Trade Topics How Cotton is Traded Futures Market Glossary of Terms Trading of basic commodities represents one of humanity's oldest commercial activities. Every major trading center throughout history developed some sort of central marketplace where people could meet and trade necessary or desirable foods, fibers, and other basic commodities. Cash markets today are defined as a market where physical goods are purchased either immediately for cash or where they are contracted for with payment occurring at the time of delivery. Today, cash market trading of cotton is done primarily by using computers, telephones and fax machines and incorporates one of the following types of contracts or agreements. 1. Spot contract or marketing cotton for immediate delivery and immediate payment. 2. Forward contract or a promise to deliver a specified number of bales or production from a specified number of acres at some point in the future. Forward contracts utilize many different parameters and terms, which are agreed upon by buyer and seller at the time the contract is made. For instance, some forward contracts specify the exact number of bales to be delivered while some agree to accept the total production from a specified number of acres called "acreage" contracts. Still others allow a percentage of an agreed upon historical yield to be fixed. Regardless, many variations exist and are offered by most brokers and merchants to producers seeking price protection for a crop that has not been harvested. 3. Basis contract or an agreement by buyer and seller to simply set the current basis without finalizing the price of cotton. This agreement allows a producer to eliminate basis risk, stop storage charges from accruing, and in most cases draw a percentage of the cotton's value to use until the final price is agreed upon. In a rising market this contract works exceptionally well as the risk of a deteriorating basis is eliminated, and the seller gains all market appreciation, however, in a falling market the seller has unlimited price risk. Basis contracts are offered by most brokers and merchants and are available for spot transactions as well as forward contracts. 4. Equity contracts are made when growers place cotton in the Commodity Credit Corporation non-recourse loan. By designating an agent to redeem the cotton, the difference between cash market value and loan rate can be agreed upon by buyer and seller. These contracts are also offered by most brokers and merchants and are normally made both spot and forward. Futures Market: The futures contract is a standardized legal commitment to deliver or receive delivery of a specific quantity of a commodity on a specified date at a specified delivery point. With the contract standardized in terms of delivery months and locations, quantity and grade, the only element left to negotiate is price. The current price of the "nearby" futures contract (the contract with the closest expiration date) represents a benchmark for the cash market price. The worldwide dissemination of the futures price information contributes to wider market participation, which allows a more efficient reflection of the conditions in the cash market. More buyers and sellers in the marketplace mean better pricing opportunities therefore increasing the quality of the price discovery process. The exchange ensures the accuracy of the trading process through its clearly defined and monitored rules that include an arbitration process to resolve trading disputes. Futures exchanges serve essentially two types of traders, hedgers who seek to transfer their cash market price risk to other futures market participants and investors or speculators who are willing to assume that risk in exchange for the opportunity to profit form price movement in the futures market. Commodity funds that assemble large amounts of capital for the purpose of futures market speculation fall into the latter category. The hedger enters the futures market to transfer or reduce risk associated with cash market transactions. Hedging involves establishing a position in the futures market equal to and opposite a position in the cash market. Hedging is not about taking risk. Hedging is the opposite of speculating. An effective hedging strategy reduces risk exposure. A gain in the futures market will offset a loss in the cash market, or vice versa. A grower who harvests cotton, for example, has cotton to sell. Therefore, the grower is said to be "long" physical or cash cotton. To hedge the crop, the grower would establish the opposite or 'short' position in the futures market by selling futures contracts. The grower therefore protects the selling price of the cash cotton. Actuals: The physical or cash commodity, which is different from a futures contract. See Cash commodity. Arbitrage: The purchase of a commodity against the simultaneous sale of a commodity to profit from unequal prices. The two transactions may take place on different exchanges, between two different commodities, in different delivery months, or between the cash and futures markets. See Spreading. Arbitration: The procedure available to customers for the settlement of disputes. Assignment: Options are exercised through the option purchaser's broker, who notifies the clearinghouse of the option's exercise. The clearinghouse then notifies the option seller that the buyer has exercised. When futures options are exercised, the buyer of a call is assigned a long futures contract, and the seller receives the corresponding short. Conversely, the buyer of a put is assigned a short futures contract upon exercise, while the seller receives the corresponding long. At the market: When issued, this order is to buy or sell a futures or options contract as soon as possible at the best possible price. See Market order. At-the-money: An option is at-the-money when its strike price is equal, or approximately equal, to the current market price of the underlying futures contract. Bar chart: A graphic representation of price movement disclosing the high, low, close, and sometimes the opening prices for the day. A vertical line is drawn to correspond with the price range for the day, while a horizontal "tick" pointing to the left reveals the opening price, and a tick to the right indicates the closing price. After days of charting, patterns start to emerge, which technicians interpret for their price predictions. Basis: The difference between the cash price and the futures price of a commodity. CASH - FUTURES = BASIS. Basis also is used to refer to the difference between prices at different markets or between different commodity grades. Bear call spread: The purchase of a call with a high strike price against the sale of a call with a lower strike price. The maximum profit receivable is the net premium received (premium received - premium paid), while the maximum loss is calculated by subtracting the net premium received from the difference between the high strike price and the low strike price (high strike price - low strike price net premium received). A bear call spread should be entered when lower prices are expected. It is a type of vertical spread. Bear market (bear/bearish): When prices are declining, the market is said to be a "bear market"; individuals who anticipate lower prices are "bears." Situations believed to bring with them lower prices are considered "bearish." Bear put spread: The purchase of a put with a high strike price against the sale of a put with a lower strike price in expectation of declining prices. The maximum profit is calculated as follows: (high strike price - low strike price) - net premium received where net premium received = premiums paid - premiums received. Bear spread: Sale of a near month futures contract against the purchase of a deferred month futures contract in expectation of a price decline in the near month relative to the more distant month. Example: selling a December contract and buying the more distant March contract. Bearish: When market prices tend to go lower, the market is said to be bearish. Someone who expects prices to trend lower is "bearish." Bid: The request to buy a commodity at a