Trading Handbook

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."

• Trade is voluntary exchange of goods and/or services.

• Exchanges may take place between two parties (bilateral trade) or amongst
more than two parties (multilateral trade).

• Trading is simply the buying and/or selling of a commodity for risk

management or revenue generation purposes. If a company only buys a
commodity it is a procurer or buyer, if it only sells it is a retailer or seller. An
organization that does both is a trader

• Buyers, sellers and traders interacting in the market create traded volume

• Sophisticated trading strategies are needed and participants with predictable

buying or selling patterns are losing out.

• It is clear that organizations will trade to achieve different objectives, for

example, optimization of internal long/short positions or speculatively for
profit generation reasons.

• 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

2. How does a trade start

• 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.

Given below is a view of the life cycle stages of a trade.

Exposure Reports

Trader

Deal Details Risk

Management
Credit Check
Credit Control Trade
Capture
Deal Details

Deal Details

Contracts
Shipping Administration

Completed
Contracts

Operations Actual Details

Inventory
Management Load Tel
Details

Freight Cost Invoicing & Inventory

Freight Cost Costing Costing
Calculation Inventory
Cost

Revenues
A/R and A/P Sales, Revenues
& Cost & Cost

P&L Management
Reporting Reporting

Management
P&L Reports
Reports

Management

Trading system

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3. Who are the Players in Trading

Most of those who participate in the futures or options markets can be

categorized broadly into one of two groups

• 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

A speculator takes a position in the futures or options market in the hope of

generating profit. If a speculator takes a long position and the market price
goes up, the position is profitable. Likewise, profits accrue on a short position
as market prices drop.

Locals

An individual speculator who physically trades on the Exchange floor is known

as a local. Typically, this individual provides market liquidity by constantly
buying and selling throughout the trading session.

By committing their own trading capital, these traders are willing to assume
the risks that hedgers wish to transfer in pursuit of profit.

Markets

The trading takes place at a common environment and to facilitate the

smooth trading, various institutions came up, who are responsible to set the
rules and regulations of the market. These institutions are called as
exchanges. As apart of their activity they also try to predict the future price in
relative to the present price.

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4. Where Trading will be done

Exchange:

• A central marketplace with established rules and regulations where buyers

and sellers meet to trade futures and options contracts or securities.

• Exchanges include board of trade or exchange designated by the Commodity

Futures Trading Commission (CFTC) or Derivatives Transaction Execution
Facility (DTEF).

• A marketplace, or any organization or group that provides or maintains a

marketplace for trading securities, options, futures, or commodities.

• The deals traded on exchanges are referred to as 'Exchange-traded deals'.

Over The Counter (OTC):

• The trading of commodities, contracts, or other instruments not listed on any

exchange.

• OTC transactions can occur electronically or over the telephone.

• Refers to stocks not traded on registered exchanges.

• Also referred to as 'Off-Exchange'.

• The deals traded on OTC are referred to as 'OTC-traded deals'.

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.

5. Different Trade Types

5.1. Physical Trade

• A contract to a buy/sell of real commodity.

• It involves physical transport/movement of commodity from seller to the

buyer.

• Mode of transport is an essential part of this trade. Could be ships, pipes or

trucks.

• Physical Trades are some times referred to as Wet Trades also.

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5.2. Paper Trade

• A contract to buy/sell oil which does not involve movement of commodity.

• Contracts where delivery is settled in cash, rather than by delivery of the

physical product on which the contract is based.

• Derivatives (like options & swaps) plays a major role in this trade.

6. Derivate Trade Types

Trade Types

Physical Trade Paper Trade

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:

• Futures or contracts for future delivery at a specified price.

• 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.

• An agreement that a buyer will purchase a specific quantity of an item for a

prearranged price on a stated, future date.

• The delivery is not made immediately, but instead at an agreed-upon future

date.

• Traded on exchanges which include standardized terms, such as quantity,

quality, price, and location and time of delivery.

• 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.

• Forwards are entirely flexible, as they are privately negotiated between

parties, they can be for any conceivable undelivered and for any settlement
date.

