The Institute for Financial Markets. Introduction to the Futures and Options Markets

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Table of Contents - Futures and Options on Futures Contracts - Market Institutions and Professionals - Life of a Futures Contract - Hedging and Spreading

Futures and options on futures contracts Introduction Modern futures markets have been traced to the trading of rice futures in eighteenth century Osaka, Japan. In the United States, futures trading began in the mid-nineteenth century with corn contracts in Chicago and cotton in New York. Today, futures and options on futures trading is a leading financial activity throughout the world, with contracts traded on a wide variety of commodities, financial instruments and indexes. Exchange-traded futures and options on futures provide several important economic benefits, including the ability to shift or otherwise manage the price risk of cash market or tangible positions. As open markets where large numbers of potential buyers and sellers compete for best prices, futures markets effectively discover and establish competitive prices. In part because these markets provide the opportunity for leveraged investments, they attract large pools of risk capital. As a result, futures markets are among the most liquid of all global financial markets, providing low transaction costs and ease of entry and exit. This, in turn, fosters their use by an array of business enterprises and investors to manage their price risks. And the savings resulting from effective risk management can be passed on to the final consumers of the commodities, currencies and financial instruments that underlie the futures and options on futures contracts.

Figure 1 Annual Futures & Options on Futures Contract Volume [Courtesy of FIA]

Today's futures industry functions with a number of time-tested institutional arrangements, including clearinghouse guarantees and exchange self-regulation. Futures and Options on

Futures Markets also reflect a tradition of innovation and growth, with new products, new exchanges and record trading volumes appearing each year. And while the U.S. markets have continued their pattern of steady expansion, recent increases in trading activity have been most pronounced outside the United States in the newer markets of Europe, Asia, Australia and Latin America, as evidenced in Figure 1.

Futures Contracts A futures contract is a standardized agreement between two parties that a) commits one to sell and the other to buy a stipulated quantity and grade of a commodity, currency, security, index or other specified item at a set price on or before a given date in the future; b) requires the daily settlement of all gains and losses as long as the contract remains open; and c) for contracts remaining open until trading terminates, provides either for delivery or a final cash payment (cash settlement). These contracts have several key features: 

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The buyer of a futures contract, the "long," agrees to receive delivery; The seller of a futures contract, the "short," agrees to make delivery; The contracts are traded on exchanges either by open outcry in specified trading areas (called pits or rings) or electronically via a computerized network; Futures contracts are marked to market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing

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accounts; Futures contracts can be terminated by an offsetting transaction (i.e., an equal and opposite transaction to the one that opened the position) executed at any time prior to the contract's expiration. The vast majority of futures contracts are terminated by

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offset or a final cash payment rather than by delivery; and The same or similar futures contracts can be traded on more than one exchange in the United States or elsewhere, although normally one contract tends to dominate its competitors on other exchanges in terms of trading activity and liquidity.

A standardized futures contract has a specific:  

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Underlying instrument--the commodity, currency, financial instrument or index upon which the contract is based; Size--the amount of the underlying item covered by the contract;

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Delivery cycle--the specified months for which contracts can be traded;

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and therefore all obligations under it terminate;

Expiration date--the date by which a particular futures trading month ceases to exist Grade or quality specification and delivery location--a detailed description of the "par" commodity, security or other item that is being traded and, as permitted by the contract, a specification of items of higher or lower quality or of alternate delivery locations available at a premium or discount; and

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Settlement mechanism--the terms of the physical delivery of the underlying item or of a terminal cash payment. The only non-standard item of a futures contract is the price of an underlying unit, which is determined in the trading arena.

The mechanics of futures trading are straightforward: both buyers and sellers deposit funds--traditionally called margin but more correctly characterized as a performance bond or good faith deposit--with a brokerage firm. This amount is typically a small percentage--less than 10 percent--of the total value of the item underlying the contract.

