Chapter 5 - Speculating with Futures Contracts

Question 1

What is a commodity product spread?

Answer 1

A spread that involves the purchase or
sale of a commodity futures contract
against the opposite position in the
products of the commodity.

Question 2

What are day traders?

Answer 2

A type of speculator whose time
horizon is a single day.

Question 3

What is fundamental analysis?

Answer 3

The study of an asset’s current and
expected supply and demand situation
in order to help forecast future price
movements.

Question 4

What is an intercommodity spread?

Answer 4

A spread that involves the purchase
and sale of futures contracts that have
different but related underlying assets.
The two contracts may trade on the
same or different exchanges.

Question 5

What is an intermarket spread?

Answer 5

A spread that involves the purchase
and sale of futures contracts that have
the same underlying asset but trade on
different exchanges.

Question 6

What is an intramarket spread?

Answer 6

Also known as a calendar or time
spread. Involves buying and selling
futures contracts that trade on the
same exchange and that have the
same underlying interest but different
expiry months.

Question 7

What are locals (scalpers)?

Answer 7

Floor traders who trade for their own
accounts.

Question 8

What are managed futures accounts?

Answer 8

Individual accounts where a client
gives discretionary authority over to a
commodity trading professional.

Question 9

What are managed futures funds?

Answer 9

Essentially mutual funds that invest in
futures markets.

Question 10

What are mini contracts?

Answer 10

Derivative contracts representing a
fraction (typically 1/5 or 1/10) of a
standard futures or options contract.

Question 11

What are position traders?

Answer 11

A type of speculator who is hoping to
profit from longer-term price trends.

Question 12

What is a spread strategy?

Answer 12

Describes a market strategy that
attempts to take advantage of relative
price changes between two different
but similar futures contracts.

Question 13

What are spread traders?

Answer 13

Trader simultaneously taking a long
position in one asset and a short
position in a related asset.

Question 14

What is technical analysis?

Answer 14

The study of past price and volume
data in order to anticipate future
market movements.

Question 15

What is a whipsaw?

Answer 15

Situation where a speculator is forced
to close out a position due to an
adverse price movement, only to see
the price quickly rebound back in the
favoured direction.

Question 16

Explain and list the reasons why speculators are attracted to futures markets.

Answer 16

Speculators are attracted to futures markets for a variety of reasons. The primary reasons include:

i. ease of entry and exit;
ii. a wide variety of opportunities;
iii. leverage; and
iv. excitement.

Question 17

Describe the different types of futures speculators.

Answer 17

• Locals
  Locals operate from the floor of the exchange and generally have a very short time horizon for their trades.
• Day traders
  Day traders tend to take more risk than locals and try to liquidate all positions by the end of each trading day.
• Position traders
  Position traders attempt to profit from longer-term price swings and in the process avoid getting whipsawed
  as much as day traders and locals.
• Spread traders
  Spread traders try to profit from changing relationships between two or more futures contracts. Once a
  potential trade opportunity is identified, spread traders buy the underpriced futures contract and sell the
  overpriced futures contract.
• Managed product investors
  Managed product investors invest in the futures market through professionally managed vehicles, including
  managed accounts and managed futures funds.

Question 18

Explain what a futures spread strategy is.

Answer 18

A futures spread strategy involves the purchase of one futures contract and the simultaneous sale of one or
more different futures contracts that are related in some fashion.
Each individual futures contract in a spread is referred to as a leg of the spread.

Question 19

Identify the four different types of futures spread strategies.

Answer 19

There are four types of futures spreads:

• Intramarket spreads (also known as time or calendar spreads)
  An intramarket spread involves the purchase and sale of futures contracts that have the same underlying asset
  but different delivery months.
• Intercommodity spreads
  An intercommodity spread involves the purchase and sale of futures contracts that have different but related
  underlying assets.
• Intermarket spreads
  An intermarket spread involves the purchase and sale of futures contracts with the same underlying asset
  trading on different exchanges.
• Commodity product spreads
  A commodity product spread involves the purchase and/or sale of a commodity futures contract with an
  opposite position in the futures contracts of the products of that commodity.

Question 20

Calculate the profit or loss from a futures spread strategy.

Answer 20

For most types of spreads, the profit or loss on the spread strategy can be calculated in one of two ways:

• First, a profit or loss from each leg of the spread can be calculated separately. Adding up the separate profits
  and losses results in an overall profit or loss for the spread.
• Second, the profit or loss can be derived from a single calculation using the spread prices directly.

Question 21

Explain the differences between fundamental and technical analysis.

Answer 21

Fundamental analysis is the study of an asset’s supply and demand factors to help forecast future price
movements. Technical analysis involves the study of price, open interest, and volume to help forecast future
price movements. Rather than attempting to understand the supply and demand factors that cause price
movements (as fundamental analysis does), technical analysis focuses on the price movements themselves.

