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Table of Contents
Trading Handbook
1. What is Trading............................................................................................3
2. How does a trade start..................................................................................3
3. Who are the Players in Trading.......................................................................5
4. Where Trading will be done............................................................................6
5. Different Trade Types....................................................................................6
5.1. Physical Trade........................................................................................6
5.2. Paper Trade............................................................................................7
6. Derivate Trade Types....................................................................................7
6.1. Derivative..............................................................................................7
6.2. Futures..................................................................................................8
6.3. Forwards................................................................................................8
6.4. Options................................................................................................10
6.5. Swaps.................................................................................................15
7. General Trade Terms...................................................................................19
Trading Handbook 2
1. What is Trading
• The word trade means "An exchange of one thing for another."
• Exchanges may take place between two parties (bilateral trade) or amongst
more than two parties (multilateral trade).
• Buyers, sellers and traders interacting in the market create traded volume
• The process of buying and selling securities; can be conducted for a firm's
account or for its customers; either conducted on an exchange or over the
counter
• A trade starts out with one person offering something to another person in
exchange for an item that he /she wants.
• A person makes an offer and the other person either accepts, declines, or
proposes a different offer.
• If the offer has been accepted by the other party the next step is to decide
how both the parties will send them. This is the end of the trade.
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• The Entire Trading Life Cycle has various activities of which Trade Capture
forms a very crucial milestone as the subsequent completion of the other
activities depends on the accuracy, efficient capture of the deal data.
Exposure Reports
Trader
Deal Details
Contracts
Shipping Administration
Completed
Contracts
Inventory
Management Load Tel
Details
Revenues
A/R and A/P Sales, Revenues
& Cost & Cost
P&L Management
Reporting Reporting
Management
P&L Reports
Reports
Management
Trading system
Trading Handbook 4
3. Who are the Players in Trading
• Hedgers
• Speculators
Brokers
Brokers are simply intermediaries who carry out buying and selling
instructions from hedgers or speculators.
Hedgers
Hedgers are market participants who want to transfer risk. They can be
producers or consumers. A producer hedger wants to transfer the risk that
prices will decline by the time a sale is made. A consumer hedger wants to
transfer the risk that prices will increase before a purchase is made.
Speculators
Locals
By committing their own trading capital, these traders are willing to assume
the risks that hedgers wish to transfer in pursuit of profit.
Markets
Trading Handbook 5
4. Where Trading will be done
Exchange:
Counter Party:
• The party on the other side of the deal. I.e. if one is the buyer, the counter-
party is the seller and vice-versa.
Trading Handbook 6
5.2. Paper Trade
• Derivatives (like options & swaps) plays a major role in this trade.
Trade Types
Physical
Forward
Derivatives
Futures
6.1. Derivative
• Derivatives are instruments that have no intrinsic value, but derive their value
from something else.
• They hedge the risk of owning things that are subject to unexpected price
fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government
bonds.
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There are two types of Derivatives:
• Options that give one party the opportunity to buy from or sell to the other
side at a prearranged price.
6.2. Futures
• Futures are derivative contracts that give the holder the opportunity to buy or
sell the underlying at a pre-specified price some time in the future.
• They come in standardized form with fixed expiry time, contract size and
price.
• Less riskier as future contract shifts the credit risk exposure to the exchange,
in case the prices go higher than the pre-arranged price at the arrival of the
future date.
• But you can only trade the specific contracts supported by the exchange.
Example: A farmer who uses a contract, to sell wheat before the harvest at a
predetermined fixed price. The contract in this case is used to protect the farmer
against an unexpected decrease of the price in wheat, thus reducing his exposure
to market risk. On the other hand, the buyer accepts the risk associated with the
fixed price and faces the possibility of either financial gain or loss, depending on
the difference between the fixed price and the actual price at the time of harvest.
Now this can be called Futures if the contract is through an exchange or if
the contract is over-the-counter, this can be called as Forwards.
6.3. Forwards
• Deals same as Futures except the fact that deals here are traded over-the-
counter.
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• But it is more risky leaving the dealer vulnerable, in case the prices go higher
than the pre-arranged price at the arrival of the future date as exchange is
not there to absorb the risk.
Full Forwards:
• The forward deal struck should have the quantity of commodity as full (as per
the standards).
Example: For commodity BFO (a grade), the full forward quantity is 600,000
BBL, and for Dubai (another grade) – full forward quantity is 500,000
BBL. And when a forward deal is struck with full quantity for respective
grades, it’s referred to as Full Forwards.