Figure 2:

Figure 3:

Payoff Diagram of a Long Futures Position

Payoff Diagram of a Short Futures Position

As indicated in Figure 2, if you buy (go long) a futures contract and the price goes up, you profit by the amount of the price increase times the contract size; if you buy and the price goes down, you lose an amount equal to the price decrease times the contract size. Figure 3 reflects the profit and loss potential of a short futures position. If you sell (go short) a futures contract and the price goes down, you profit by the amount of the price decrease times the contract size; if you sell and the price goes up, you lose an amount equal to the price increase times the contract size. These profits and losses are paid daily via the futures margining system, as illustrated later in this program.

Options on Futures Contracts An option on a future is the right, but not the obligation, to buy or sell a specified number of underlying futures contracts or a specified amount of a commodity, currency, index or financial instrument at an agreed upon price on or before a given future date. Options on futures are traded on the same exchanges that trade the underlying futures contracts and are standardized with respect to the quantity of the underlying futures contracts (by custom, one futures contract), expiration date, and exercise or strike price (the price at which the underlying futures contract can be bought or sold). In the United States, standardized options on futures that are exercisable directly into securities and securities indexes are classified as securities subject to regulation by the Securities and Exchange Commission (SEC); these contracts are traded on U.S. securities exchanges. In contrast, futures and options on futures (including options on many stock index futures) are

regulated by the Commodity Futures Trading Commission (CFTC) and traded on futures exchanges. The situation differs outside of the United States where, in many countries, there is a less distinct regulatory separation of the futures and securities industries and where, in many cases, financial futures are traded on stock exchanges. There are two types of options on futures - call options and put options. A call option on a futures contract gives the buyer the right, but not the obligation, to purchase the underlying contract at a specified price (the strike or exercise price) during the life of the option. A futures put option gives the buyer the right, but not the obligation, to sell the underlying contract at the strike or exercise price before the option expires. The cost of obtaining this right to buy or sell is known as the option's "premium." This is the price that is bid and offered in the exchange pit or via the exchange's computerized trading system. As with futures, exchange-traded options on futures positions can be closed out by offset--execution of a trade of equal size on the other side of the market from the transaction that originated the position. The major difference between futures and options on futures arises from the different obligations of an option's buyer and seller. A futures contract obligates both buyer and seller to perform the contract, either by an offsetting transaction or by delivery, and both parties to a futures contract derive a profit or loss equal to the difference between the price when the contract was initiated and when it was terminated. In contrast, an option buyer is not obliged to fulfill the option contract. The option buyer's loss is limited to the premium paid, but in order for the buyer to make a profit, the price must increase above (call option) or decrease below (put option) the option's strike price by the amount of the premium paid. In turn, the option seller (writer or grantor), in exchange for the premium received, must fulfill the option contract if the buyer so chooses. This situation--the option's exercise--takes place if the option has value (is "in the money") before it expires. Prerequisites for Futures and Options on Futures Markets Wherever there is price volatility, there is a potential need for futures and options on futures contracts. Originally developed for food and fiber crops, futures markets now also encompass livestock, precious and industrial metals, petroleum and other energy products, fixed-income securities, interbank deposits, currencies and stock indexes, as well as other intangibles such as catastrophic insurance. Whatever the item underlying the futures or options on futures contract, every market needs certain ingredients to flourish. These include:

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Risk-shifting potential--the contract must provide the ability for those with price risk in the underlying item to shift that risk to a market participant willing to accept it. Price volatility--the price of the underlying item must change enough to warrant the need for shifting price risk. Cash market competition--the underlying cash (or physicals) market must be broad enough to allow for healthy competition, which creates a need to manage price risk and decreases the likelihood of market corners, squeezes or manipulation. Trading liquidity--active trading is needed so that sizable orders can be executed rapidly and inexpensively. Standardized underlying entity--the commodity, security, index or other item underlying the futures contract must be standardized and/or capable of being graded so that it is clear what is being bought and sold.

