the Chicago Produce Exchange, then renamed itself the Chicago Butter and Egg Board because that was what was listed on the exchange. As the number of commodities traded increased—including hides, onions and potatoes—it was inevitable the exchange would adopt its present, more general name in 1919. CBOT and CME have recently merged as the CME Group.
The types of assets underlying futures became more diverse:
- frozen pork bellies began trading in 1961, the 1st year futures on stored meat was traded;
- live cattle was added in 1964, the 1st futures contract for live animals.
In 1972, the CME introduced financial futures that consisted of 8 currency futures. The 1st cash-settled futures contract—CME Eurodollar—was introduced in 1981. Allowing cash settlement instead of physical delivery allowed the futures market to expand into products that either can't be delivered or would be difficult to deliver physically, such as futures based on stock indexes, such as the S&P 500 stock index, that was introduced in 1982. Offering cash-settled futures eliminates physical delivery, which hedgers and speculators have no interest in, while providing the 2 important advantages of futures: the ability to hedge portfolios and to profit from speculation.
Today, underlying assets include agricultural commodities, foreign exchange products, interest rate products, equity products largely based on major indexes, alternative investment products, which includes energy, weather, economic derivatives, and housing index products, and TRAKRS (Total Return Asset Contracts), based on commodities, euro currency, and gold, for instance.
The futures market is regulated in the United States (US) by the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA) and by the exchanges themselves. The CFTC, created by the Commodity Futures Trading Commission Act of 1974, is a federal agency that regulates all futures trading in the United States, and oversees the NFA. The exchanges must obtain approval for any regulatory changes, and for the introduction of any new futures or options on futures. All futures exchanges must have trading rules, contracts, and disciplinary procedures approved by the CFTC.
The NFA, a self-regulatory agency, regulates the activities of its members, including brokers trading futures and their agents. NFA's responsibilities include screening, testing and registering persons applying to conduct business in the futures industry. NFA and the exchanges have responsibility for auditing and enforcing compliance with industry rules, such as financial requirements, segregation of customers' funds, accounting procedures, sales activities, and floor trading practices.
A futures contract's specification details (also called: contract specs) include the type, quality, and quantity of the underlying asset or commodity, months traded, daily limits, minimum tick increments, trading hours and other details unique to each product. All contract specs can be found online at the exchange trading the contract.
The underlying assets of futures contracts are agricultural commodities, metals and minerals, energy, such as oil and coal, currencies, and what are called financial futures: fixed-income securities and stock market indexes. Financial futures are, by far, the largest market for futures.
The futures price is the price paid at the specified date for the commodity. The exchange sets allowable grades for agricultural commodities, such as No. 1 soft, red wheat or No. 2 hard winter wheat.
Example of Contract Details for 2 Butter Futures and 1 Option on Butter Futures.
Source: Chicago Mercantile Exchange
|CME Butter Futures|
|Trade Unit||40,000 pounds of Grade AA butter|
|Settle Method||Physically Delivered|
|Point Descriptions||1 point = $.0001 per pound = $4.00|
|Contract||Six months of March, May, July, September, October, and December.|
|Hours||9:30 a.m. to 1:10 p.m. LTD (12:10 p.m. If the LTD is on a day that the market closes early, then the time is 11:10 a.m.)|
|Listed||All listed months|
|Limits||$0.05/lb., 500 pts., $2000 Expandable price limits, see Rule 1202.D|
|CME Butter Options|
|Trade Unit||One Butter Futures Contract|
|1 point = $.0001 per pound = $4.00|
|Contract||Mar, May, Jul, Sep, Oct, Dec and Flex Options.|
|Strike Price Interval||Cents per pound at $0.02 intervals (i.e., 1.20, 1.22, 1.24)|
|Hours||9:30 a.m.-1:12 p.m. LTD (12:10 p.m.)|
|Listed||All listed series|
|Strike||All listed intervals|
|CME Cash-Settled Butter Futures|
|Trade Unit||20,000 times the USDA monthly weighted average|
price per pound in the US for Grade AA Butter
|Settle Method||Cash Settled|
|1 point=.00025 per pound =$5.00|
|Contract||12 consecutive calendar months.|
|Trading Venue||CMEÂ® GlobeÂ®|
|Hours||9:30 a.m.-1:10 p.m. (12:10 p.m. LTD)|
|Limits||$.05 per pound expanded to $.10 per pound after one day limit move. No limits during last 5 days of the expiring contract month.|
Like options, futures contracts have a limited lifespan, known as contract maturities. Most contracts expire in less than a year, which is why the expiration month is sufficient to determine the expiration date. However, a few contracts last longer—sometimes more than 2 years, such as the CME Eurodollar futures. A good many contracts expire quarterly—in March, June, September, and December. Futures contracts also have a day in the expiration month designated as the last day of trading. For instance, the September CME Canadian Dollar futures contract's last day of trading is the business day immediately preceding the 3rd Wednesday of September.