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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.

• Forwards are similar contracts but customizable in terms of contract size,

expiry date and price, as per the needs of the user.

Full Forwards:

• They are forward deals with specific standardized quantities of

commodities for the deals.

• The forward deal struck should have the quantity of commodity as full (as per
the standards).

• They are executed in terms of delivery (physically).

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.

Example: For commodity BFO (a grade) , the full forward quantity is

600,000 BBL. Lets say a partial forward for a duration is struck for BFO (a
grade) with quantity as 400,000 BBL, and one more similar partial forward is
struck with-in same duration with quantity as 200,000 BBL , then both
these Partials can be combined (400,000 + 200,000 = 600,000)
and converted to one full forward.

Exchange For Physical (EFP):

• It’s the acronym for Exchange for Physical.

• Actual exchanging between an OTC contract and a futures (i.e. exchange-

based) contract which takes place off exchange between parties.

• A futures contract provision involving exchanging the delivery of physical

product for a futures position.

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 • An EFP occurs during the futures contract trading period.

• Such deals are usually done between energy majors.

6.4. Options

Trade Types

Physical Trade Paper Trade

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.

Options are classified into various categories and are below

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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.

• American Option: An option that may be exercised on any day ahead of

expiry. These trade on the futures exchanges.

• European Option: Option that can only be exercised on the date of expiry.

• Asian Option: An option that is exercised against an average over a period.

• 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

Options: Buy Call

Breakeven Price

Profit

Share Price

Loss

Strike Price

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 • Strategy View: Investor thinks that the market will rise significantly in the
short-term.

• Strategy Implementation: Call options are bought with a strike price of a.

The more bullish the investor is, the higher the strike price should be.

• Upside Potential: Profit potential is unlimited and rises as the market rises.

• Breakeven Point at Expiry: Strike price plus premium.

• Downside Risk: Limited to the premium paid - incurred if the market at

expiry is at, or below, the strike a

Options: Sell Put

• Strategy View: Investor is certain that the market will not go down, but
unsure/unconcerned about whether it will rise.

• Strategy Implementation: Put options are sold with a strike price a. If an

investor is very bullish, then in-the-money puts would be sold.

• Upside Potential: Profit potential is limited to the premium received. The

more the option is in-the-money, the greater the premium received.

• Breakeven Point at Expiry: Strike price less premium

• Downside Risk: Loss is almost unlimited ("almost" as the underlying price

can not fall below zero!). High risk strategy. Potential huge losses incurred if
the market crashes

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 Options: Buy Put

• Strategy View: Investor thinks that the market will fall significantly in the
short-term.

• Strategy Implementation: Put option is bought with a strike price of a. The

more bearish the investor is, the lower the strike price should be.

• Upside Potential: Profit potential is unlimited (well, not really unlimited of

course as the market can not fall below zero).

• Breakeven Point at Expiry: Strike price minus premium paid.

• Downside Risk: Limited to the premium paid - incurred if at expiry the

market is at or above the strike a.

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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.

• Strategy Implementation: Call option is sold with a strike price of a. If the

investor is very certain of his view then at-the-money options should be sold,
if less certain, then out-of-the-money ones should be sold.

• Upside Potential: Limited to the premium received - received if the market

at expiry is at, or below, the option strike.

• 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.

• Strategy Implementation: Call option is bought with a strike price of a and

another call option sold with a strike of b, producing a net initial debit,
OR
Put option is bought with a strike of a and another put sold with a strike of b,
producing a net initial credit.

• Upside Potential: Limited in both cases - Calls: difference between strikes

minus initial debit.
Puts: Net initial credit.
Maximum profit if market at expiry is above the higher strike.

• Downside Risk: Limited in both cases - Calls: net initial debit

Puts: difference between strikes minus initial credit
Maximum loss if at expiry market is below the lower strike.

6.5. Swaps

• Swap is a derivative, where two counterparties exchange one stream of cash

flows against another stream. These streams are called the legs of the swap.

• 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.

• In market, approximately 75% of all OTC transactions are Swaps.