Partial Forwards:
• The Forward deals, where the quantity is NOT equal to the full quantity (as
per the defined standards) ,the trade is called a Partial forward.
• They are not executed in terms of delivery. They get mostly settled at the
market price (cash-settled).
• But two or more partial deals for the same commodity for the same period,
involving same parties can be converted into the full forwards and get it
settled physically.
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• An EFP occurs during the futures contract trading period.
6.4. Options
Trade Types
Options
• A system of trading under which, the writer of the option gives someone the
right but not the obligation to buy or sell an underlying commodity.
• An agreement between two parties that gives one party, the option holder,
the option but not the obligation to buy
or sell an asset.
• Options contracts do not imply a sale. Instead they imply a possible sale by
granting the potential buyer the option to choose whether or not they wish to
purchase the commodity.
• The price of the option, which is called the strike price, and the maturity date
are fixed and the option issuer, the counterparty, does not have the same
flexibility that the option holder enjoys.
For this reason, the option holder may expect to pay a premium to the option
issuer.
• If the option holder can purchase the actual commodity at that price on or
before the associated date at a price which is favorable to them, they will
probably exercise the option and make the purchase. If the price is too high
at that time, they can choose not to exercise the option, and the contract
expires and they lose only the premium.
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• Call Option: Call Option is the right to buy a particular asset at a pre-
determined fixed price (strike price) at a time up to the maturity date.
• Put Option: Put Option is the right to sell a particular asset at the strike price
up to maturity.
• European Option: Option that can only be exercised on the date of expiry.
• At the Money: An option with an exercise price at the current market level of
the underlying.
• In the Money: An option with an exercise price higher than the current value
of the underlying commodity
• Out of Money: An option with an exercise prices lower than the current
market level of the underlying instrument
Breakeven Price
Profit
Share Price
Loss
Strike Price
Trading Handbook 11
• Strategy View: Investor thinks that the market will rise significantly in the
short-term.
• Upside Potential: Profit potential is unlimited and rises as the market rises.
• Strategy View: Investor is certain that the market will not go down, but
unsure/unconcerned about whether it will rise.
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Options: Buy Put
• Strategy View: Investor thinks that the market will fall significantly in the
short-term.
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Options: Sell Call
• Strategy View: Investor is certain that the market will not rise and is unsure
whether it will fall.
• Downside Risk: Unlimited. Losses on the position will worsen as the market
rises.
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Options: Bull Spread
• Strategy View: Investor thinks that the market will not fall, but wants to cap
the risk.
6.5. Swaps
• First Oil Swap was traded in 1986, 8 years after Futures trading started in
Nymex. 1 billion Barrel mark for swap trading achieved in 1989
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• Simple Swap is an agreement where by a floating price is exchanged for a
fixed price over a specified period.
• Swaps are now used by every kind of user of the financial markets - banks,
insurance companies, non-financial corporations and institutional investors.
• The term of the swap is a whole number, commonly one, two, three, five, and
seven and could be till 10 years.
• The fixed or floating payments take place at regular intervals, for example
every month, six or 12 months.
• The principal of the swap remains constant for the term of the swap.
• The fixed rate remains constant for the term of the swap.
• The floating rate is set at the beginning of each interest period and paid in
arrears at the end of the interest period.
Example:
Producer and the Intermediary agree a fixed price, for example, $18 a barrel
for an agreed oil specification, and a floating price, often a reference price
derived from Platt’s or one of the futures market.
Formulae:
Therefore if the producer bought an $18 Swap for 50,000 bbl per month
Differential Swap
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• Differential swap is based on the difference between a fixed differential for
two products, and the actual or floating differential over time.
Purpose:
• Refiners usually receive the fixed- price side of the swap, ensuring a known,
forward relationship for the price of their various products.
• If they sell the diff and the diff narrows, then the refiner receives the
difference, if it expands, the refiner pays out.
• Diff Swaps may also be used by companies as a way of managing basis risk
assumed during their normal hedging activity.
• Refining margin is locked at a certain base level with the help of Margin or
Crack Swap.
Purpose:
• Refiners who prefer to fix a known refining margin can enter into a refining
margin swap, whereby the product output of the refinery and the crude
(feedstock) input are simultaneously hedged i.e. the products are sold and
the crude is bought for forward periods.
• The refiner either pays or receives the difference between margins, therefore
guaranteeing the profit of the refiner.