A purchaser of a futures contract has the long position, whereas the seller of the contract has a short position. The short position holder delivers the commodity to the long position holder at the settlement date. The long position holder profits when the price of the commodity increases, whereas the short position holder profits when the price of the commodity decreases.
Many futures contracts are bought and sold to hedge risk. A long hedge involves buying a futures contract to guarantee a fixed price for the asset. A short hedge involves selling a futures contract to guarantee getting a minimum price for the asset. For instance, a farmer who wants to protect against possible price declines for his crop would sell a futures contract for the crop to lock in the price. Thus, commodity users are long hedgers—they buy futures contracts to hedge any price increases, while commodity producers are short hedgers—they sell futures contracts to hedge against price decreases.
While hedging enables businesses to set prices and determine cash flow in the future, it also eliminates any potential profits that might have been realized without the hedge. Thus, if a farmer sells a contract for his corn to sell at a particular price at harvest time, he will not receive any more money for his crop, even if the price of corn skyrockets.
Hedging is not usually perfect. There is usually a difference in basis from the time that the contract was bought until it was closed out. Sometimes, a hedger will have to sell or buy something that a futures contract doesn't exactly cover, but the price movement will be similar. For instance, a futures contract for live cattle may specify that the cattle be corn-fed. So a rancher raising grass-fed cattle—a lower quality cattle—may sell a futures contract for corn-fed cattle, to cross-hedge his position. If the price for cattle declines, it will probably decline whether it is corn-fed or grass-fed, so this rancher will lose on his grass-fed cattle, but will gain on his short position on corn-fed cattle.
He will have to close out of his position before expiration, because he cannot fulfill the contract by delivering corn-fed cattle. Cross hedging is hedging one commodity with a futures contract for a related commodity. In addition to basis risk, there is also a price risk in cross hedging in that the futures contract price will diverge from the hedged commodity.
Every short position is offset by a long position. Therefore, the net proceeds of all transactions is zero. Every profit is offset by a loss, and, therefore, the futures markets have no significant impact on the prices of the underlying commodities.
The Mechanics of Order Flow
The old method, and still commonly used method of trading futures is, after sending an order to a broker, the broker sends it to the trading floor of a futures exchange for that particular futures contract, where floor traders and exchange members, through hand and visual signals—the so-called open outcry method—transmit buy and sell orders. Open outcry trading also uses electronic tickers and display boards, hand-held computers, and electronic entry and reporting of transactions. The display boards also show quotes from other American futures exchanges.
The exchange has trading pits, where buyers and sellers standing on steps that descend into the pit shout orders and signal the orders with their hands. Each pit specializes in a specific commodity, and is the only place to trade that commodity. Options on that futures commodity are typically located in an adjacent pit. Workstations surround each pit provide members of the exchange a communication link to brokers and large institutional investors. These orders are then either flashed to the trading specialist through hand signals, or delivered to the pit by runners. Different sections of the pit correspond to different contract expiration months, with the nearest month, by far the most actively traded, occupying the largest section.
Electronic trading predominates both worldwide and in the US, where buy and sell orders are matched or queued in computerized trading systems. Matches are executed immediately; unmatched orders are queued by price, with the highest price listed as the current bid price, and the sell order with the lowest price as the current ask price. Buy or sell orders with the same price are queued on a first in/first out (FIFO) basis.
