THE INVESTMENT PROGRAM

The Miller Group, LLC has developed proprietary trading techniques and methodology utilizing covered option writes, covered butterfly options as well as synthetic long and short trading strategies. The use of credit spreads, and or synthetic options eliminate the possibility of margin calls or the loss of an amount greater that the original investment by participants who subscribe to the trading program. This commodity trading program may utilize futures, EFP’s, off-exchange transactions or Security Futures products to further hedge positions taken pursuant to this trading program. This Commodity trading program will only engage in trading of these strategies and method. At the sole discretion of the CTA the percentage of funds utilized at any given time and for a given trade may range from 0% to 90%. Commodity futures contracts are traded on margin which typically ranges from about 2% to 20% of the value of the contract. Low margin provides large amount of leverage, i.e., futures contracts for a larger number of units (bushels, pounds, etc.) of a commodity, having a value substantially greater than the margin, may be traded for a relatively small amount of money. Hence a relatively small change in the market price of a commodity can produce a corresponding large profit or loss. If the CTA invests a substantial portion of the assets of the trading program in such a situation, a substantial change, up or down, in the value of the trading program could result. For example, if at the time of purchase 5% of the price of a futures contract is deposited as margin, a 5% decrease in the price of the futures contract would, if the contract were to close out, result in a total loss of the margin deposit. Brokerage commissions and other expenses also would be incurred and would have to be paid despite the loss. The CTA may trade any commodity futures, options, security futures, off-exchange products and EFP’s on any exchange and in any market sector that is allowed by the FCM including foreign exchanges. Trading on the CME, CBOT, NYBOT and NYMERC exchanges are regulated by the CFTC. Trading on exchanges outside the jurisdiction of the United States do not afford the protection and regulation of exchanges located within the United States and regulated by the CFTC.

The following are estimates for products and exchanges traded by the trading program. Trading of stock index options and financial options on the CME is estimated at 85%. Trading of energy options, soft commodities and precious metals options on the NYMERC and NYBOT is estimated at 10%. Trading of grain options and livestock options on the CBOT and CME is estimated at 2%. Trading of synthetic long and short futures positions is estimated at 2%. Foreign Exchange futures and options, EFP’s and Security Futures products is estimated at 1%. The estimates presented of both markets and exchanges may at the discretion of the CTA vary dramatically from the estimates presented. 

Trading decisions will be made by the CTA utilizing the strategies and methodology outlined above using both fundamental and technical analysis. Technical analyses may include the study of; open interest, volume, volatility, trading ranges, support and resistance, moving averages, trends, channels, Delta, Theta, Gama, Vega, decay, strike price, contract month and a variety of  other technical studies. The CTA will extensively rely on various option and technical analytical software programmed to proprietary analyze and identify opportunities within various markets and products.

Commodity futures traders basically rely on one of two types of analysis "technical" or "fundamental" for their trading decisions. Technical analysis is based on the theory that a study of the markets themselves will provide a means of anticipating the external factors that affect the supply and demand of a particular commodity in order to predict future prices. On the other hand, fundamental analysis relies on a study of those external factors.  As an example with respect to an agricultural commodity, some of the fundamental factors that affect the supply of soybeans include the acreage planted, crop conditions (drought, flood, disease, etc.), labor disputes affecting planting, harvesting, distribution, and the previous year's crop carry over. The demand for soybeans consists of domestic usage and exports, which are affected by general world economic conditions and the cost of soybeans in relation to the cost of competing food products. As an example with respect to currency, some of the fundamental factors that affect the demand for a currency include the inflation and interest rates of the currency's domestic market, exchange controls, and that country's balance of trade, business, and political stability. The supply of a currency can be determined by, among other things, government spending, credit controls, domestic money supply, and prior years' trade balances.

Technical analysis of the markets generally includes a study of, among other things, the actual daily, weekly, monthly or annual price fluctuations, volume variations, or changes in open interest, utilizing charts, computer software, or a combination of the two for analysis of these items. Such approaches to the commodity futures markets may use a series of mathematical measurements and calculations designed to monitor market activity for the particular strategies used.  Trading recommendations are based on signals generated by charts, manual calculations or computer software. As an example with respect to a financial commodity, one set of procedures might evaluate the following factors, among others, on a daily basis:  (1) the price trends of a fine commodity and levels at which to initiate new positions and terminate old positions;  (2) the volatility that the particular financial commodity has displayed in the past; (3) the condition of the market of the financial commodity being traded in terms of whether it is a trending market or an erratic and non-trending market; (4) the state of the financial commodity markets in terms of determining the proper points for initiating new positions and allowing increases in existing commitments.