• Swaps are now used by every kind of user of the financial markets - banks,
insurance companies, non-financial corporations and institutional investors.

General characteristics of Swaps:

• 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.

Purpose: Producers sell swap to lock their sales price

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.

Case A: When Floating Price is Lower

Producer received from the intermediary the difference between fixed and
floating

Case B: When Floating Price is Higher

Producer pays the difference between the floating price and fixed price to the
intermediary.

Formulae:

Price Difference: Contracted Monthly Volume * (Fixed Price – Floating Price)

Therefore if the producer bought an $18 Swap for 50,000 bbl per month

If the floating price is $17.2 for the month of December

Producer would receive: 50,000 bbl * ($18 - $17.2) = $40,000

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:

• Differential Swaps are typically used by refiners to hedge changing margins

between refined products.

• 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.

Margin or Crack Swap

• Refining margin is locked at a certain base level with the help of Margin or
Crack Swap.

PRODUCT REFINERY PRODUCT

A B

Fixed differential between product A and B is exchanged for Floating differential

between product A and B.

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

• In a barter swap one commodity is swapped for another.

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.

Benefits of Fixed/Float Swaps:

• Price protection - Receive a guaranteed fixed price for an agreed quantity of a

commodity on an agreed future date.

• Customization - You determine the quantity of the commodity you want to

cover, the timeframe and the price protection level that suits your needs.

• Simplicity - Do the transaction in the currency of your choice, and being an

OTC derivative, no exchange charges to be incurred.

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.

• It is more popularly referred as 'basis-swaps', as it helps in hedging the basis

risks.

• 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.

• Is used in the energy industry as a technique for managing price fluctuations,

most commonly fuel prices which may vary from market to market or country
to country.

Freight Swaps

• Swaps to hedge against freight movements.

• 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.

• The unit for a freight swap trade is "World scale".

• 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.

7. General Trade Terms

• Price:

It refers to the update of the published market prices for respective

commodities.

Trading Handbook 19
 • Curves:

It is the continuous image of unit interval.

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:

A financial market of a certain group of securities in which prices are rising or

are expected to rise.

It signifies market anticipation.

It is characterized by optimism, buyer confidence and expectations that

strong prices will continue.

• Bear Market:

A market condition in which the prices of securities (here commodities) are

falling or are expected to fall.

No bull market can last forever, and sooner or later a bear market will be
expected to come.

• Settlement:

The combined process of billing and payment for products or securities.

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:

A transportable article of trade or commerce that can be traded or sold

Any goods or services which are exchanged for money

Something of value that can be bought or sold, usually a product or raw

material

• Exposure:

The potential credit/loss due to the market value of a contract with

counterparty

The financial implication of market price moves.

The amount of funds invested in a particular type of security and/or market

sector or industry and usually expressed as a percentage of total
portfolio holdings thus it is the amount an investor has at risk or the
amount the investor can lose.

• 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

Is a risk management technique intended to mitigate the (trading) company's

exposure to fluctuations in interest rates, foreign currency exchange rates,
or other market factors. The elimination or reduction of such exposure is
accomplished by engaging in capital markets activities to establish
offsetting positions

To protect a physical position against an adverse price movement

• Market Position -> Long:

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.

• Market Position -> Short:

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.

Mediating for a deal between another trader and the counter-party.

• Master Trade Agreement:

This agreement defines the rules/guidelines for the deal contracts between
the trader and the counter parties.

This agreement is commonly used for contracts in various energy derivative

markets.

These standard master agreements are defined by various trade bodies, and
trading companies abide to them for their deals in trade market.

• General Terms & Conditions:

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:

The ability of an asset to quickly be converted into cash

Generally, the greater the number of buyers and sellers of a particular asset,
the more liquid it is considered to be.

A market is said to be 'liquid' when it has a high level of trading activity,

allowing buying and selling of commodities with minimum price disturbance.

• Index:

An indicator of average price change for a group of commodities that

compares, prices for those same commodities in some other
period, commonly called the base period

Trading Handbook 22