Ir options trading
Both sides expect to gain, or they would not trade. Another way of saying this is that the loser may be perfectly happy to lose. That is because many businesses use futures markets as a form of insurance. A candy maker, for example, might buy sugar and cocoa futures contracts to lock in a price for some portion of its requirement for these important ingredients.
The contracts are as good as physically buying the commodities and storing them. If prices rise, the futures contracts will also be more valuable.
The company can choose to sell the contracts and pocket the cash, then buy the commodities from its usual suppliers at market prices, or else accept delivery of the ingredients from the seller of the contract and buy less on the market. Either way, its cost of raw materials is lower than if it had not bought the contracts.
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The company has cushioned itself against a price risk and does not have to worry that its production and marketing strategy will be disrupted by a sudden price increase. But what if prices fall? In that case the company loses some money on its futures contracts. But the same price decrease that causes that loss also caused something good: the company pays less for its ingredients.
Remember, the purpose of buying the futures contract was to protect against something bad happening—a price rise. The bad thing did not happen; prices fell instead. The loss on the futures contract is the cost of insurance, and the company is no worse off than a person who purchases fire insurance and then does not have a fire. The biggest users of the futures markets rely on them for risk management. That is surely one reason why defaults are rare. But there is an additional security measure between the individual trader and the clearinghouse.
Buyers and sellers of futures must do business through intermediaries who are exchange members. Instead of standing between two individual traders, therefore, the clearinghouse stands between two exchange member firms. If the customer cannot pay the margin, the firm closes the account, sells off the positions, and may have to take a small loss. While firms pay attention to the credit of their customers, the clearinghouse pays attention to the credit of the firms.
The clearinghouse needs to make good on a trade only if losses are so great that the exchange member firm itself fails. This happens occasionally when firms badly mismanage their risks or when a major financial crisis occurs. Because futures contracts offer assurance of future prices and availability of goods, they provide stability in an unstable business environment. Futures have long been associated with agricultural commodities, especially grain and pork bellies, but they are now more likely to be used by bankers, airlines, and computer makers than by farmers—at least in North America and Europe.
By the early s, although commodities remained the mainstay of futures markets in Asia, in the developed countries of the West financial futures contracts had almost totally eclipsed commodities. In Japan, by contrast, commodity futures trading dwarfed financial futures. This does not mean that commodities were more important than finance in the Japanese economy, of course. Financial futures got a slow start in Japan because Japanese regulations discouraged them. Traders who wanted to trade such futures had to—and did—trade them elsewhere. Obviously, the idea of hedging against an unstable financial environment has great appeal.
Companies like Caterpillar, Microsoft, or Citibank can now protect themselves against currency shifts by buying and selling futures contracts or similar instruments. Investors use contracts on interest rates, bonds , and stock indexes to protect against a decline in the value of their investment s, just as farmers have long used futures to protect against a drop in the price of corn or beans.
Farmers who planted corn in the spring had no way of knowing what the price of their crop would be when they harvested in the fall. But a farmer who planted in the spring and sold a futures contract committed to deliver his grain in the fall for a definite price.
Not only did he receive cash in the spring in return for his commitment, but he also received the contract price for his crop even if the market price subsequently fell because of an unexpected glut of corn. In exchange the farmer gave up the chance to get a higher price in the event of a drought or blight; he received the same fixed price for which he had contracted.
In the latter case, the farmer would have netted more if he had not sold the future; however, most farmers prefer not to gamble on the corn market. Farming is risky enough, thanks to uneven rainfalls and unpredictable pests, without adding the risk of changes in market prices. Farmers thus seek to lock in a value on their crop and are willing to pay a price for certainty. They give up the chance of very high prices in return for protection against abysmally low prices. This practice of removing risk from business plans is called hedging.
As a rule of thumb, about half of the participants in the futures markets are hedgers who come to market to remove or reduce their risk. For the market to function, however, it cannot consist only of hedgers seeking to lay off risk.
