Understand Commodity Futures and Option Contracts
and Your Contractual Obligations
- Commodity futures and option contracts
A futures contract is a legally binding agreement between two parties to buy or sell in the future, on a designated exchange, a specific quantity of a commodity at a specific price. The buyer and seller of a futures contract agree now on a price for a product to be delivered, or paid, for at a set time in the future, known as the "settlement date." Although actual delivery of the commodity can take place in fulfillment of the contract, most futures contracts are actually closed out or "offset" prior to delivery.
An option on a commodity futures contract is a legally binding agreement between two traders giving the buyer, who pays a market determined price known as a "premium," the right (but not the obligation), within a specific time period, to exercise his option. Exercise of the futures option will result in the person being deemed to have entered into a futures contract at a specified price known as the "strike price." In some cases, an option may confer the right to buy or sell the underlying asset directly, and these options are known as options on the physical asset.
- How to trade futures or option contracts
Futures contracts and options on futures contracts must be executed on or subject to the rules of a commodity exchange. But you, as an individual, cannot trade directly on an exchange. A person or firm must trade on your behalf. People and firms who trade on your behalf as a customer generally must be registered with the National Futures Association.
- Categories of accounts through which you may trade
In an individual account, trading is done only for you. In a "non-discretionary" individual account, you make all the trading decisions and the broker may not execute any transactions without your prior approval. In a "discretionary" individual account, you give permission for the firm carrying your account or some third party to make trading decisions on your behalf.
You may open an individual account with a registered Futures Commission Merchant or through an Introducing Broker. An Introducing Broker may accept your orders and transmit them for execution to a Futures Commission Merchant with which the Introducing Broker has a relationship. An Introducing Broker is not permitted to accept any funds from you—you deposit funds directly with the Futures Commission Merchant. In an individual discretionary account, you grant power-of-attorney to a Futures Commission Merchant, an Introducing Broker, one of their Associated Persons, or a Commodity Trading Advisor to make trading decisions on your behalf.
In a commodity pool, you purchase a share or interest in the pool, and trades are executed for the pool, rather than for the individuals who have interests in the pool. Pool participants share ratably in gains or losses.
- Your contractual obligations
Individual account. When you enter into a futures or option contract through an individual account, you are required to make a payment referred to as a "margin payment" or "performance bond." This payment is small relative to the value of your market position, providing you with the ability to "leverage" your funds. Because trading commodity futures and option contracts is leveraged, small changes in price, which occur frequently, can result in large gains or losses in a short period of time.
Each day, your broker will calculate the current value of futures and option contracts held in your account. If the equity in your account has declined in value to the "maintenance margin level" (approximately 75 percent of the amount required to enter into the trades originally), you are required to provide more margin money to restore the initial margin level (this is called a "margin call"). This eliminates the need to make repeated margin calls when daily price changes are relatively small.
If you fail to meet a margin call within a reasonable period of time, which could be as little as one hour, your brokerage firm may close out your positions to reduce your margin deficiency. If your position was liquidated at a loss, you would continue to be liable for that loss. You can, therefore, lose substantially more than your original margin deposit.
Commodity pool. In a commodity pool, you have purchased a share or interest in the pool and it is the pool itself that must make the performance bond payments and margin calls described above. Your contractual obligations as a participant in the pool, including your liability for any losses to the pool, must be described in the pool's disclosure document.
Other Factors You Should Consider
- Commissions and fees and your rate of return
Obviously, fees will reduce your rate of return and should, therefore, be examined carefully. In an individual account, the disclosure statement does specify fees and expenses. However, you are encouraged to consult your broker and be fully aware of the fees you will be charged. A commodity pool is required to provide you with a complete description of fees, commissions, and other expenses. Before allocating any funds to a pool, you should pay particular attention to the "break-even analysis" and other required fee disclosures to determine how fees will affect your potential rate of return.
- Limits on losses
Before participating in a commodity pool, read the disclosure document closely for information on losses. Losses to commodity pool participants are ordinarily (but not always) limited to the amount of your participation. Sometimes in a commodity pool, in order to protect against catastrophic losses, a loss greater than a given percentage will trigger the sale of all open positions and will result in closing the pool account. The disclosure document must clearly state this possible course of action.
In an individual account, the leveraged nature of transactions can result in significant losses or gains, and losses may exceed your initial margin deposit. If so, you are responsible for covering those losses with additional funds.
- Evaluating a broker’s record
If you plan to participate in a commodity pool, information on past performance must be included in the risk disclosure document, which is required to be provided to you by the Commodity Pool Operator. Bear in mind that past performance is not a predictor of future results.
If you authorize a Commodity Trading Advisor to direct the trading of your individual account, the Commodity Trading Advisor must provide you with a disclosure document including information on past performance. In reading the disclosure document, note whether the performance results are based on actual trading results of client accounts. The Commodity Trading Advisor must disclose whether information is based on the Advisor's own proprietary (personal) account, or based on hypothetical or simulated results. If the information is based on hypothetical or simulated results, the Commodity Trading Advisor must disclose the inherent limitations of these results. No representation may be made that any account will or is likely to achieve profits or losses similar to those shown.
If you plan to open an individual account, and plan to ask your Futures Commission Merchant, Introducing Broker, or one of their Associated Persons for advice or have the firm or Associated Person trade on your behalf, get as much information as possible about the firm's or the Associated Person's track record on behalf of other clients. While the firm or associated person is not required to provide this information, be wary of any firm or associated person who is not forthcoming or who provides you with incomplete information.
- Limits on withdrawing your investment
The funds needed to meet initial margin requirements in an individual account can only be withdrawn after trades are settled and, in some cases, after all open positions are closed. Accruals on futures contracts are paid out daily. Funds held in an individual account above and beyond the required margin or account-opening requirements should be able to be withdrawn. If you participate in a commodity pool, you may or may not be able to withdraw some or all of your money at any given time. Some pools have limitations on when funds can be withdrawn. You may only be able to redeem your funds on a monthly, quarterly, or even annual basis. Restrictions on the withdrawal of money should be evaluated by reading the disclosure document and asking questions before you invest in the pool.
- Account information you should receive from your broker
In the case of an individually managed or personal account, you should receive confirmation by mail of all purchases and sales, and a month-end summary of transactions, showing gains, losses, and a mark-to-market valuation of your open positions and current account value. Your broker should also be willing and able to provide you with this information on a daily basis. In a commodity pool, your pool operator ordinarily should send you a monthly statement of net asset value. However, if commodity pool assets do not exceed $500,000 at the beginning of the pool's fiscal year, reporting will be made quarterly.
- Protection of your funds
In an individual account, funds that you have deposited with your commodity brokerage firm to trade on commodity exchanges located in the United States are required to be segregated (held separately) from any of the brokerage firm's own funds. The amount segregated will increase or diminish as you make or lose money from your trading. Also, even though your brokerage firm is required to segregate your funds, you may still not be able to recover the full amount of any funds in your account if the brokerage firm becomes insolvent and there are insufficient funds available to cover the obligations to all of its customers. Your account is not insured.
If, in your individual account, you trade on commodity markets located outside of the United States, your brokerage firm will set up a trading account for you, which is in addition to the account set up for your trading on U.S. markets. The funds in your foreign account will be segregated by your brokerage firm only while you maintain an open position on a foreign market, and then only to the extent of any margin required on that position, plus or minus any unrealized gain or loss on that position. You should ask your broker about account protection and should be aware of the limitations imposed on the protection of the funds in your commodity trading brokers accounts.
A Commodity Pool Operator is required to disclose what percentage of the pool's assets will be held in segregation.