AN INTRODUCTION TO FUTURES - cmegroup.com

1 FUTURESAND OPTIONSAN INTRODUCTION TO 2 FUTURESAND OPTIONSAN INTRODUCTION TO STUDENT MANUAL3 Global Leadership in the Financial Marketplace CME is the largest and most diverse financial FUTURES and optionsexchange in the world - handling over 1 billion FUTURES contractsworth more than $660 trillion in a single year. Founded in 1898,we serve the risk-management needs of customers around the globeby offering the widest range of benchmark financial products availableon any exchange, traded via our CME Globex electronic tradingplatform and on our trading floors. Our innovative products covermajor market segments - including interest rates, equities, foreignexchange, commodities and alternative investment products - andimprove the way these markets work for customers INTRODUCTION to FUTURES and OptionsPAGE chapter 1 THE BIRTH OF FUTURES1 chapter 2 THE FUTURES MARKETS14 chapter 3 TRADING VENUES.

2 OPEN OUTCRY & ELECTRONIC TRADE MATCHING21 chapter 4 TERMINOLOGY AND ORDER TYPES36 chapter 5 HEDGING AND SPECULATING49 chapter 6 ARBITRAGE56 chapter 7 SPREADING59 chapter 8 FUNDAMENTAL AND TECHNICAL ANALYSIS68 chapter 9 FUTURES AND EXCHANGE-TRADED OPTIONS ON FUTURES81 chapter 10 FOLLOWING FUTURES AND OPTIONS PRICES88 APPENDIXGLOSSARY93 THE ART OF HAND SIGNALS100 CME WEB SITE108 ANSWER KEY FOR QUIZZES110 TABLE OF CONTENTS5An INTRODUCTION to FUTURES and Options has been prepared by the CME Market Education Department. We hopethat this manual will broaden any knowledge you may already have about FUTURES and options or spark an interest in this industry if you have not come into contact with it before now.

3 We also offer a number of other courses, both online and in classrooms, related to the FUTURES industry. Please check our course catalog, available in print from our office and online at If you have any questions, please contact the CME Market EducationDepartment in Chicago at (312) 930-6937 or by dialing special acknowledgement to Larry Schneider, Director of Sales and Marketing for the Zaner Group,former CME member, and an instructor in the CME Market Education Department for more than 25 years;and to the interns from DePaul University, for their invaluable assistance in the updating of this text.

4 1 THEBIRTHOFFUTURES1An INTRODUCTION to FUTURES and OptionsIn the BeginningIn the mid-1840s, Chicago began to emerge as the market center for farmers in neighboringstates. At harvest time, farmers converged on the city to sell their grain. There was often somuch grain that the farmers had to dump a lot of it into Lake Michigan because there werenot enough buyers and no way to store it. This was unfortunate, because by the time springrolled around, grain was in short supply. How did these extreme conditions of having too much grain and then not enough of it affectgrain prices? Let s take a closer look at the forces of supply and demand to give us a clue.

5 A Tomato Story As an example, take a look at what happens to the price of tomatoes in the have so many tomatoes to sell that they must lower their prices to get people to buyall of them. (Who can resist a bargain?) When prices fall because of excess supply, buyershave the upper what happens in the winter? People want tomatoes then just as much as in the as you know, fewer tomatoes are available. Tomatoes can t be grown in the cold, somost are grown in greenhouses (or these days, shipped from warm places). You can t grownearly as many tomatoes in a greenhouse as you can on a large farm, and shipping is moredifficult than having a supply nearby, so fewer tomatoes are brought to the market.

6 Peoplewho want tomatoes for their salads and BLTs during the winter find that there is moredemand for tomatoes than supply. When a lot of people want to buy something that s notreadily available, they end up competing with one another to purchase what they want, andin this process prices go up. People who still want tomatoes in the winter find that they mustbe willing to spend more money to buy them. Prices of tomatoes rise to a point where a lotof buyers drop out tomato prices have become too expensive for them. The tomatoes goto the people willing to pay that higher price, and get sold despite that higher price.

7 chapter 1It all started with too much or too little price of just about everything has a lot to do withsupply and MANYTOO FEWThe Birth of the farmers now have the upper hand? They sure do! Demand for tomatoes in the winter exceeds the supply. And this story shows you that the price of just about anything has a lot to do with supply and demand, tomatoes to the 1840sLet s go back to see what happened with the farmers bringing their grain to Chicago eachyear at harvest time. Even if they d been able to store some of it they couldn t bring it to the city in the winter because the rivers were frozen and they were unable to transport it bybarge.

8 Then in the spring trails were so muddy that wagons would get stuck. Due to thesedifficulties, there was an excess of grain in the fall and severe shortages in the spring. Using what you have just learned about supply and demand, can you figure out what happened to grain prices in the fall and in the spring? As you may have guessed, the excesssupply in the fall forced the farmers to lower their prices to induce the grain merchants tobuy their grain. But in the spring, when supplies were all but depleted, demand for grain wasso great that prices began to rise astronomically. By now, you must be asking yourself if therewasn t a better way to handle this feast or famine cycle.

9 As it turned out, there was. Chicago Board of TradeA few of the more savvy grain merchants decided to band together in 1848 to form anorganized grain exchange the Chicago Board of Trade (CBOT). The CBOT provided a central meeting place where buyers and sellers of grain could get together and conduct business. With a formal exchange operating, wealthy investors saw an opportunity to buildhuge silos to store the grain for year-round consumption. This helped smooth out the grainThe Birth of FuturesExplain what would happen to the price of tomatoes under each of the following A severe drought during the growing Highly unusual sub-freezing temperatures in A report by the surgeon general linking tomatoes to an increased risk of skin QUIZ #1 Excesses and shortages playedhavoc with CBOT startedin 1848 as a INTRODUCTION to FUTURES and Optionssupply problems and helped bring a certain measure of price stability to grain over the courseof the (Chicago Mercantile Exchange)

10 The success of the CBOT inspired others to create exchanges that would assist the process of buying and selling FUTURES contracts on other farm products. In 1874, merchants formedthe Chicago Produce Exchange, later named the Chicago Butter and Egg Board, and then in 1919 the CME (Chicago Mercantile Exchange). The commodities traded at the exchangethroughout these years were butter and eggs. Later, CME began offering trading in hides,onions and the 1950s, CME also began trading contracts on turkeys and frozen eggs. And in1961 CME introduced a new contract that really put the exchange on the map frozenpork belly FUTURES .