Contract Innovations The futures industry has a long history of product innovation. Corn, wheat, and cotton trading dates from the post-Civil War period in the United States. Metals trading began in the 1920s, while refined agricultural products--soybean meal and oil--became available in the early 1950s. A new wave of innovation began in the 1960s when futures on a perishable commodity--livestock--were first introduced. In 1972, following the demise of the Bretton Woods system of fixed exchange rates, the financial futures era began with the introduction of futures contracts on foreign currencies. With the legalization of private ownership of gold by U.S. citizens at the end of 1974, gold futures commenced trading. As interest rates became more volatile, futures exchanges introduced interest rate futures, beginning in 1975 with the GNMA contract based on a pool of mortgages. The following year three-month Treasury-bill futures were introduced, and in 1977 the very popular Treasury-bond futures contract debuted. Energy futures trading in the United States dates from the 1978 inauguration of heating oil futures. Following the weakening of OPEC's control over the global oil market, other successful petroleum-based futures, most notably crude oil and gasoline contracts, were introduced. All these relatively recent futures contracts adopted and adapted the delivery mechanism designed for grain and cotton trading developed in the mid-1800s. That delivery mechanism assured price convergence between the expiring futures contract and the underlying cash market, thereby validating futures contracts as hedging instruments. In 1981, Eurodollar futures became the first futures contract that did not require delivery. Instead, the contract called for settlement in cash, in effect a payment on the last trading day of the difference between a reputable, independent and widely accepted cash price and the

futures price. The cash-settlement innovation safeguarded the futures contract's usefulness to hedgers and opened the way for new types of contracts on which a delivery option would be impossible or prohibitively expensive; most notable among these are stock index futures, which began trading in 1982. That same year options on futures were reintroduced after a 50-year ban in the United States. The mid- to late-1980s also were a period of phenomenal international growth of Futures and Options on Futures Markets, as numerous new exchanges opened throughout the world. While these exchanges offer a range of contracts, their most successful products fall into three broad categories modeled on the innovative contracts introduced in Chicago from 1977 to 1982--futures and options on futures on government bonds, short-term interbank interest rates and stock indexes. The U.S. prototypes of these successful global contracts are the U.S. Treasury bond, Eurodollar, and S&P 500 stock index futures and options on futures. A Comparison of Futures, Equities, Forwards and Over-the-Counter Derivatives Futures have a number of characteristics in common with equities, forward contracts and over-the-counter (OTC) derivatives, as well as a number of dissimilarities. A comparison of these financial instruments is useful to understand the purposes and functions of futures contracts. Futures and Equities Important differences between futures and equities include:  

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Purpose--futures markets exist to facilitate risk shifting and price discovery; the principal purpose of equities markets is to foster capital formation. Short positions--in futures trading there is a short for every long; in equities markets, short positions are normally a minor factor. In addition, establishing a short position in a futures market is no more difficult than establishing a long position. In contrast, a short position in equities requires owning or borrowing the securities and payment of dividends. Margin--the customer funds deposited to carry a futures position are a performance bond or good faith money, securing the promise to fulfill the contract's obligations. Typically, futures positions are marked to market on a daily basis, and no interest is charged to maintain a futures position. In margined stock purchases, the margin acts as a down payment, and the balance of the purchase price is borrowed, with interest charged. There is no daily marking to market in the equities

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markets, but if prices change by a significant amount a maintenance margin call is made. Maturity--the life of a futures contract is limited to its specified expiration date; most equities are issued without a termination date. Price and position limits--a price limit on a futures contract establishes the maximum range of trading prices during a given day. A futures position limit establishes the maximum exposure a market participant may assume in a particular market. Many futures markets have price and/or position limits. Equities typically do not have limits on price movements or the size of positions. Supply--while the outstanding number of equities is fixed at a given moment, there is no theoretical limit on the number of futures or options on futures that may exist at a particular time in a specific market. Ownership record--unlike equities, where a customer can ask a broker for a certificate that evidences ownership, there are no comparable certificates for futures or options on futures. A customer's written record of a futures position is the trade confirmation received from the brokerage house through which the trade was made. Market-making system--open-outcry futures markets typically operate with a multiple market-maker system, involving floor traders and floor brokers competing on equal footing in an auction-style, open-outcry market. Equities markets typically operate with a specialist system, where the designated specialist has specified privileges and responsibilities with respect to a given stock, although non-specialist brokers also may compete for trades.