specified price; the opposite of offer. Board of trade: An exchange or association of persons participating in the business of buying or selling any commodity or receiving it for sale on consignment. Generally, an exchange where commodity futures and/or futures options are traded. See also Contract market and Exchange. Board orders: See Market if touched order. Break: A sudden price move; prices may break up or down. Break-even: Refers to a price at which an option's cost is equal to the proceeds acquired by exercising the option. The buyer of a call pays a premium. His break-even point is calculated by adding the premium paid to the call's strike price. For example, if you purchase a May 58 cotton call for 2.25¢ per pound when May cotton futures are at 59.48¢/lb., the break-even price is 60.25¢/lb. (58.00¢/lb. + 2.25¢/lb. = 60.25¢/lb.). For a put purchaser, the break-even point is calculated by subtracting the premium paid from the put's strike price. Please note that, for puts, you do not exercise unless the futures price is below the break-even point. Broker: An agent who executes trades (buy or sell orders) for customers. He receives a commission for these services. Bull call spread: The purchase of a call with a low strike price against the sale of a call with a higher strike price; prices are expected to rise. The maximum potential profit is calculated as follows: (high strike price - low strike price) - net premium cost, where net premium cost = premiums paid - premiums received. The maximum possible loss is the net premium cost. Bull market (bull/bullish): When prices are rising, the market is said to be a "bull market"; individuals who anticipate higher prices are considered "bulls." Situations arising which are expected to bring higher prices are called "bullish." Bull put spread: The purchase of a put with a low strike price against the sale of a call with a higher strike price; prices are expected to rise. The maximum potential profit equals the net premium received. The maximum loss is calculated as follows: (high strike price - low strike price) - net premium received where net premium received = premiums paid - premiums received. Bull spread: The purchase of near month futures contracts against the sale of deferred month futures contracts in expectation of a price rise in the near month relative to the deferred. One type of bull spread, the limited risk spread, is placed only when the market is near full carrying charges. See Limited risk spread. Bullish: A tendency for prices to move up. Butterfly spread: Established by buying an at-the-money option, selling 2 out-of-the money options, and buying an out-of-the money option. A butterfly is entered anytime a credit can be received; i.e., the premiums received are more than those paid. Buy stop/sell stop orders: See Stop orders. Calendar spread: The sale of an option with a nearby expiration against the purchase of an option with the same strike price, but a more distant expiration. The loss is limited to the net premium paid, while the maximum profit possible depends on the time value of the distant option when the nearby expires. The strategy takes advantage of time value differentials during periods of relatively flat prices. Call option: A contract giving the buyer the right to purchase something within a certain period of time at a specified price. The seller receives money (the premium) for the sale of this right. The contract also obligates the seller to deliver, if the buyer exercises his right to purchase. Carrying charges: The cost of storing a physical commodity, consisting of interest on the invested funds, insurance, storage fees, and other incidental costs. Carrying costs are usually reflected in the difference between futures prices for different delivery months. When futures prices for deferred contract maturities are higher than for nearby maturities, it is a carrying charge market. A full carrying charge market reimburses the owner of the physical commodity for its storage until the delivery date. Carryover: The portion of existing supplies remaining from a prior production period. Cash commodity/cash market: The actual or physical commodity. The market in which the physical commodity is traded, as opposed to the futures market, where contracts for future delivery of the physical commodity are traded. See also Actuals. Cash flow: The cash receipts and payments of a business. This differs from net income after taxes in that non-cash expenses are not included in a cash flow statement. If more cash comes in than goes out, there is a positive cash flow, while more outgoing cash causes a negative cash flow. Cash market: A market in which goods are purchased either immediately for cash, as in a cash and carry contract, or where they are contracted for presently, with delivery occurring at the time of payment. All terms of the contract are negotiated between the buyer and seller. Cash price: The cost of a good or service when purchased for cash. In commodity trading, the cash price is the cost of buying the physical commodity on the current day in the spot market, rather than buying contracts in the futures market. Certificate of Depsosit (CD): A large time deposit with a bank, having a specific maturity date and yield stated on the certificate. CDs usually are issued with $100,000 to $1,000,000 face values. Certificated stock: Stocks of a physical commodity that have been inspected by the exchange and found to be acceptable for delivery on a futures contract. They are stored at designated delivery points. Charting: When technicians analyze the futures markets, they employ graphs and charts to plot the price movements, volume, open interest, or other statistical indicators of price movement. See also Technical analysis and Bar chart. Clearing margin: Funds deposited by a futures commission merchant with its clearing member. Clearing member: A clearinghouse member responsible for executing client trades. Clearing members also monitor the financial capability of their clients by requiring sufficient margins and position reports. Clearinghouse: An agency associated with an exchange which guarantees all trades, thus assuring contract delivery and/or financial settlement. The clearinghouse becomes the buyer for every seller, and the seller for every buyer. Close or closing range: The range of prices found during the last two minutes of trading. The average price during the "close" is used as the settlement price from which the allowable trading range is set for the following day. Commercials: Firms that are actively hedging their cash grain positions in the futures markets; e.g., millers, exporters, and elevators. Commodity: A good or item of trade or commerce. Goods tradable on an exchange, such as corn, gold, or hogs, as distinguished from instruments or other intangibles like T-Bills or stock indexes. Commodity Credit Corporation (CCC): A government-owned corporation established in 1933 to support prices through purchases of excess crops, to control supply through acreage reduction programs, and to devise export programs. Commodity Futures Trading Commission (CFTC): A federal regulatory agency established in 1974 to administer the Commodity Exchange Act. This agency monitors the futures and futures options markets through the exchanges, futures commission merchants and their agents, floor brokers, and customers who use the markets for either commercial or investment purposes. Commodity pool: A venture where several persons contribute funds to trade futures or futures options. A commodity pool is not to be confused with a joint account. Commodity Pool Operator (CPO): An individual or firm who accepts funds, securities, or property for trading commodity futures contracts, and combines customer funds into pools. The larger the account, or pool, the more staying power the CPO and his clients have. They may be able to last through a dip in prices until the position becomes profitable. CPOs must register with the CFTC and NFA, and are closely regulated. Commodity Trading Advisor (CTA): An individual or firm who directly or indirectly advises others about buying or selling futures or