Futures and Options Markets
There must be someone who comes to market in order to take on risk. Some speculators, against all odds, have become phenomenally wealthy by trading futures.
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Interestingly, even the wealthiest speculators often report having gone broke one or more times in their career. Because speculation offers the promise of astounding riches with little apparent effort, or the threat of devastating losses despite even the best efforts, it is often compared to casino gambling. The difference between speculation in futures and casino gambling is that futures market speculation provides an important social good, namely liquidity. If it were not for the presence of speculators in the market, farmers, bankers, and business executives would have no easy and economical way to eliminate the risk of volatile prices, interest rates, and exchange rates from their business plans.
Speculators, however, provide a ready and liquid market for these risks—at a price. Speculators who are willing to assume risks for a price make it possible for others to reduce their risks. Competition among speculators also makes hedging less expensive and ensures that the effect of all available information is swiftly calculated into the market price. Weather reports, actions of central banks, political developments, and anything else that can affect supply or demand in the future affect futures prices almost immediately.
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There seems to be no limit to the potential applications of futures market technology. The exchange later introduced crude oil, gasoline, and natural gas futures. Airlines, shipping companies, public transportation authorities, home-heating-oil delivery services, and major multinational oil and gas companies have all sought to hedge their price risk using these futures contracts. Meanwhile, international stock market investors have discovered that stock-index futures, besides being useful for hedging, also are an attractive alternative to actually buying stocks.
Because a stock-index future moves in tandem with the prices of the underlying stocks, it gives the same return as owning stocks. Yet the stock-index future is cheaper to buy and may be exempt from certain taxes and charges to which stock ownership is subject. Some large institutional investors prefer to buy German stock-index futures rather than German stocks for this very reason. Because stock-index futures are easier to trade than actual stocks, the futures prices often change before the underlying stock prices do.
In the October crash, for example, prices of stock-index futures in Chicago fell before prices on the New York Stock Exchange collapsed, leading some observers to conclude that futures trading had somehow caused the stock market crash that year. In fact, investors who wanted to sell stocks could not sell quickly and efficiently on the New York Stock Exchange and therefore sold futures instead.
The futures market performed its function of price discovery more rapidly than the stock market did. Futures contracts have even been enlisted in the fight against air pollution and the effort to curb runaway health insurance costs.
When the Environmental Protection Agency decided to allow a market for sulfur dioxide emission allowances under the amendments to the Clean Air Act, the Chicago Board of Trade developed a futures contract for trading what might be called air pollution futures. The reason?
If futures markets provide price discovery and liquidity to the market in emission allowances, companies can decide on the basis of straightforward economics whether it makes sense to reduce their own emissions of sulfur dioxide and sell their emission allowance to others, or instead to sustain their current emission levels and purchase emission allowances from others.
Without a futures market it would be difficult to know whether a price offered or demanded for emissions allowances is high or low. But hedgers and speculators bidding in an open futures market will cause quick discovery of the true price, the equilibrium point at which buyers and sellers are both equally willing to transact. Similar reasoning has led to some decidedly unconventional applications of futures technology.
The Iowa Electronic Market introduced political futures in , and this market has generally beaten the pollsters at predicting not only the winner of the White House but also the winning margin. This makes sense because people are much more careful with information when they are betting money on it than when they are talking to a pollster. Economist Richard Roll showed that the orange juice futures market is a slightly better predictor of Florida temperatures than the National Weather Service.
Swaps are very different from options though they can be combined to form a derivative called a swaption, or an option to enter into a swap. As the name implies, swaps are exchanges of one asset for another on a predetermined, typically repeated basis. Such an agreement, called an interest rate swap, would buffer the bank against rising interest rates while protecting the finance company from lower ones, as in the following table:. A credit default swap CDS is a type of swap used to create an unregulated form of insurance against a default by a bond issuer such as a country or corporation.
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