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Sunday, October 21, 2007
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Understanding Futures & Options trading
Technicians utilize a three dimensional approach to market analysis which includes a study of price, volume and open interest. Of these three, price is the most important. However, volume and open interest provide important secondary confirmation of the price action on a chart and often provide a lead indication of an impending change of trend.
Volume represents the total amount of trading activity or contracts that have changed hands in a given futures market for a single trading day. The greater the amount of trading during a market session the higher will be the trading volume. As mentioned earlier, a higher volume bar on the chart means that the trading activity was heavier for that day. Another way to look at this, is that the volume represents a measure of intensity or pressure behind a price trend. The greater the volume the more we can expect the existing trend to continue rather than reverse. Technicians believe that volume precedes price, meaning that the loss of upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart.
Open Interest is the total number of outstanding contracts that are held by market participants at the end of each day. Where volume measures the pressure or intensity behind a price trend, open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both.
Each trade completed on the floor of a futures exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract. The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change. By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can be drawn. Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend ( up, down or sideways) will continue. Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves. A levelling off of steadily increasing open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
The relationship between the prevailing price trend, volume, and open interest can be summarized by the following table.
By monitoring the price trend, volume and open interest the technician is better able to gauge the buying or selling pressure behind market moves. This information can be used to confirm a price move or warn that a price move is not to be trusted.
Volume represents the total amount of trading activity or contracts that have changed hands in a given futures market for a single trading day. The greater the amount of trading during a market session the higher will be the trading volume. As mentioned earlier, a higher volume bar on the chart means that the trading activity was heavier for that day. Another way to look at this, is that the volume represents a measure of intensity or pressure behind a price trend. The greater the volume the more we can expect the existing trend to continue rather than reverse. Technicians believe that volume precedes price, meaning that the loss of upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart.
Open Interest is the total number of outstanding contracts that are held by market participants at the end of each day. Where volume measures the pressure or intensity behind a price trend, open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both.
Each trade completed on the floor of a futures exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract. The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change. By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can be drawn. Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend ( up, down or sideways) will continue. Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves. A levelling off of steadily increasing open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
The relationship between the prevailing price trend, volume, and open interest can be summarized by the following table.
| Price | Volume | Open Interest | Interpretation |
| Rising | Rising | Rising | Market is Strong - New buyers are entering |
| Rising | Falling | Falling | Market is Weakening - Possible Top |
| Falling | Rising | Rising | Market is Weak - Bearish |
| Falling | Falling | Falling | Market is Strengthening - Possible Bottom |
By monitoring the price trend, volume and open interest the technician is better able to gauge the buying or selling pressure behind market moves. This information can be used to confirm a price move or warn that a price move is not to be trusted.
Futures & Options
Futures
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.
Hedgers typically include producers and consumers of a commodity.
For example, in traditional commodities markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed.
Options
Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified amount of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.
The theoretical value of an option can be determined by a variety of techniques, including the use of sophisticated option valuation models. These models can also predict how the value of the option will change in the face of changing conditions. Hence, the risks associated with trading and owning options can be understood and managed with some degree of precision.
Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Another important class of options are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.
Contract Option
Every financial option is a contract between the two counterparties. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:
* whether the option holder has the right to buy (a call option) or the right to sell (a put option)
* the amount and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
* the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
* the expiration date, or expiry, which is the last date the option can be exercised
* the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount.
The value of an option can be estimated using a variety of quantitative techniques, although most commonly through the use of option pricing models such as Black-Scholes and the binomial options pricing model. In general, standard option valuation models depend on the following factors:
* The current market price of the underlying security,
* the strike price of the option, particularly in relation to the current market price of the underlier,
* the cost of holding a position in the underlying security, including interest and dividends,
* the time to expiration together with any restrictions on when exercise may occur, and
* an estimate of the future volatility of the underlying security's price over the life of the option.
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.
Hedgers typically include producers and consumers of a commodity.
For example, in traditional commodities markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed.
Options
Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified amount of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.
The theoretical value of an option can be determined by a variety of techniques, including the use of sophisticated option valuation models. These models can also predict how the value of the option will change in the face of changing conditions. Hence, the risks associated with trading and owning options can be understood and managed with some degree of precision.
Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Another important class of options are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.
Contract Option
Every financial option is a contract between the two counterparties. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:
* whether the option holder has the right to buy (a call option) or the right to sell (a put option)
* the amount and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
* the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
* the expiration date, or expiry, which is the last date the option can be exercised
* the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount.
The value of an option can be estimated using a variety of quantitative techniques, although most commonly through the use of option pricing models such as Black-Scholes and the binomial options pricing model. In general, standard option valuation models depend on the following factors:
* The current market price of the underlying security,
* the strike price of the option, particularly in relation to the current market price of the underlier,
* the cost of holding a position in the underlying security, including interest and dividends,
* the time to expiration together with any restrictions on when exercise may occur, and
* an estimate of the future volatility of the underlying security's price over the life of the option.