futures options. Analyses, reports, or newsletters concerning futures may be issued by a CTA; he may also engage in placing trades for other people's accounts. CTAs are required to be registered with the CFTC and to belong to the NFA. Congestion: A charting term used to describe an area of sideways price movement. Such a range is thought to provide support or resistance to price action. Contract: A legally enforceable agreement between two or more parties for performing some specified act; e.g., delivering 5,000 bales of cotton of a specified grade, at a specified time, place, and price. Contract month: The month in which a contract comes due for delivery according to the futures contract terms. Contrarian theory: A theory suggesting that the general consensus about trends is wrong. The contrarian takes the opposite position from the majority opinion to capitalize on overbought or oversold situations. Convergence: The coming together of futures prices and cash market prices on the last trading day of a futures contract. Cover: Used to indicate the repurchase of previously sold contracts as, he covered his short position. Short covering is synonymous with liquidating a short position or evening up a short position. Covered position: A transaction which has been offset with an opposite and equal transaction; for example, if a cotton futures contract had been purchased, and later a call option for the same commodity amount and delivery date was sold, the trader's option position is "covered." He holds the futures contract deliverable on the option if it is exercised. Also used to indicate the repurchase of previously sold contracts as, he covered his short position. Day order: An order which, if not executed during the trading session the day it is entered, automatically expires at the end of the session. All orders are assumed to be day orders unless specified otherwise. Day-trader: Futures or options traders (often active on the trading floor) who usually initiate and offset position during a single trading session. Dealer option: A put or call on a physical good written by a firm dealing in the underlying cash commodity. A dealer option does not originate on, nor is it subject to the rules of an exchange. Deep in-the-money: An option is "deep in-the money" when it is so far in-the-money that it is unlikely to go out-of-the-money prior to expiration. It is an arbitrary term and can be used to describe different options by different people. Deep out-of-the-money: Used to describe an option that is unlikely to go into-the-money prior to expiration. An arbitrary term. Default: Failure to meet a margin call or to make or take delivery. The failure to perform on a futures contract as required by exchange rules. Deferred delivery: Futures trading in distant delivery months. Deferred pricing: A method of pricing where a producer sells his commodity now and buys a futures contract to benefit from an expected price increase. Although some people call this hedging, the producer is actually speculating that he can make more money by selling the cash commodity and buying a futures contract than by storing the commodity and selling it later. (If the commodity has been sold, what could he be hedging against?) Delivery: The transportation of a physical commodity (actuals or cash) to a specified destination in fulfillment of a futures contract. Delivery month: The month during which a futures contract expires, and delivery is made on that contract. Delivery notice: Notification of delivery by the clearinghouse to the buyer. Such notice is initiated by the seller in the form of a "Notice of Intention to Deliver." Delivery point: The location approved by an exchange for tendering and accepting goods deliverable according to the terms of a futures contract. Delta: The correlation factor between a futures price fluctuation and the change in premium for the option on that futures contract. Delta changes from moment to moment as the option premium changes. Demand: The desire to purchase economic goods or services (and the financial ability to do so) at the market price constitutes demand. When many purchasers demand a good at the market price, their combined purchasing power constitutes "demand." As this combined demand increases or decreases, other things remaining constant, the price of the good tends to rise or fall. Derivative: A financial instrument whose characteristics and value are based on the characteristics and value of another financial instrument or product. Direct hedge: When the hedger has (or needs) the commodity (grade, etc.) specified for delivery in the futures contract, he is "direct hedging." When he does not have the specified commodity, he is cross hedging. Discount: Quality differences between those standards set for some futures contracts and the quality of the delivered goods. If inferior goods are tendered for delivery, they are graded below the standard, and a lesser amount is paid for them. They are sold at a discount; Price differences between grades of cash contracts. Discount rate: The interest rate charged by the Federal Reserve to its member banks (banks which belong to the Federal Reserve System) for funds they borrow. This rate has a direct bearing on the interest rates banks charge their customers. When the discount rate is increased, the banks must raise the rates they charge to cover their increased cost of borrowing. Likewise, when the discount rate is lowered, banks are able to charge lower interest rates on their loans. Downtrend: A channel of downward price movement. Economic good: That which is scarce and useful to mankind. Economy of scale: A lower cost per unit produced, achieved through large-scale production. The lower cost can result from better tools of production, greater discounts on purchased supplies, production of by-products, and/or equipment or labor used at production levels closer to capacity. A large cattle feeding operation may be able to benefit from economies such as lower unit feed costs, increased mechanization, and lower unit veterinary costs. Elasticity: A term used to describe the effects price, supply, and demand have on one another for a particular commodity. A commodity is said to have elastic demand when a price change affects the demand for that commodity; it has supply elasticity when a change in price causes a change in the production of the commodity. A commodity has inelastic supply or demand when they are unaffected by a change in price. Equity: For cotton placed in CCC loan, the difference in the cash market value and the loan amount. Exchange: An association of persons who participate in the business of buying or selling futures contracts or futures options. A forum or place where traders (members) gather to buy or sell economic goods. There are 9 domestic futures exchanges currently operating as non-profit member organizations. Exchange rates: The price of foreign currencies. If it costs $.42 to buy one Swiss Franc, the exchange rate is .4200. As one currency is inflated faster or slower than the other, the exchange rate will change, reflecting the change in relative value. The currency being inflated faster is said to be becoming weaker because more of it must be exchanged for the same amount of the other currency. As a currency becomes weaker, exports are encouraged because others can buy more with their relatively stronger currencies. Exercise: When a call purchaser takes delivery of the underlying long futures position, or when a put purchaser takes delivery of the underlying short futures position. Only option buyers may "exercise" their options; option sellers have a passive position. Expiration: An option is a wasting asset; i.e., it has a limited life, usually nine months. At the end of its life, it either becomes worthless (if it is at-the-money or out-of-the-money), or is automatically exercised for the amount by which it is in-the-money. Expiration date: The final date when an option may be exercised. Many options expire on a specified date during the month prior to the delivery month for the underlying futures contract. Ex-pit transactions: Occurring outside the futures exchange