Futures and Forward Contracts A forward contract can be considered a customized futures contract. A forward is an agreement between two parties to buy or sell a commodity or asset at a specific future time for an agreed upon price. Typically, the contract is between a producer and a merchant; two financial institutions; or a financial institution and a corporate client. Historically, forward contracts developed as customized instruments involving delivery of an underlying commodity or financial instrument. Important distinctions between forward and futures contracts include: 

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Contract guarantee--the performance of futures and options on futures contracts is guaranteed by the clearinghouse of the exchange on which the contracts are executed. Because no such clearinghouse exists for forward contracts, participants must pay particular attention to counterparty creditworthiness. Cash flows--exchange-traded contracts involve daily payments of profits and losses via a mark-to-market margining system, while forward

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contracts generally do not involve daily or other periodic payments of accumulated gains or losses. As a result, large paper losses and gains may accumulate with forward contracts and increase the likelihood and cost of a default. Alternatively, depending upon the creditworthiness of the counterparties and the magnitude of the exposure, parties to forward contracts may be required to post collateral and/or make periodic payments against accumulated losses. Contract terms--futures contracts are standardized; forward contracts are created on a customized basis, with terms such as the grade of the underlying commodity or asset, delivery location and date, credit arrangements and default provisions negotiated between and tailored to the needs of the two parties. Liquidity--in the absence of standardized contracts and a large number of buyers and sellers, forward markets often lack the low transaction costs and ease of entry and exit found on liquid exchange markets.

Futures and Over-the-Counter Derivatives Over-the-counter derivatives encompass tailored financial instruments, such as swaps, swaptions, caps and collars, that are traded in the offices of the world's leading financial institutions. OTC derivatives are similar to forward contracts that have been used by commercial enterprises for over a century; each of the previously mentioned distinctions between futures and forwards discussed above also applies to a comparison of futures and OTC derivatives. As with forwards, the growth of OTC derivatives trading has been fostered by the existence of liquid futures and options on futures exchange markets in which the risks of the customized OTC instruments can be transferred to a broader marketplace.

Market institutions and professionals

Regulators The U.S. futures industry has three levels of regulation: 1. the Commodity Futures Trading Commission, an independent federal regulatory agency; 2. the National Futures Association, an industry-wide self-regulatory organization, and 3. the futures exchanges that have regulatory obligations for their members. Exchanges Futures and options on futures exchanges are associations of members organized to provide competitive markets and the facilities and staffs to support such markets. The first U.S. futures exchange was the Chicago Board of Trade, organized in the mid-nineteenth century to provide a central marketplace where buyers and sellers could meet under rules that protect the interest of all concerned. Since then, the number of futures exchanges throughout the world has rapidly increased to more than 90 and the not-for-profit membership model was not followed by new exchanges and many have demutualized to become a for-profit organization. In the United States, exchange membership is available only to individuals, some of whom hold a membership for their firm. Members of an exchange may exercise their trading privileges as independent market-makers (so-called floor traders or locals) trading for their own accounts or as floor brokers executing customer orders. Exchange members who trade both for customers and for themselves are called dual traders. Today, a sizeable amount of futures and options on futures trading is conducted through computerized, electronic Futures and Options on Futures Markets and less by open outcry in exchange pits or trading rings. Computerized Futures and Options on Futures Markets have grown significantly during the last two decades with the evolution of the technological trading process, both as the sole mode of trading and as hybrid or an after-hours supplement to open-outcry trading. Most European and Asian exchanges are fully electronic, and other exchanges like the ICE Futures U.S .(formerly the New York Board of Trade), Minneapolis Grain Exchange and BM&F Bovespa in Latin America have closed their trading pits. In open-outcry trading, exchange members stand in pits making bids and offers, by voice and with hand signals, to the rest of the traders in the pit. Customer