At least 65% of all futures exchanges are outside of the United States, and most trade electronically. Worldwide competition is forcing the US futures exchanges to go electronic, since electronic trading is faster and cheaper. However, open outcry trading still has significant, albeit dwindling, volume, as exchange members cling to their vested interest in floor trading. At CME, for instance, some contracts trade simultaneously on the floor and electronically; other contracts, on the floor during exchange hours, then electronically other times; while other contracts are only traded electronically.
The CME Globe, first operational in 1992, was the 1st electronic derivatives market, and is operational at all hours from Sunday evening to Friday afternoon.
|A list of the major futures exchanges in the United States.|
In addition to these exchanges, almost all stock exchanges
also trade some futures or options on futures.
|List of United States Futures Exchanges|
|Chicago Board of Trade (CBOT)|
|Chicago Board Options Exchange (CBOE)|
|Chicago Mercantile Exchange (CME)|
|International Securities Exchange (ISE)|
|Kansas City Board of Trade (KCBT)|
|Minneapolis Grain Exchange (MGE)|
|New York Board of Trade (NYBOT)|
|New York Mercantile Exchange (NYMEX)|
When a buyer and seller agree on price, quantity, expiration month, and the underlying asset, the clearinghouse then buys the seller's contract, then sells it to the buyer. Because the clearinghouse is the trader to both parties, neither worries about contract performance. Furthermore, each trader can close out his position independently of the other.
If a trader fails to fulfill his contract, then only the clearinghouse is hurt. To prevent this from happening, a performance bond (margin), must be posted, in the form of cash, or near-cash equivalents, such as T-bills. The initial performance bond (or initial margin requirement) is typically 5%-15%, with more volatile commodities requiring a higher amount. The requirements are lower for a hedger than a speculator, because the hedger is covered. The performance bond minimum is determined by the exchange, but the broker may set a higher amount. Furthermore, the futures contracts are marked to market every day, and the traders' account balances are credited or debited accordingly, with credits increasing the margin in an account and debits decreasing it. For this reason, the margin in futures is sometimes referred to as variation margin, because it varies with the value of the futures contracts. There is a maintenance performance bond (or maintenance margin percentage) typically 75% of the initial requirement, so that if the account balance drops below the maintenance requirements, then the trader will be subject to a performance bond call (or margin call) to bring the account balance back to the original requirement. If the trader fails to deposit more money, then the clearinghouse will offset enough contracts to bring the balance to the required level.
Although the money deposited in a futures account is often called margin, it is not the same as margin used to purchase stocks, because the trader is not borrowing money to buy a futures contract, and no interest has to be paid. In fact, you don't actually buy a futures contract, you take on a contractual obligation as a seller or buyer of the contract, which, in and of itself, costs nothing. If I have a futures contract to purchase wheat in July, then I don't actually pay for it until the day of the delivery, if I don't offset the contract before then. In this way, a futures contract is like a forward contract, because the money in the account isn't used to pay for the underlying asset until the final day of the contract. In a sense, the contract is settled every day as the account is marked to market. The money deposited in a futures account is a good faith deposit to insure that the trader will fulfill the obligation of the contract, which is why it is more properly called a performance bond. The deposit in a futures account can even be in the form of T-bills that earns interest.
Listings for Futures
Futures contracts are designated by product codes, or ticker symbols, just as other securities. Most are 2 or 3 letters with a final letter to designate the month of expiration. Sometimes the ticker symbol for a futures contract traded on the exchange floor is different from the futures contract traded electronically. For instance, the ticker symbol for live cattle is LC, but on the CME Globe, it is LE. Another example of a product code is JYZ for the CME Japanese Yen that expires in December. JY stands for Japanese Yen, while the final Z designates an expiration month of December.
Options on futures have a similar format: option, contract, month. So the ticker symbol for a CME Live Cattle put option is PKV. The codes for the expiration months is the same as it is for futures.
