Level: Intermediate

A futures contract is defined as an agreement to buy or sell an underlying at a later time, but today, futures have far more important uses and implications on the general market.

What is a Future?

Think of a future as a contract. Futures were initially created for the agricultural world. Farmers, who put time and money into their crops, did not want to see their profits evaporate just because of changing spot prices for the crop they were raising. Food manufacturers also wanted to lock in a stable price in order to ensure that they could purchase raw food at a reasonable price. The solution was an agreement between the two parties: Farmers agreed to sell to the manufacturer a product for a certain price. This contract is called a futures contract simply because it locks in a price of exchange for both the buyer and a seller regardless of the spot price at any future time.

Let’s consider a general example. A established a future contract with B to sell one unit of product to B for a price of X. Imagine that the price of the product increases to X + 10. The result would be a relative loss for A of 10, in terms of opportunity cost, and a gain for B of 10. On the other hand, if the spot price of the product had since depreciated, A would win by 10 and B would lose by 10. This is a conservative situation, analogous to conservative forces in physics. Money is conserved, and this is a zero sum game between the two parties.

Instead of taking actual delivery of the product, what would happen if the contract was cash settled? Take the same situation and the same futures contract. A few months after the contract is established, the product price is at X + 10. That would result in a loss for A, and a gain for B, as we have determined before. However, the contract has not reached maturity, and A wishes to nullify the contract before further losses are realized. A cannot legally nullify the contract under U.S. contract law without B’s consent. However, what A could do is negotiate with B in order to establish another contract. This contract would state that B would sell A one unit of product for X+10. Upon maturity, both A and B would swap product in order to realize A’s loss and B’s gain, both of which are dependent on the move since the second contract was established. The swapping of the product was unnecessary. Therefore, instead of physically trading product twice, why couldn’t A and B have simply settled the two contracts with cash? A would have to pay B the amount of 10, and there would be an equivalent and more efficient solution. This nullification retains the same initial property of a single contract: money is conserved. Therefore, we can expand this situation to involve more than one person.

Let’s use the same example, but also assume that B is unwilling to strike a second contract with A. Instead, a third party, C, is introduced. A establishes a contract with C that states that C would sell A one unit of product for X + 10. Consider what would happen at expiration if the final price of product was X + 5. A would lose 10, because he already nullified his positions previously. B would net a gain of 5. C would also net a gain of 5. Again, the conservative nature of the contractual exchanges is retained. Let’s extrapolate this situation to the general market. C could represent an entire network of buyers and sellers, with only a few parties actually using futures to hedge the actual product or take delivery of it. This is where the fundamental nature of the futures market comes around, and it explains why such a wide variety of futures products for trading exist, why traders trade them even though they are not interested in the underlying itself, and the inherent risk in trading such products.

Today, the futures market is extremely large, with $81 trillion outstanding in 2008. Compare this to the entire world’s stock market, at $55 trillion.

What is the Structure of a Future?

Look at the following link to see a list of traded commodities that futures exist on: http://en.wikipedia.org/wiki/List_of_traded_commodities. Futures are traded on more underlyings, too. For example, the E-mini S&P futures have an underlying of the S&P 500 index. The index cannot be traded, or exchanged, or delivered, so the resulting bets are settled in cash. This again points to the speculative nature of futures and exemplifies how few people actually wish to own the underlying.

Trading hours: These vary depending on the underlying. A full list for CME-traded products is here: http://www.cmegroup.com/trading_hours/. The E-mini’s hours are: MON – FRI: 5:00 p.m. previous day – 4:15 p.m.; trading halt from 3:15 p.m. – 3:30 p.m. As you can see, hours differ significantly from the stock market.

Tick size: This is the increment in which contracts are traded. The E-minis trade in increments of 0.25. Additionally, there is a multiplier for each contract traded, just like with options, that varies. The E-mini multiplier is 50, which means the actual dollar value is $12.50 for each increment.

Exchanges: These exchanges are some of the more popular ones: Chicago Board of Trade (CBOT), CBOE Futures Exchange (CFE), Chicago Mercantile Exchange (CME), Commodity Exchange (COMEX),  Globex (GBLX), Intercontinental Exchange (ICE), Kansas City Board of Trade (KCBT), Minneapolis Grain Exchange (MGEX), and the New York Mercantile Exchange (NYMEX).

Futures are issued for different underlyings with different expirations. The one you will see listed is the nearest expiration, or the “active” one. Volume is usually highest for these contracts also. Different naming conventions for expirations can be seen at Wikipedia.

Why Do Futures Matter?