orders coming into the futures pit are delivered to floor brokers or dual traders who execute them according to the order's instructions. For example, a "market" order tells the broker to execute the order immediately at the prevailing price in the pit; a "limit" order specifies the price (or better) at which the order can be filled; and a "stop" order tells the broker to execute an order at the market price if a certain price is reached. Other types of orders specify the time of the trade (e.g., at the market's open or close) or allow a broker discretion in the execution. Orders also can indicate the period for which they are valid, e.g., a day, a week or until canceled. The Life of a Futures Contract chart traces a customer order from its initiation through the clearing process and indicates how futures volume and open interest are created, extinguished and tallied. Clearinghouses and Margins All futures and options on futures exchanges have clearinghouses that play a central role in these markets. Most notably, a futures clearinghouse facilitates trade among strangers by eliminating counterparty risk and guaranteeing the integrity of the contracts. In the United States, historically, each futures exchange has had its own clearinghouse--either formed as a separate entity or as a part of the exchange. Recently, a number of U.S. futures exchanges have begun exploring modes of common clearing; in other countries, such as the United Kingdom, and for U.S. securities options, a single clearinghouse serves several exchanges. Only clearinghouse members can submit trades to the clearinghouse, and while every member of a clearinghouse must also be a member of the related exchange, not all exchange members are members of the clearinghouse. Clearinghouse membership involves financial requirements and responsibilities over and above those of exchange membership, including the maintenance of a guaranty deposit at the clearinghouse. This deposit serves as a reserve fund that can be used, if necessary, to meet the financial obligations of a defaulting clearing member. It is the clearinghouse's responsibility to collect original margin from its members for the futures and options on futures contracts traded on the exchange. The clearinghouse's original margin, which is the minimum amount clearing members normally collect from their customers, reflects historical price volatility and generally is set at a level sufficient to protect the clearinghouse against one day's maximum (or historically very large) price movement in the particular futures or options on futures contract. As part of the daily marking to market of futures and options, clearing members each day pay to or receive from the clearinghouse funds known as variation

margin. In volatile markets variation margin may be collected intraday, with clearing members sometimes required to deposit funds within one hour of the margin call. In contrast to clearinghouse margins, minimum customer margins in Futures and Options on Futures Markets are set by the exchanges on which the contracts trade. For most contracts, there is a difference between the amount of margin exchanges require to be deposited when a trade is initiated (initial margin) and the minimum amount of margin the customer must maintain in his or her account at all times for each open position (maintenance margin). For a few contracts and for many commercial accounts, the initial and maintenance margin levels may be the same. The process of marking futures positions to market each day ensures that accounts are kept current. If there is profit, this can be paid to the customer. If there is a loss, the customer pays the full amount. If the loss is greater than the margin funds on deposit, the customer is required to pay the difference. The Margining Example provides an example of how customer margins work in practice. Futures Commission Merchants A futures brokerage firm, known as a futures commission merchant (FCM), is the intermediary between public customers, including hedgers and institutional investors, and the exchanges; it is the only entity outside the futures clearinghouse that can hold customer funds. A brokerage firm provides the facilities to execute customer orders on the exchange and maintains records of each customer's positions, margin deposits, money balances and completed transactions. In return for providing these services, a brokerage firm collects commissions. In the United States, a futures brokerage firm must meet a number of regulatory requirements, including the maintenance of a minimum level of net capital. A futures brokerage firm also must be a member of the National Futures Association (NFA), an industry-wide self-regulatory organization. An FCM may be a full-service or a discount firm. Some FCMs are part of national or regional brokerage companies that also offer securities and other financial services, while other FCMs offer only futures and/or options on futures to their customers. In addition, some FCMs have as a parent or are related to a commercial bank, agribusiness company or other commercial enterprise. Introducing Brokers An introducing broker (IB) is an individual or firm that has established a relationship with one or more brokerage firms. Similar to an FCM, an IB is