Trading volume is the number of trades. When someone buys a contract, then someone else has to sell it. This would seem like 1 transaction; however, because the clearinghouse is actually the buyer to every seller and the seller to every buyer, each buy increments trading volume by 1, and so does each sale. So when there is a seller and buyer for a particular contract, then the clearinghouse intervenes in the transaction, buying the contract from the seller and selling it to the buyer, resulting in a trading volume increment of 2.
Open interest is the number of outstanding contracts on a given asset that matures at a specified time. It is equal either to the number of long positions or the number of short positions. Thus, a single trade, both the short side and the long side, is counted as an open interest of 1. Open interest is low when the contracts first start trading, then increase as the last month of the contract approaches. Then most traders close out their positions before the final day of the contract. As in options, a short seller closes his position by buying back the same contract, and the long buyer closes her position by selling the contract. Because most traders of futures are either speculators trying to make a profit, or hedgers trying to protect a portfolio position, few of them make or take actual delivery of the underlying commodity. Only about 1%-3% take actual delivery of the contract's underlying asset for those assets that have a delivery settlement (in contrast to a cash-settled futures contract).
The prices for futures and options on futures can be obtained from major newspapers or from the Internet. Newspapers group the contract listings by their underlying asset: grain, oilseed, livestock, food, metal, petroleum, interest rates, currencies, and index futures. Some of the contract terms are also specified, such as quantity or quality.
While price listings are much like stocks or options, there are 2 prices quoted for highest and lowest value since the contract started trading, called the Life-of-Contract High and Life-of-Contract Low. The closing price for the day is known as the settle price.
Types of Futures Orders
As with stocks, there are different types of orders that can be placed for futures. However, these orders differ to some extent, depending on whether the order is filled though the open outcry method, or electronically. The types of orders that can be placed electronically also depends on the broker and the software used to place the order.
The types of orders that can generally be submitted are much the same as for stocks. A market order is filled immediately at the current market price. A limit order is an order to buy or sell at a specified price or a better price. A market-limit order is filled at the best available price, but if there are not enough contracts at that price to complete the order, the rest of the order becomes a limit order at that price.
A stop-loss order is a market order that is only triggered if the contract reaches a certain price, and is generally used to limit losses. A buy stop is triggered by a price above the market. When the market price reaches that level, the buy stop becomes a market order. This type of order is often used by short sellers to limit their losses. A sell stop is placed below the market, and is triggered when the market price falls to the sell stop price. A sell stop helps to limit losses for a long position. A stop-limit order is the same as a stop-loss order, except that the order becomes a limit order at the stop price instead of a market order. The stop-limit order is not reliable as a means to limit losses because the price can move past the limit without triggering the order.
A spread order is an order to buy 1 contract at a specified price and to sell another contract of the same or related commodity for a specified price difference.
Other orders may be available for electronic trades depending on the software used to place the order.
The settlement of a futures contract is either by delivery of the commodity or by cash settlement. Most future contracts are actively traded and are closed out by offsetting before the settlement date. Eliminating a futures position is sometimes called offsetting, because a long or short position is eliminated by purchasing the offsetting contract. A short position is closed by buying back the contract that was sold, and a long position is closed by selling the contract that was bought. Thus, most future contract holders rarely take actual delivery of the product, even when the product is a deliverable commodity.
Delivery for agricultural commodities is made by transfer of warehouse receipts from approved warehouses. Financial futures may be settled by a wire transfer, and stock index futures are settled in cash, just as stock index options are settled.
Cash-settled futures contracts are closed out either by an offsetting trade, or by a final mark-to-market settlement adjustment, using the Final Settlement Price as determined by the exchange, of the trader's account. A final mark-to-market adjustment is made to the trader's performance bond account the day after the final day of trading. The trader will only either receive the difference, if it was profitable, between the initial price and the final price of the contract—not the full contract value—or pay this difference, if it was a loss.