trading pits. This includes cash transactions, the delivery process, and the changing of brokerage firms while maintaining open positions. All other transactions involving futures contracts must occur in the trading pits through open outcry. Federal Reserve Board: A board of Directors comprised of seven members which directs the federal banking system, is appointed by the President of the United States and confirmed by the Senate. The functions of the board include formulating and executing monetary policy, overseeing the Federal Reserve Banks, and regulating and supervising member banks. Monetary policy is implemented through the purchase or sale of securities, and by raising or lowering the discount rate - the interest rate at which banks borrow from the Federal Reserve. Fill or Kill order (FOK): Also known as a quick order, is a limit order which, if not filled immediately, is canceled. First notice day: Notice of intention to deliver a commodity in fulfillment of an expiring futures contract can be given to the clearinghouse by a seller (and assigned by the clearinghouse to a buyer) no earlier than the first notice day. First notice days differ depending on the commodity. Floor broker: A person who executes orders on the trading floor of an exchange on behalf of other people. They are also known as pit brokers because the trading area has steps down into a "pit" where the brokers stand to execute their trades. Floor trader: Exchange members present on the exchange floor to make trades on their own behalf. They may be referred to as scalpers or locals. Forward contract: A contract entered into by two parties who agree to the future purchase or sale of a specified commodity. This differs from a futures contract in that the participants in a forward contract are contracting directly with each other, rather than through a clearing corporation. The terms of a forward contract are negotiated between the buyer and seller, while exchanges set the terms of futures contracts. Forward pricing: The practice of locking in a price in the future, either by entering into a cash forward contract or a futures contract. In a cash forward contract, the parties usually intend to tender and accept the commodity, while futures contracts are generally offset, with a cash transaction occurring after offset. Free market: A market place where individuals can act in their own best interest, free from outside forces (freedom means freedom from government) restricting their choices, or regulating or subsidizing product prices. Free market also refers to the political system where the means of production are owned by free, non-regulated individuals. Full carry: When the difference between futures contract month prices equals the full cost of carrying (storing) the commodity from one delivery period to the next. Carrying charges include insurance, interest, and storage. Fundamental analysis: The study of specific factors, such as weather, wars, discoveries, and changes in government policy, which influence supply and demand and, consequently, prices in the market place. Futures Commission Merchant (FCM): An individual or organization accepting orders to buy or sell futures contracts or futures options, and accepting payment for his services. FCMs must be registered with the CFTC and the NFA, and maintain a minimum capitalization of $300,000. Futures contract: A standardized and binding agreement to buy or sell a predetermined quantity and quality of a specified commodity at a future date. Standardization of the contracts enhances their transferability. Futures contracts can be traded only by auction on exchanges registered with the CFTC. Gap: A term used by technicians to describe a jump or drop in prices; i.e., prices skipped a trading range. Gaps are usually filled at a later date. Give-up: A customer "give-up" is a trade executed by one broker for the client of another broker and then "given-up" to the regular broker; e.g., a floor broker with discretion must have another broker execute the trade. Good till Cancelled (GTC): A qualifier for any kind of order extending its life indefinitely; i.e., until filled or canceled. Grantor: Someone who assumes the obligation, not the right, to buy (for a put) or sell (for a call) the underlying futures contract or commodity at the strike price. See also Writer. Guarantee fund: One of two funds established for the protection of customers' monies; the clearing members contribute a percentage of their gross revenues to the guarantee fund. See also Surplus fund. Guided account: An account that has a planned trading strategy and is directed by either a CTA or a FCM. The customer is advised on specific trading positions, which he must approve before an order may be entered. These accounts often require a minimum initial investment, and may use only a predetermined portion of the investment at any particular time. Not to be confused with a discretionary account. Hedge ratio: The relationship between the number of contracts required for a direct hedge and the number of contracts required to hedge in a specific situation. The concept of hedging is to match the size of a positive cash flow from a gaining futures position with the expected negative cash flow created by unfavorable cash market price movements. Hedger: One who hedges; one who attempts to transfer the risk of price change by taking an opposite and equal position in the futures or futures option market from that position held in the cash market. Hedging: Transferring the risk of loss due to adverse price movement through the purchase or sale of contracts in the futures markets. The position in the futures market is a substitute for the future purchase or sale of the physical commodity in the cash market. If the commodity will be bought, the futures contract is purchased (long hedge); if the commodity will be sold, the futures contract is sold (short hedge). High: The top price paid for a commodity or its option in a given time period, usually a day or the life of a contract. Inelasticity: A statistic attempting to quantify the change in supply or demand for a good, given a certain price change. The more inelastic demand (characteristic of necessities), the less effect a change in price has on demand for the good. The more inelastic supply, the less supply changes when the price does. Inflation: The creation of money by monetary authorities. In more popular usage, the creation of money that visibly raises goods prices and lowers the purchasing power of money. It may be creeping, trotting, or galloping, depending on the rate of money creation by the authorities. It may take the form of "simple inflation," in which case the proceeds of the new money issues accrue to the government for deficit spending; or it may appear as "credit expansion," in which case the authorities channel the newly created money into the loan market. Both forms are inflation in the broader sense. Initial margin: When a customer establishes a position, he is required to make a minimum initial margin deposit to assure the performance of his obligations. Futures margin is earnest money or a performance bond. Interest: What is paid to a lender for the use of his money and includes compensation to the lender for three factors: 1) Time value of money (lender's rate): the value of today's dollar is more than tomorrow's dollar. Tomorrow's dollars are discounted to reflect the time a lender must wait to "enjoy" the money, not to mention the uncertainties tomorrow brings. 2) Credit risk: the risk of repayment varies with the creditworthiness of the borrower. 