Participation Swap
• Participation Swap is similar to a regular Swap in that the fixed price payer is
100% protected when the prices rise above the agreed price but, unlike an
ordinary swap, the client “participates” in the downside.
Example:
Trading Handbook 17
A participation Swap was agreed at a level of $80 per tonne for a high sulphur
fuel oil (HSFO), with a 50% participation, the buyer would be fully protected
against prices above $80 per tonne, but would also retain 50% of the savings
generated when prices fell below $80 per tonne. If prices fell to $70 per
tonne, the client would only pay out $5 per tonne rather than the $10 per
tonne due under the regular swap.
Double – Up Swap
• By using this instrument, swap users can achieve a swap price which is better
than the actual market price, but the swap provider will retain the option to
double the swap volume before the pricing period starts. Swap combined with
an Option.
Extendable Swap
• Similar to Double-Up Swap except that the provider has right to extend the
swap at the end of the agreed period, for a predetermined period.
Pre-Paid Swap
• Fixed payment cash flow can be discounted back to its net present value and
paid to the used.
Barter Swaps
Fixed-Float Swaps
• A swap where for an agreed future date, a fixed price is secured for your
commodity whose market price (floating price) fluctuates with uncertainty.
• By receiving a fixed commodity market price trader can budget and plan with
more certainty.
• A price settled at the time of the deal, where a percentage of the price is fixed
(agreed) and the remaining percentage is floating (variable) and dependant
on the future market.
Trading Handbook 18
Negative side of Fixed/Float Swaps:
• The transaction does not cover the basis risk, which is the risk arising from
entering into the transaction not being identical to the risk being covered.
• You cannot benefit from favorable commodity price movements.
Float-Float Swaps
• The swapping of one type of float rate index for another. Like if the expected
price of crude is referenced to the price at one location, exchanging that price
for the price at another location constitutes a float-float swap.
• Can also involve swapping the base currency, such as swapping the base
price of a commodity in US dollars for the base price in Japanese yen.
Freight Swaps
• The contract does not involve any actual freight or any actual ships. It is
purely a financial agreement.
• Are over-the-counter trades bought and sold in terms of World scale prices
and settled against 11 key tanker routes listed on the London-based Baltic
Exchange.
• Exceptionally, high volatility in the price of freight means that in the physical
underlying markets which are the world shipping markets, natural buyers
(refiners, importers, traders etc) have to take into account a high risk of price
movements in freight when calculating the cost of transport. This leads to
Freight Swaps.
• Price:
Trading Handbook 19
• Curves:
When it comes to price curve: It is the price quotes for the commodities to be
used for Market-to-Market calculations.
Price quotes are mostly from brokers who have published their curve.
It’s a curve that traces out the price decisions of all the markets and firms in
the economy under a given set of circumstances.
The steepness (or slope) of the curve indicates demand sensitivity to price
changes.
• Bull Market:
• Bear Market:
No bull market can last forever, and sooner or later a bear market will be
expected to come.
• Settlement:
Accounts are not said to be settled until both customer and supplier have
everything to which their agreement entitles them, and that includes all
payment to the supplier and all receipts and other materials needed by the
buyer.
The finalizing of a transaction, the trade and the counterparts are entered into
the books which could be a ledger.
• Settlement Risk:
Risk that arises when payments are not exchanged simultaneously and
generally arising due to time differences.
• Herstatt Risk:
Trading Handbook 20
NextGen
ment
Risk that counterparty does not deliver security or its value in cash as per
agreement.
• Commodity:
• Exposure:
• Hedging:
Is to offset (tackle) the potential risks and returns of one position by taking
out an opposing position to create an outcome of greater certainty
The market position of a trader who has bought a commodity and not yet sold
it unless the trader sells it, will have to accept delivery at some time in the
future.
Trader will be the holder of a long position in the market in above case.
The market position of a futures contract seller whose sale compels to deliver
the commodity unless he settles his contract by a balancing purchase
Trading Handbook 21
• Hedging:
Trader who strikes the deal acts as an agent for another Trader who is
completing the deal.
This agreement defines the rules/guidelines for the deal contracts between
the trader and the counter parties.
These standard master agreements are defined by various trade bodies, and
trading companies abide to them for their deals in trade market.
These are the terminologies and the conditions which two parties (the trader
and the counter-party) agree for a deal when involved in a deal contract.
• Liquidity:
Generally, the greater the number of buyers and sellers of a particular asset,
the more liquid it is considered to be.
• Index:
Trading Handbook 22