Question 22

If a speculator bought 1 June gold futures contract (100 ounces) at a price of $1,740.20 and offset the contract
at $1,778.60, what is the return on margin if the speculator had made a margin deposit of $7,000?

a. −67.68%
b. −54.86%
c. 54.86%
d. 67.68%

Answer 22

c. 54.86%

(($1,778.60 − $1,740.20) × 100 × 1) ÷ $7,000

Question 23

A speculator bought 3 November canola futures (20 tonnes per contract) at $402.50. The speculator
subsequently sold the contracts at $421.70 per tonne and, as a result, earned a 20% return on margin. What
total initial margin deposit did the speculator make?

a. $1,152
b. $1,920
c. $3,840
d. $5,760

Answer 23

d. $5,760

Total dollar profit: ($421.70 − $402.50) × 20 × 3 = $1,152
Total margin deposited: $1,152 ÷ 20% = $5,760

Question 24

If a speculator wants to profit from relative price changes in different delivery months of the same underlying
commodity, what type of spread would she enter into?

Answer 24

An intramarket spread offers speculators the chance to profit from a relative price change in the different
delivery months of the same underlying commodity.

Question 25

A trader bought 5 July canola futures (20 tonnes per contract) at $406.80 per tonne and simultaneously sold
5 November canola futures at $422.10 per tonne. The trader subsequently offset the spread with November
canola trading $28.50 per tonne higher than July canola. What is the trader’s overall profit or loss on the
spread trade?

a. $2,640 loss.
b. $1,320 loss.
c. $1,320 profit.
d. $2,640 profit.

Answer 25

b. $1,320 loss.

($15.30 − $28.50) × 20 × 5
The spread was initiated by selling the November contracts at a premium (i.e., higher price) of $15.30
($422.10 November price − $406.80 July price) over the July price. Because the trader is short the higher-
priced contract, she wants the spread to narrow (i.e., the November premium relative to July to get smaller)
to earn a profit. In this case, the spread actually widened to a $28.50 November premium, and the trader
realized a loss.

Question 26

A speculator bought 10 soybean futures (5,000 bushels per contract) at $6.45 per bushel, sold 11 soybean
meal futures (100 tons per contract) at $165.80 per ton, and sold 9 soybean oil futures (60,000 lbs. per
contract) at $0.2763 per lb.
Two weeks after implementing the spread, the speculator sells 10 soybean futures at $6.5475, buys 11 soybean
meal futures at $168.70 per ton, and buys 9 soybean oil futures at $0.2765 per lb.
What is the speculator’s overall profit or loss on the spread?

a. $8,173 loss.
b. $1,577 loss.
c. $1,577 profit.
d. $8,173 profit.

Answer 26

c. $1,577 profit.

Soybeans: ($6.5475 − $6.45) × 5,000 × 10 = $4,875 profit
Soybean meal: ($165.80 − $168.70) × 100 × 11 = $3,190 loss
Soybean oil: ($0.2763 − $0.2765) × 60,000 × 9 = $108 loss
Total profit is $1,577 ($4,875 − $3,190 − $108)

Question 27

List three limitations of fundamental analysis.

Answer 27

Three limitations of fundamental analysis include:

• Imprecise in forecasting specific price levels.
• Imprecise as to the timing of an expected price move.
• It is difficult to build all of the factors that could potentially impact prices into a fundamental forecast.

Question 28

Explain why an investor would short the higher price contract if they were expecting the spread to narrow and go long the higher price if they were expecting the spread to widen in a futures spread play.

Answer 28

Shorting the Higher Price in a Futures Spread:

1. Initial Position: You sell the higher-priced future (short) and buy the lower-priced future (long).
2. Objective: For profit, the spread (difference between the two prices) should narrow.
3. Why: If the higher price drops or the lower price rises (or both), the difference between them decreases. Since you sold at a higher price, you’ll profit from the decrease when you close the position.

Shorting the Lower Price in a Futures Spread:

1. Initial Position: You sell the lower-priced future (short) and buy the higher-priced future (long).
2. Objective: For profit, the spread should widen.
3. Why: If the lower price drops further or the higher price rises more (or both), the difference between them increases. Since you sold at a lower price, you’ll profit from the increase when you close the position.

In essence:

• Short higher price: Profit from a narrowing spread (prices get closer together).
• Short lower price: Profit from a widening spread (prices get further apart).

In futures trading, a spread involves taking two positions at once to profit from the difference in prices between two related futures contracts. Here’s a simple breakdown:

Buying a futures spread:
- You buy one futures contract and simultaneously sell another.
- You profit if the price of the bought contract increases relative to the sold contract.

Selling a futures spread:
- You sell one futures contract and simultaneously buy another.
- You profit if the price of the sold contract decreases relative to the bought contract.

Essentially, you’re betting on the price difference between the two contracts, rather than on the direction of the overall market.