3) Inflation: as the purchasing power of a dollar declines, more dollars must be repaid to maintain the same purchasing power. Interest is one of the components of carrying charges; i.e., the cost of the money needed to finance the commodity's purchase or storage. The market rate of interest can also be used to establish an opportunity cost for the funds that are tied up in any investment. Interest rate futures: Futures contracts traded on long-term and short-term financial instruments: U.S. Treasury bills and bonds and Eurodollar Time Deposits. More recently, futures contracts have developed for German, Italian, and Japanese government bonds, to name a few. In-the-money: A call is in-the-money when the underlying futures price is greater than the strike price. A put is in-the-money when the underlying futures price is less than the strike price. In-the-money options have intrinsic value. Intra-market: A spread within a market. An example of an intra-market spread is buying a cotton contract in the nearby month and selling a cotton contract on the same exchange in a distant month. Intrinsic value: The amount an option is in the-money, calculated by taking the difference between the strike price and the market price of the underlying futures contract when the option is "in-the-money." Introducing Broker (IB): An individual or firm who can perform all the functions of a broker except one. An IB is not permitted to accept money, securities, or property from a customer. An IB must be registered with the CFTC, and conduct its business through an FCM on a fully disclosed basis. Inverted market: A futures market in which near-month contracts are selling at prices that are higher than those for deferred months. An inverted market is characteristic of a short-term supply shortage. The notable exceptions are interest rate futures, which are inverted when the distant contracts are at a premium to near month contracts. Last trading day: The last day on which a futures contract is traded. Law of demand: Demand exhibits a direct relationship to price. If all other factors remain constant, an increase in demand leads to an increased price, while a decrease in demand leads to a decreased price. Law of supply: Supply exhibits an inverse relationship to price. If all other factors hold constant, an increase in supply causes a decreased price, while a decrease in supply causes an increased price. Leverage: The control of a larger sum of money with a smaller amount. By accepting the liability to purchase or deliver the total value of a futures contract, a smaller sum (margin) may be used as earnest money to guarantee performance. If prices move favorably, a large return on the margin can be earned from the leverage. Conversely, a loss can also be large, relative to the margin, due to the leverage. Liability: 1) In the broad legal sense, responsibility or obligation. For example, a person is liable to pay his debts, under the law; 2) In accounting, any debt owed by an individual or organization. Current, or short-term, liabilities are those to be paid in less than one year (wages, taxes, accounts payable, etc.). Long-term, or fixed, liabilities are those that run for one year or more (mortgages, bonds, etc.); 3) In futures, traders deposit margin as earnest money, but they are liable for the entire value of the contract; 4) In futures options, purchasers of options have their liability limited to the premium they pay; option writers are subject to the liability associated with the underlying deliverable futures contract. Limit: See Price limit, Position limit, and Variable limit. Limit move: The increase or decrease of a price by the maximum amount allowed for any one trading session. Price limits are established by the exchanges, and approved by the CFTC. They vary from contract to contract. Limit orders: A customer sets a limit on price or time of execution of a trade, or both; for example, a "buy limit" order is placed below the market price. A "sell limit" order is placed above the market price. A sell limit is executed only at the limit price or higher (better), while the buy limit is executed at the limit price or lower (better). Limited risk: A concept often used to describe the option buyer's position. Because the option buyer's loss can be no greater than the premium he pays for the option, his risk of loss is limited. Limited risk spread: A bull spread in a market where the price difference between the two contract months covers the full carrying charges. The risk is limited because the probability of the distant month price moving to a premium greater than full carrying charges is minimal. Line-bar chart: See Bar chart. Liquidate: Refers to closing an open futures position. For an open long, this would be selling the contract. For a short position, it would be buying the contract back (short covering, or covering his short). Liquidity (liquid market): A market which allows quick and efficient entry or exit at a price close to the last traded price. The ability to liquidate or establish a position quickly is due to a large number of traders willing to buy and sell. Locals: The floor traders who trade primarily for their own accounts. Although "locals" are speculators, they provide the liquidity needed by hedgers to transfer the risk of price change. Long: One who has purchased futures contracts or the cash commodity, but has not taken any action to offset his position. Also, purchasing a futures contract. A trader with a long position hopes to profit from a price increase. Long hedge: A hedger who is short the cash (needs the cash commodity) buys a futures contract to hedge his future needs. By buying a futures contract when he is short the cash, he is entering a long hedge. A long hedge is also known as a substitute purchase or an anticipatory hedge. Long-the-basis: A person who owns the physical commodity and hedges his position with a short futures position is said to be long-the-basis. He profits from the basis becoming more positive (stronger). Low: The smallest price paid during the day or over the life of the contract. Maintenance margin: The minimum level at which the equity in a futures account must be maintained. If the equity in an account falls below this level, a margin call will be issued, and funds must be added to bring the account back to the initial margin level. The maintenance margin level generally is 75% of the initial margin requirement. Margin: Margin in futures is a performance bond or "earnest money." Margin money is deposited by both buyers and sellers of futures contracts, as well as sellers of futures options. See Initial margin. Margin call: A call from the clearinghouse to a clearing member (variation margin call), or from a broker to a customer (maintenance margin call), to add funds to their margin account to cover an adverse price movement. The added margin assures the brokerage firm and the clearinghouse that the customer can purchase or deliver the entire contract, if necessary. Market order: An order to buy or sell futures or futures options contracts as soon as possible at the best available price. Time is of primary importance. Market-if-touched order (MIT): They are similar to stop orders in two ways: 1) They are activated when the price reaches the order level; 2) They become market orders once they are activated; however, MIT orders are used differently from stop orders. A buy MIT order is placed below the current market price, and establishes a long position or closes a short position. A sell MIT order is placed above the current market price, and establishes a short position or closes a long position. Mark-to-market: The IRS's practice of calculating gains and losses on open futures positions as of the end of the tax year. In other words, taxpayers' open futures positions are marked to the market price as of the end of the tax year and taxes are assessed as if the gains or losses had been realized. Maturity: The period during which a futures contract can be settled by delivery of the actuals; i.e., the period between the first notice day and the last trading day. Also, the due date for financial instruments. Maximum price fluctuation: See Limit move. Minimum price fluctuation: The smallest allowable fluctuation in a futures price or futures option premium. Moving average: An average of prices for a specified number of days. If it is a three (3) day moving average, for example, the first three days' prices are averaged (1,2,3), followed by the next three days' average price (2,3,4), and so on. Moving averages are used by technicians to spot changes in trends. Naked: When an option writer writes a call or put without owning the underlying asset. National Futures Association (NFA): A "registered futures association" authorized by the CFTC in 1982 that requires membership for FCMs, their agents and associates, CTAs, and CPOs. This is a self-regulatory group for the futures industry similar to the National Association of Securities Dealers, Inc. in the securities industry. Nearby: The futures contract month with the earliest delivery period. Net position: The difference between total open long and open short positions in any one or all combined futures contract months held by an individual. Neutral calendar spread: See Calendar spread. New York Cotton Exchange (NYCE): Founded in 1870, the state charter restricts trading to cotton, thus associate memberships have been established to trade other items such as orange juice, the U.S. dollar index, 5 year T-Notes, and options on the futures contracts. They are located at 4 World Trade Center, New York, NY 10048. See also New York Futures Exchange. New York Futures Exchange (NYFE): Began as a subsidiary of the New York Stock Exchange. Today, the NYFE is a division of the New York Cotton Exchange and trades stock index futures contracts based on the New York Stock Exchange Composite (NYSEC) Index, and the Kravitz Roberts Commodity Research Bureau (KR-CRB) Index. They also have an option on the NYSEC index and the KR-CRB index. The NYFE is located at 4 World Trade Center, New York, NY 10048. Nominal price (or nominal quotation): The price quotation calculated for futures or options for a period during which no actual trading occurred. These quotations are usually calculated by averaging the bid and asked prices. Normal market: The deferred months' prices for futures contracts are normally higher than the nearby months' to reflect the costs of carrying a contract from now until the distant delivery date. Thus, a "normal market," for non-interest rate futures contracts, exists when the distant months are at a premium to the nearby months. For interest rate futures, just the opposite is true. The yield curve dictates that a "normal market" for interest rate futures occurs when the nearby months are at a premium to the distant months. Notice of intention to deliver: During the delivery month for a futures contract, the seller initiates the delivery process by submitting a "notice of intention to deliver" to the clearinghouse, which, in turn, notifies the oldest outstanding long of the seller's intentions. If the long does not offset his position, he will be called upon to accept delivery of the goods. Offer: To show the desire to sell a futures contract at an established price. Offset: See Offsetting. Offsetting: Eliminating the obligation to make or take delivery of a commodity by liquidating a purchase or covering a sale of futures. This is affected by taking an equal and opposite position: either a sale to offset a previous purchase, or a purchase to offset a previous sale in the same commodity, with the same delivery date. If an investor bought an August gold contract on the COMEX, he would offset this obligation by selling an August gold contract on the COMEX. To offset an option, the same option must be bought or sold; i.e., a call or a put with the same strike price and expiration month. Offsetting positions: 1) Taking an equal and opposite futures position to a position held in the cash market. The offsetting futures position constitutes a hedge; 2) Taking an equal and opposite futures position to another futures position, known as a spread or straddle; 3) Buying a futures contract previously sold, or selling a futures contract previously bought, to eliminate the obligation to make or take delivery of a commodity. When trading futures options, an identical option must be bought or sold to offset a position. One Cancels Other (OCO): A qualifier used when multiple orders are entered and the execution of one order cancels a second or alternate order. Open: 1) The first price of the day for a contract on a securities or futures exchange. Futures exchanges post opening ranges for daily trading. Due to the fast-moving operation of futures markets, this range of closely related prices allows market participants to fill contracts at any price within the range, rather than be restricted to one price. The daily prices that are published are approximate medians of the opening range; 2) When markets are in session, or contracts are being traded, the markets are said to be "open." Open interest: For futures, the total number of contracts not yet liquidated by offset or delivery; i.e., the number of contracts outstanding. Open interest is determined by counting the number of transactions on the market (either the total contracts bought or sold, but not both). For futures options, the number of calls or puts outstanding; each type of option has its own open interest figure. Open outcry: Oral bids and offers made in the trading rings, or pits. "Open outcry" is required for trading futures and futures options contracts to assure arms-length transactions. This method also assures the buyer and seller that the best available price is obtained. Open trade equity: The gain or loss on open positions that has not been realized. Opening call: The period at market opening or closing during which futures contract prices are established by auction. Opening range: Upon opening of the market, the range of prices at which transactions occurred. All orders to buy and sell on the opening are filled within the opening range. Opportunity cost: The price paid for not investing in a different investment. It is the income lost from missed opportunities. Had the money not been invested in land, earning 5%, it could have been invested in T-Bills, earning 10%. The 5% difference is an opportunity cost. Option contract: A unilateral contract giving the buyer the right, but not the obligation, to buy or sell a commodity, or a futures contract, at a specified price within a certain time period. It is unilateral because only one party (the buyer) has the right to demand performance on the contract. If the buyer exercises his right, the seller (writer or grantor) must fulfill his obligation at the strike price, regardless of the current market price of the asset. Order: 1) In business and trade, making a request to deliver, sell, receive, or purchase goods or services; 2) In the securities and futures trade, instructions to a broker on how to buy or sell. The most common orders in futures markets are market orders and limit orders (which see). Out-of-the-money: A call is out-of- the-money when the strike price is above the underlying futures price. A put is out-of-the-money when the strike price is below the underlying futures price. Overbought: A technician's term to describe a market in which the price has risen relatively too quickly to be justified by the underlying fundamental factors. Oversold: A technical description for a market in which prices have dropped faster than the underlying fundamental factors would suggest. Pit: The area on the trading floor of an exchange where futures trading takes place. The area is described as a "pit" because it is octagonal with steps descending into the center. Traders stand on the various steps, which designate the contract month they are trading. When viewed from above, the trading area looks like a pit. Pit broker: A person on the exchange floor who trades futures contracts for others in the pits. See also Floor broker. Point and figure chart: A graphic representation of price movement using vertical rows of "x"s to indicate significant up ticks and "o"s to reflect down ticks. Such charts do not reveal minute price fluctuations, only trends once they have established themselves. Portfolio: The group of investments held by an investor. Position: Open contracts indicating an interest in the market, be it short or long. Position limit: The maximum number of futures contracts permitted to be held by speculators or spreaders. The CFTC establishes some position limits, while the exchanges establish others. Hedgers are exempt from position limits. Position trader: A trader who establishes a position (either by purchasing or selling) and holds it for an extended period of time. Power