Commodity prices and the prices of futures contracts for those commodities tend to move together, because the price of any futures contract is obviously related to the spot price (also called the cash price)—the current market price of the commodity. Basis is the difference in price between the commodity and the related futures contract. Basis can be large for those contracts with at least several months remaining until expiration, because, while the spot price is determined by the current supply and demand for the commodity, there may be different expectations about the supply and demand at expiration. This is why the prices of futures contracts with long remaining terms can move significantly in response to news or rumors about the supply and demand of the underlying commodity. But as the last day of trading approaches, the futures price will converge to the spot price, until on the last day of trading, the basis becomes zero—the price of the futures contract equals the price of the underlying commodity. This is sometimes referred to as the convergence property of futures contracts. This must be so, because if the prices were different, arbitrageurs would buy the cheaper product and sell the more expensive one until there was no difference between the 2 on the last trading day.
Profits and Losses
A futures contract can be bought or sold to hedge risk or to profit from speculation. Future contracts are marked to market and must be settled daily as the price changes. Traders can use margin requiring a cash outlay of 5-15%, which provides leverage for increased profits and losses.
The short side's profit or loss is the long side's loss or profit. In essence, it is a zero sum game—the short positions exactly offset the long positions. If F0 is the initial contract price, and Ft is the contract price when it is closed out or fulfilled, then the short trader's profit or loss is equal to F0 – Ft, whereas the long trader's profit or loss is equal to Ft – F0. If the futures position is held to maturity, then the futures price will equal the spot price on the last day of trading for the contract.
Long Profit = Spot Price at Maturity – Original Futures Price
Short Profit = Original Futures Price – Spot Price at Maturity
What makes futures so potentially profitable is the low margin requirements. Whereas, the typical initial margin requirement for stocks is 50%, the typical initial margin requirement for futures is 5% - 15%, with more volatile commodities requiring more margin. The reason why margin requirements are much less for futures than for stocks is because commodities have a much narrower trading range. There is virtually no chance that the price of oil or corn, for instance, will drop to zero, nor will it climb too high. Furthermore, the daily marking to market helps to keep account balances from getting too low in relation to potential liabilities.
Thus, large potential profits or losses can result from small changes in the price of the commodity.
A particular strategy for a better chance of making profits is to use a spread over a straight position that profits only if the contract either rises or falls in price. A spread depends on its profits and losses by the difference between 2 positions, usually a short and a long position on closely related commodities, such as cattle and hogs. For instance, maybe you observed that when prices went up, cattle prices went up more than hog prices, and when they went down, they went down less than hog prices. By using a spread—in this case, buying cattle futures and selling hog futures—you can profit regardless of what the direction of the market will be.
Spreads are often based on related commodities, which tend to rise and fall in price together. This may occur because the commodities are close substitutes. For instance, cattle provide beef, whereas hogs provide pork. If one price rises faster than the other, then people will tend to buy more of the less expensive item, and less of the more expensive item, which, in turn, drives down the price of the more expensive item and raises the price of the other. Another factor that can cause commodities to rise and fall together is the dependency on similar conditions or markets. For instance, drought or abnormally cold weather can affect many agricultural commodities. Another strong coupler of prices is when one product is derived from another. Gasoline, for instance, is going to rise and fall in price with oil, since gasoline is derived from oil.
Arbitrageurs continually look for abnormal spreads, where the price difference between 2 different, but related futures contracts, is greater or smaller than the usual difference between the contracts. If there appears to be no good reason for the difference, or if the cause giving rise to the discrepancy is expected to change within the year, then arbitrageurs will take the spread in the hope of making a profit later.
Note that spreads are taken and liquidated as a whole. While it is possible to take a spread by buying long and selling short at different times with different orders, a spread order is one that must be taken as a whole and liquidated as a whole, because it constitutes 1 order.
An interdelivery spread is a spread involving the same commodity, but with different expiration months. A bull spread is a spread that profits when prices rise. In most of these cases, the near expiration month is taken long, while the distant month is sold short, because the near month increases in price faster than the later expiration month.
An intercommodity spread is a spread on different, but related commodities that expires the same month. Profits are possible, because, although prices tend to rise and fall together, they do not change at the same rate. Thus, the price gap could become wider or narrower near expiration.