Traders who trade futures with no interest in owning the underlying still affect the underlying spot price. This concept is best illustrated with an example. The Flash Crash that occurred in 2010 that caused the Dow to drop almost 1,000 points was triggered by an event in the futures market. An institution sent a large sell order for the E-mini futures that couldn’t be filled. This triggered a major selloff in the futures market. High frequency trading algorithms then extrapolated that fall in futures, noticed a tradeable arbitrage opportunity between the E-minis and the Dow and S&P and other large corporations, and took the opportunity. This in turn caused a large selloff in the equities market as a whole.

If an individual investor like you wants to trade futures, you must obtain Tier 2 approval from your brokerage account, and maintain sufficient margin to carry out any trades. Options on futures require Tier 3 certification.

Conclusion

Futures are an important factor to consider in today’s market environment. Their history is intertwined with the speculative nature of such contracts, and explains why futures gyrations can have an effect on the market. When trading futures, keep in mind that they are instruments that are as speculative as options.

Questions

Completion of the following questions is mandatory for club officers and future officers, and is recommended practice for everyone.

1. Research the Flash Crash, and write three or four sentences on why HFT systems would take advantage of a fall in futures prices.
2. Research the history of futures, and write three or four sentences in which you explain the beginnings of the futures market (include where, when, and why).
3. Create your own scenario in which a Flash Crash occurs. Do not use the same scenario as the original one, as those failures have been corrected by safeguards. Be realistic and thoughtful while thoroughly explaining the nature of events and the sequence that leads to a large fall in the S&P 500 and/or Dow. This will be 5-10 sentences.

Hello members,

This is a table I have compiled in association with the President. Enjoy. Michael will be creating a larger version of the same table, so stay tuned for some more useful cheat sheets. Link here: https://docs.google.com/spreadsheets/d/1ib4vTWOOeNFIPl3JRjm8qM0ebscVKc_BWbBlDzMUPeQ/edit?usp=sharing

Hello members,

I have recently created a document detailing the energy sector companies in the S&P 500. This is required reading, and you should eventually memorize the tickers. See it here. I will be creating a video also on this sector.

I will also be creating a document and video for each of these sectors. Enjoy!

– Michael Trehan

Hello members,

This is the first video blog on the website. Enjoy

– Michael

Level: Intermediate

Introduction

Volatility Skew is a broad term that refers to the distribution of implied volatilities (IV) across strike prices for a single expiration. It could also refer to an IV-Expiry graph, but we will be focusing on the more common definition. For a two-dimensional graph, the values plotted for a skew would be the strike price on the x-axis, and the implied volatility of that strike on the y-axis.

Keep in mind, though, that in financial lingo, volatility skew and volatility smile are two separate terms, both of which describe the shape of the graph.

Volatility skew graphs are commonly available in most trading platforms.. However, to graph multiple expirations, you would need a volatility surface, which graphs expiration on the z-axis. These charts are not commonly available, but you can view an example below.

Volatility Smile

A volatility smile is a pattern in which the Strike-IV graph looks like the following:

This means that the ATM call is priced lower than the OTM options, both calls and puts. The actual price, of course, would be larger or smaller depending on the type, but the relative price difference is calculated from the discrepancy from a number given from an options pricing model (ex. Black-Scholes).

The discrepancy could be caused by a variety of factors, which depend on the type of security being analyzed. For example, a smile would represent fear of either a move to the upside or to the downside because it shows that people are willing to pay more than expected for the options, which are often used as insurance.

Volatility smile is more common in options with close expiries in the stock market or in the foreign exchange market in general.

Volatility Skew

Volatility skew is a situation in which strikes for only one side of strike prices have a higher implied volatility.

 

Some people call the reverse skew a “smirk,” and there are other names for different graphs. When someone refers to “skew,” they are most probably referring to reverse skew.

Reverse skew is also the most common scenario for longer-dated expiries in the equity market. This is because lower strike puts are purchased to shield against market drops. However, in other markets, like the futures market, a forward skew might exist to protect against a price spike (ex. utilities).

Evolution of the IV Surface

So far, we have been looking at what the numbers themselves actually represent. Let’s take a look at the derivative of these graphs, otherwise known as the evolution.

“Sticky strikes” is a term to represent a situation where if the spot price changes, the IV surface is unaffected for a certain strike. This is also called stick-to-strike or sticky-by-strike.

“Sticky moneyness” or sticky delta or just moneyness is a situation where if the spot price changes, the IV surface is unaffected for a certain delta. Delta is simply the variation in an options price relative to the stock price.

Modeling Methods

There are two ways that the IV can be modeled in the case of a volatility smile.

• Stochastic Volatility – Quite advanced, but it simply uses a random Brownian motion process to influence a stochastic model, which cannot be exactly predicted, but can be analyzed.
• Local Volatility – Simply the general definition of IV, where it is the function of an options-pricing model.

Conclusion

The volatility skew is a tool that lets one see how investors are pricing options, not just in raw dollar terms, but compared to the Black-Scholes model. There are many terms to represent the shape of the curve, and the change in the IV Surface has its own terminology.