of attorney: An agreement establishing an agent-principal relationship. The "power of attorney" grants the agent authority to act on the principal's behalf under certain designated circumstances. In the futures industry, a power of attorney must be in writing and is valid until revoked or terminated. Premium: The price paid by a buyer to purchase an option. Premiums are determined by "open outcry" in the pits. Price: A fixed value of something. Prices are usually expressed in monetary terms. In a free market, prices are set as a result of the interaction of supply and demand in a market; when demand for a product increases and supply remains constant, the price tends to decline. Conversely, when the supply increases and demand remains constant, the price tends to decline; if supply decreases and demand remains constant, prices tend to rise. Today's markets are not purely competitive; prices are affected by government controls and supports that create artificial supplies and demand, and inhibit free trade, thus making price predictions more difficult for those not privileged with inside government information. Price discovery mechanism: The method by which the price for a particular shipment of a commodity is determined. Factors taken into account include quality, delivery point, and the size of the shipment. For example, if the price of corn is $3.50 per bushel on the CBOT, the local price of corn per bushel can be discovered by taking into consideration the distance from Chicago that corn would have to be shipped, the difference in quality between local and Chicago corn, and the amount of corn to be transported. Once these factors are considered, both the buyer and seller can arrive at a reasonable price for their area. Price limit: The maximum price rise or decline permitted by an exchange in its commodities. Primary markets: The principal market for the purchase and sale of physical commodities. Purchase and sale statement: A form required to be sent to a customer when a position is closed; it must describe the trade, show profit or loss and the commission. Purchaser: Anyone who enters the market as a buyer of a good, service, futures contract, call, or put. Pure hedging: A technique used by a hedger who holds his futures or option position without exiting and re-entering the position until the cash commodity is sold. Pure hedging also is known as conservative or true hedging, and is used largely by inexperienced traders wary of price fluctuation, but interested in achieving a target price. Put: An option contract giving the buyer the right to sell something at a specified price within a certain period of time. A put is purchased in expectation of lower prices. If prices are expected to rise, a put may be sold. The seller receives the premium as compensation for accepting the obligation to accept delivery, if the put buyer exercises his right to sell. See also Limited risk. Pyramiding: Purchasing additional contracts with the profits earned on open positions. Quotation: Often referred to as a "quote." The actual, bid, or asked price of futures, options, or cash commodities at a certain time. Rally: An upward price movement. See Recovery. Range: The difference between the highest and lowest prices recorded during a specified time period, usually one trading session, for a given futures contract or commodity option. Recovery: Rising prices following a decline. Registered Commodity Representative (RCR): A person registered with the exchange(s) and the CFTC who is responsible for soliciting business, "knowing" his/her customers, collecting margins, submitting orders, and recommending and executing trades for customers. A registered commodity representative is sometimes called a "broker" or "account executive. Regulations (CFTC): The guidelines, rules, and regulations adopted and enforced by the Commodity Futures Trading Commission (the CFTC is a federal regulatory agency established in 1974) in administration of the Commodity Exchange Act. Reparations: Parties that are wronged during a futures or options transaction may be awarded compensation through the CFTC's claims procedure. This compensation is known as reparations because it "repairs" the wronged party. Reportable positions: Positions where the reporting level has been exceeded. See also Reporting level. Reporting level: An arbitrary number of contracts held by a trader that must be reported to the CFTC and the exchange. Reporting levels apply to all traders; hedgers, speculators, and spreaders alike. Once a trader has enough contracts to exceed the reporting level, he has a "special account," and must report any changes in his positions. Resistance: A horizontal price range where price hovers due to selling pressure before attempting a downward move. Retender: The right of a futures contract holder, who has received a notice of intention to deliver from the clearinghouse, to offer the notice for sale on the open market, thus offsetting his obligation to take delivery under the contract. This opportunity is only available for some commodities and only within a certain period of time. Ring: A designated area on the exchange floor where traders and brokers stand while executing trades. Instead of rings, some exchanges use pits. Rolling hedge: Changing a futures hedge from one contract month to another. Rolling a short hedge may be advisable when more time is needed to complete the cash transaction to avoid delivery on the futures contract. Hedge rolling may also be considered to keep the hedge in the less active, more distant months, thus reducing the likelihood of swift price movements and the resulting margin calls. Round turn: A complete futures transaction (both entry and exit); for example, a sale and covering purchase, or a purchase and liquidating sale. Commissions are usually charged on a "round-turn" basis. Scalper: A floor trader who buys and sells quickly to take advantage of small price fluctuations. Usually a scalper is ready to buy at the bid and sell at the asked price, providing liquidity to the market. The term "scalper" is used because these traders attempt to "scalp" a small amount on a trade. Selective hedging: The technique of hedging where the futures or option position may be lifted and re-entered numerous times before the cash market transaction takes place. A hedge "locks-in" a target price to minimize risk. Lifting the hedge lifts the risk protection (increasing the possibility of loss), but also allows the potential for gain. Sell stop order: See Stop orders. Selling hedge: See Short hedge. Settlement: The clearinghouse practice of adjusting all futures accounts daily according to gain or loss from price movement is generally called settlement. Settlement price: Established by the clearinghouse from the closing range of prices (the last 30 seconds of the day). The settlement price is used to determine the next day's allowable trading range, and to settle all accounts between clearing members for each contract month. Margin calls and invoice prices for deliveries are determined from the settlement prices. In addition to this, settlement prices are used to determine account values and determine margins for open positions. Short: Someone who has sold actuals or futures contracts, and has not yet offset the sale; the act of selling the actuals or futures contracts, absent any offset. Short covering: Buying by shorts to liquidate existing positions. Short hedge: When a hedger has a long cash position (is holding an inventory or growing a crop) he enters a short hedge by selling a futures contract. A sell or short hedge is also known as a substitute sale. Short-the-basis: When a person or firm needs to buy a commodity in the future, he can protect himself against price increases by making a substitute purchase in the futures market. The risk this person now faces is the risk of a change in basis (cash price - futures price). This hedger is said to be short-the-basis because he will profit if the basis becomes more negative (weaker). Sideways: A market with a narrow price range; i.e., little upward or downward price movement. Special account: An account which has a reportable