responsible for maintaining customer relationships and servicing customer accounts, and its sales force receives commissions. However, an IB cannot accept funds from its customers, and, as a result, all customers of IBs must open and maintain accounts with an FCM. There are two types of introducing brokerage firms--independent and guaranteed. IBs that have sufficient capital to meet regulatory requirements may choose to introduce their clients through a number of different FCMs. Such IBs are known as independent or non-guaranteed IBs. A guaranteed IB has a legal and regulatory relationship with the guarantor FCM through which the IB introduces its customers. Commodity Pools Many large institutions as well as numerous individual investors throughout the world now include managed futures positions in their portfolios. These positions can be in the form of commodity pools or individually managed accounts at an FCM. A private commodity pool or public commodity fund operates much like a stock or bond mutual fund in that investors with limited resources or time can purchase diversified investments that are professionally managed. As with mutual funds, a number of commodity pools are sponsored by major brokerage firms. However, in many cases commodity pools provide significantly more leverage than stock mutual funds. Commodity pools also provide limited liability to their investors, since the risk of loss is no greater than the amount of capital invested. This contrasts with an individual futures account, including individually managed accounts, in which the investor can receive margin calls and lose more money than was initially deposited. Commodity Trading Advisors A commodity trading advisor (CTA) trades for others and/or makes trading recommendations to others. CTAs are responsible for trading individually managed accounts and are hired to trade on behalf of commodity pools and funds. CTAs typically receive two types of compensation: a management fee, which is levied whether or not the client makes money, and an incentive fee, charged as a percentage of net new trading profits in the client's account.

Life of a future contract How Futures Contracts are Created and Extinguished (Offset) 1. Creation of a Futures Contract: Neither Buyer Nor Seller Has Any Current Futures Positions.

How Futures Contracts are Created and Extinguished (Offset) 2. Extinguishing (Offset) of a Futures Contract: Buyer and Seller Have Current Opposite Futures Positions

*Assume Buyer's and Seller's FCMs are members of the clearinghouse.

How Futures Contracts are Created and Extinguished (Offset) 3. Creation and Extinguishing (Offset) of a Futures Contract: One Trader Has A Current Futures Position and One Trader Does Not.

*Assume Buyer's and Seller's FCMs are members of the clearinghouse.

Hedging and spreading Hedging Historically, futures market participants have been divided into two broad categories: hedgers, who seek to reduce risks associated with dealing in the underlying commodity or security, and speculators (including professional floor traders), who seek to profit from price changes. More recently, a new category of participant has emerged--the portfolio manager who uses futures and options as essential elements of portfolio management. For speculators, the attraction of futures markets includes their leverage, the diversification they add to a portfolio, the ease of assuming short as well as long positions, and the low cost of market entry and exit. Speculators and market-makers assume the risk transferred by hedgers and provide the liquidity that assures low transaction costs and reliable price discovery in futures markets. Hedging is central to Futures and Options on Futures Markets, and a familiarity with hedging practices is necessary to understand how these markets work. In simplest terms, hedgers:   

Identify their price risk, Decide how much to hedge, and Decide where and how to hedge.

In futures markets hedging involves taking a futures position opposite to that of a cash market position. That is, a corn farmer would sell corn futures against his crop; an importer of Japanese cars would buy yen futures against her yen liability; a precious metals merchant would purchase gold futures against a fixed-price gold sales contract; and a pension fund manager would sell stock index futures against the fund's portfolio of equities in anticipation of a market decline. Examples of the types of risk - management activities that rely on the use of futures include:       

Stabilizing cash flows; Setting purchase or sale prices of commodities and securities; Diversifying holdings; More closely matching balance sheet assets and liabilities; Reducing transaction costs; Decreasing costs of storage; and Minimizing the capital needed to carry inventories.