An intermarket spread takes advantage of price differences, even among futures contracts with the same terms, between different exchanges. This can result because the markets do not have a direct connection, and thus, the supply and demand in one market will likely be slightly different in another market. Although arbitrageurs narrow this difference, the process is not perfect or instantaneous, and is continuously changing. Thus, opportunities arise for those arbitrageurs actively searching for such discrepancies. For instance, wheat is traded at 4 Midwest exchanges, and gold futures are traded in Chicago, New York, and London. Without arbitrage, prices for wheat and gold at the different exchanges would likely diverge to some extent.
An intermarket spread can also involve related futures instead of the same futures in different markets. This is particularly true of financial futures. Stock indexes, for instance, often move together. Thus, different index futures can be traded in different markets for possible spread profits.
Taxes — Section 1256 Contracts
The IRS classifies exchange-listed futures contracts as §1256 contracts, which are regulated futures contracts that are marked to market by an exchange that is subject to the oversight of the Commodity Futures Trading Commission.
Since futures accounts are marked to market daily, with earnings credited and losses debited from the accounts at the end of every day, tax authorities have decided to take advantage of this by taxing accrued earnings for the year, regardless of when the position is closed out.
Marked to Market Rules
A gain or loss must be determined on all §1256 contracts held for speculative profits — but not for hedging — at the end of the tax year that would result if they were all sold. These results will later be used to modify the actual gain or loss realized when the contracts are finally sold.
Regulated futures contracts receive preferential tax rates: 60% of capital gains or losses are considered long-term, which is usually taxed at a lower rate, and the remaining 40% is considered short-term capital gains or losses, regardless of the actual holding period for the contract.
Example — How Gains and Losses are Reported for Tax Purposes — the 60/40 Rule
In 2004, you bought a regulated futures contract for $50,000. At the end of your tax year, on December 31, 2004, the mark-to-market value of the contract was $58,000. Therefore 60% × $8,000 = $4,800 of your gain is subject to the long-term capital gain tax rate and 40% × $8,000 = $3,200 is subject to the short-term rate.
On March 1, 2005, you sold the contract for $55,000. Since you paid taxes on a $8,000 gain on your 2004 return, your 2005 return will report a loss of $3,000 ($58,000 - $55,000), 60% of which is characterized as long-term and 40% as short-term.
Gains and losses from all §1256 contracts — contracts actually closed out and held contracts that are marked to market — are figured and reported in Part I of Form 6781, Gains and Losses From Section 1256 Contracts and Straddles.
Options on Futures
A futures contract is a legal obligation to buy or sell a commodity for a specified price on a specified date. An option on a futures contract is the right, but not the obligation, to buy or sell the specified futures contract at a specified price before the expiration date. With a futures contract, you can fulfill your obligation by either exercising the contract, or offsetting the contract by buying back a short position or selling a long position. An option on a futures contract offers the same ways to close the options contract: exercise it by buying or selling the futures contract, or by offsetting it by buying back a short options position or selling a long position.
However, an option contract offers one other course of action not available to the holder or seller of a futures contract—an option seller or holder can simply let the contract expire, and will do so if it is worthless at expiration. For this reason, options on futures are less risky than futures, because all that is lost for the option holder when the option expires is the premium, which is the amount that the option cost. However, premiums for options on futures contracts are generally much higher than for stock options. As is true with options in other assets, the risk for short option positions is substantial while the profit is limited to the premium received.
Options on futures are like options on stocks, but the underlying asset is a futures contract instead of a stock. The contract terms for options on futures is the same as options for stocks: put or call, strike price, expiration date, and quantity. Note, however, that options on futures expire before the underlying futures contract. For instance, Sep 2005 CME British pound call options expired on September 9, 2005, while the underlying futures contracts expired on September 19.
Flexible Options, Serial Options, and Options on Spreads
In addition to regular options on futures, there are also some specialized options available for futures:
- Flexible options allow institutional investors to specify some of the contract terms for options, such as a nonstandard strike price, expiration date, and whether it will be an American or European option.
- Serial options expire monthly. The underlying futures contract is the next one to expire for a given asset.
- Options on spreads are options on Futures Contract Spreads, which is the purchase and sale of a futures contract on the same underlying asset, but that expires in separate months at a specified price difference.