position in either futures or futures options. See also Reporting level. Speculation: An attempt to profit from commodity price changes through the purchase and/or sale of commodity futures. In the process, the speculator assumes the risk that the hedger is transferring, and provides liquidity in the market. Speculator: One who buys and sells stocks, land, etc., risking his capital with the goal of earning a profit from price changes. In contrast to gamblers, speculators understand and evaluate existing market risks on the basis of data and experience, while gamblers are those who seek out man-made risks or "invest" in a roll of the dice. Spot: The market in which commodities are available for immediate delivery. It also refers to the cash market price of a specific commodity. Spread: l) Positions held in two different futures contracts, taken to profit from the change in the difference between the two contracts' prices; e.g., long a January Soybean contract and short a March Soybean contract would be a bull spread, used to profit from a narrowing in the difference between the two prices; 2) The difference between the prices of two futures contracts. If January beans are $6.15 and March beans are $6.28, the spread is -.13 or 13?under ($6.15 - 6.28 = -.13). Spreading: The purchase of one futures contract and the sale of another in an attempt to profit from the change in price differences between the two contracts. Inter-market, intercommodity, inter- delivery, and commodity product are examples of spreads. Stop orders: An order which becomes a market order once a certain price level is reached. These orders are often placed with the purpose of limiting losses. They also are used to initiate positions. Buy stop orders are placed at a price above the current market price. Sell stop orders are placed below the market price. A buy stop order is activated by a bid or trade at or above the stop price. A sell stop is triggered by a trade or offer at or below the stop. Stopped out: When a stop order is activated and a position is offset, the trader has been "stopped out." Storage: The cost to store commodities from one delivery month to another. Storage is one of the "carrying charges" associated with futures. Straddle: For futures, the same as spreading. In futures options, a straddle is formed by going long a call and a put of the same strike price (long straddle), or going short a call and a put of the same strike price (short straddle) . Strangle spread: Makes maximum use of the premium's time value decay. To utilize a strangle most profitably, choose a market that is trading within a given range (volatility peaking), and sell an out-of-the-money call and an out-of-the-money put. Strike price: The specified price at which an option contract may be exercised. If the buyer of the option exercises (demands performance), the futures contract positions will be entered at the strike price. Strong basis: A relatively small difference between cash prices and futures prices. A strong basis also can be called a "narrow basis," or a "more positive basis": for example, a strong basis usually occurs in grains in the spring before harvest when supplies are low. Buyers must raise their bids to buy. As the cash prices rise, relative to futures prices, the basis strengthens. A strong basis indicates a good selling market, but a poor buying market. Supply: The quantity of a good available to meet demand. Supply consists of inventories from previous production, current production, and expected future production. Because resources are scarce, supply creates demand. Only price must be determined. Support: A horizontal price range where price hovers due to buying pressure before attempting a downward move. Surplus fund: A fund established by an exchange for the protection of customers' monies; a portion of all clearing fees are set aside for this fund. Symbols: Letters used to designate which futures or options price and which contract month is desired. Symbols are used to access quotes from various quote systems. Synthetic position: A hedging strategy combining futures and futures options for price protection and increased profit potential; for example, by buying a put option and selling (writing) a call option, a trader can construct a position that is similar to a short futures position. This position is known as a synthetic short futures position, and shows a profit if the futures prices decline, and receives margin calls if prices rise. Synthetic positions are a form of arbitrage. Technical analysis: Technical analysis uses charts to examine changes in price patterns, volume of trading, open interest, and rates of change to predict and profit from trends. Someone who follows technical rules (called a technician) believes that prices will anticipate changes in fundamentals. Technician: One who uses technical analysis to forecast price movements. Terms: The components, elements, or parts of an agreement. The "terms" of a futures contract include: which commodity, its quality, the quantity, the time and place of delivery, and its price. All the terms of futures and futures option contracts are standardized by the exchange, except for price, which is determined through "open-outcry" in the exchanges' trading pits. Tick: The minimum allowable price fluctuation (up or down) for a futures contract. Different contracts have different size ticks. Ticks can be stated in terms of price per unit of measure, or in dollars and cents. See also Point. Time value: The premium of an out-of-the money option reflecting the probability that an option will move into-the-money before expiration constitutes the time value of the option. There also may be some time value in the premium of an in-the-money option, which reflects the probability of the option moving further into the money. To determine the time value of an in-the-money option, subtract the amount by which the option is in-the-money (intrinsic value) from the total premium. Trading range: The prices between the high and the low for a specific time period (day, week, life of the contract). Trend: A significant price movement in one direction or another. Trends may go either up or down. Underlying futures contract: The futures contract covered by an option; for example, a 300 Dec. corn call's underlying futures contract is the December corn futures contract. Uptrend: A channel of upward price movement. Value: The importance placed on something by an individual. Value is subjective and may change according to the circumstances. Something that may be valued highly at one time may be valued less at another time. Volatile: A market which often is subject to wide price fluctuations is said to be volatile. This volatility is often due to a lack of liquidity. Volume: The number of futures contracts, calls, or puts traded in a day. Volume figures use the number of longs or shorts in a day, not both. Such figures are reported on the following day. Weak basis: A relatively large difference between cash prices and futures prices. A weak basis also can be called a "wide basis," or a "more negative basis": for example, a weak basis usually occurs in grains at harvest time when supplies are abundant. Buyers can lower their bids to buy. As the cash prices decline, relative to futures prices, the basis weakens (gets wider). A weak basis indicates a poor selling market, but a good buying market. Writer: One who sells an option. A "writer" (or grantor) obligates himself to deliver the underlying futures position to the option purchaser, should he decide to exercise his right to the underlying futures contract position. Option writers are subject to margin calls because they may have to produce the long or short futures position. A call writer must supply a long futures position upon exercise, and thus receive a short futures position. A put writer must supply a short futures position upon exercise, and thus receive a long futures position. Yield: 1) The production of a piece of land; e.g., his land yielded 100 bushels per acre. 2) The return provided by an investment; for example, if the return on an investment is 10%, the investment yields 10%.