The cash-futures basis The difference between a commodity's or security's cash and futures prices is known as the "cash-futures basis," as illustrated inFigure 4. While futures trading can eliminate price level risk, it cannot eliminate the risk that the basis will change unfavorably and unpredictably during the lifetime of the hedge. The cash-futures basis is subject to many influences, including Figure 4: seasonal factors, weather conditions, Cash-futures Basis temporary gluts or scarcities of commodities, and the availability of transport facilities. Other factors affecting the relationship between cash and futures prices are costs related to carrying commodities and securities, such as interest rates and warehouse fees. In certain financial markets, basis reflects the difference between long-term and short-term interest rates. Basis risk is particularly prevalent in "cross hedging" one commodity with another one. For example, if the commodity to be hedged does not have an exact match in the futures market, the closest commodity may have to be substituted—e.g., an airline might use crude or heating oil futures to hedge jet fuel needs or a money manager may use the S&P 500 Index futures contract to hedge his portfolio of stocks. Prices of the two types of fuel or the two groups of securities may move closely for significant periods of time, but there is no guarantee that past price relationships will continue into the future. Care must be taken to evaluate properly the relationship between the commodity underlying the futures contract and the cash commodity being hedged. Spreading A spread position is the simultaneous purchase and sale of two related futures or options on futures positions. Spread positions are undertaken when the prices of two futures or options on futures contracts are considered out-of-line with each other. In many ways futures and options spreads are analogous to arbitrage or quasi-arbitrage positions. Futures spreads can be divided into two broad categories: intramarket spreads and intermarket spreads.

Intramarket Spreads An intramarket spread, also called a time spread, comprises a long position in one contract month against a short position in another contract month in the same futures contract on the same exchange. An example would be long March Sugar #11 futures contract, the world benchmark contract for raw sugar trading vs. short July sugar futures on ICE Futures U.S. or short September soybean futures vs. long January soybean futures on the Chicago Board of Trade (CME Group).

Figure 5:

Figure 6:

Carrying Charge or Contango Market

Inverted Market or Backwardation

The spread, or difference, between the prices of various futures delivery months reflects supply, demand and carrying costs. Because carrying costs generally increase over time, in many futures markets the price of each succeeding delivery month is higher than that of the preceding delivery month. This is called a carrying-charge, or contango, market, as illustrated in Figure 5. In contrast, in some futures markets the highest price is for the nearby or spot month, and each successive delivery month is priced lower than the preceding month, as depicted in Figure 6. This is called an inverted market, or one in backwardation. Inverted markets sometimes occur when demand for the cash commodity is strong relative to its current supply. Inverted markets also occur when the income from holding the cash position exceeds the costs of carrying the position--for example, a U.S. Treasury bond futures position when long-term interest rates (the underlying bonds' yield) exceed short-term rates (the cost of financing the cash bond portfolio).

Intermarket Spreads An intermarket spread consists of a long position in one market and a short position in another market trading the same or a closely related commodity. An example is light sweet crude oil futures at the New York Mercantile Exchange (CME Group) and Brent crude oil futures on the ICE Futures Europe or wheat contracts traded on the Chicago Board of Trade (CME Group) and the Kansas City Board of Trade. Intermarket spreads often involve different grades, locations or specifications of a commodity, thereby introducing additional basis risk. Also included among intermarket spreads are commodity-products spreads, which comprise a long position in a commodity against short positions of an equivalent amount of the products derived from the commodity, or vice versa. Examples are the soybean crush and the petroleum crack spreads. A crush spread involves a long soybean futures position, representing the raw, unprocessed beans, against short positions in soybean meal and soybean oil futures. The petroleum crack spread involves purchasing crude oil futures and selling the products-heating oil and gasoline futures.