At the end of each trading day, a trader using a technical trading system typically obtains settlement and other price information for each commodity that its system follows. This price information is used to generate a series of trading signals. If a trading system is maintained on a computer, the prices will be entered into the computer and a program, which consists of a series of mathematical calculations. If the trading system does not operate on a computer, the trader will manually apply such information to a series of rules or equations that constitute its trading system. Certain trading systems may signal a trend in the market allowing the trader to adjust his positions accordingly.  In other types of trading systems, the trading system will indicate an exact price at which to open and close positions for each commodity followed and the trader will attempt to enter or exit positions in accordance with such prices.

Although a technical trading system often consists of a series of fixed rules applied manually or by computer, the system still requires that the trader make certain subjective judgments.  For example, he must select the commodities and markets which it will follow, and the commodities and markets which it will actively trade and the contract months in which it will maintain positions.  A trader will also have to determine when he will liquidate a position in a contract month that is about to expire and initiate a position in a more distant contract month.

The CTA’s objective in providing trading management services is to affect appreciation of this clients' assets through speculative trading of commodity interests, which include, without limiting the foregoing, commodity futures contracts, forward contracts, physical commodities, and related options thereon on exchanges and in markets both foreign and domestic.  The specific commodity interest to be traded will be selected from time to time by the CTA on the basis discussed below.  The CTA may trade any futures contracts that are traded now, or may be traded in the future, on futures exchanges located both within and outside the United States. The CTA may also trade options on futures contracts for the trading program. The CTA may engage in transactions in physical commodities, including exchange for physical transactions.  An exchange for physical transaction ("EFP") is transaction permitted under the rules of many futures exchanges in which two parties holding futures and cash or forward positions may close out their positions without making an open, competitive trade on the exchange.)  In addition, the CTA may trade forward contracts.

Trading decisions of the CTA will be based on methods that have been developed by the CTA. Such decisions are based on a combination of considerations including, but not limited to the foregoing:  (1) an analysis of seasonal price trends or deviation thereof; (2) open interest; (3) consensus; (4) trend analysis; and (5) risk management objectives. The trading attempts to generate returns on capital over a long period of time as well as short term capital aggrandizement.

The CTA will exercise his judgment and discretion in interpreting the technical signals generated by this trading approach, giving consideration to fundamental factors that influence market prices. The CTA will make decisions regarding the trading of commodity interests, including selecting the markets which will be followed, the commodities and markets which will be actively traded, and the contract months in which positions will be maintained. The CTA will determine when to liquidate a position in a contract month that is about to expire and whether to initiate a position in a more distant contract month. In addition, the CTA will determine the position size or number of contracts in each market to be bought or sold at any given time, the time at which orders are to be placed with and executed by a floor broker, the method by which orders are to be placed, and the types of orders that are to be placed. Those types of decisions require consideration of, among other things, the volatility of the particular market, the pattern of price movements (both intraday and intraday), open interest, trading volume, changes in spread relationships between various contract months and between related futures contracts, and overall risk exposure. In addition, those types of decisions are sometimes based on consideration of typical fundamental factors affecting the supply and demand in a particular market. The decision by the CTA not to trade certain commodities or not to make certain trades may result at times in missing price moves and hence profits of great magnitude, which other trading managers who are willing to trade these commodities may be able to capture. There is no assurance that trading directed by the CTA will be profitable or will not result in losses. One of the primary objectives of the CTA’s trading program is preservation capital, although there is no assurance that such objective will be satisfied.

The CTA believes the development of a commodity trading strategy is a continual process.  As a result of further analysis and research into the performance of the CTA’s method, changes have been made from time to time in the specific manner in which the trading method evaluates price movements in variations commodities, and it is likely that similar revisions will be made in the future.  As a result of such modifications, the trading method that may be used by the CTA in the future will differ from that used by the trading CTA in the past and might differ from that presently being used. Investors will not be informed with respect to such changes in the CTA’s trading method.  In addition, the CTA’s trading approach may change as market conditions change and the CTA may abandon trading methods on an overall trading approach altogether if the CTA perceives unique market conditions.  Accordingly, because of the large quantity of facts that may be overlooked, and the variables that may shift, the CTA’s trading approach is based on the judgment of the CTA and no assurance can be given that the trading approach will result in profits for the trading program.  The CTA continuously reviews the volatility, liquidity, and risk associated with markets and, based upon his judgment, determines the markets to be traded. From time to time the CTA may direct trading that concentrate its positions in a relatively small number of types of commodity interests.  Consequently, the trading program may not maintain a variety of diverse positions might not be as diversified as commodity trading programs. Concentration of trading in a relatively small number of types of commodity interests may subject the trading programs performance to relatively greater volatility.  There may be periods when the trading program will have no commodity positions in the market.

There can be no assurance that any trading strategies will produce profitable results, and the past performance of an CTA’s trading strategies is not necessarily indicative of their future profitability.  Profitable trading is often dependent on anticipating trends or trading patterns.  Markets subject to random price fluctuations, rather than defined trends or patterns, may generate a series of losing trades. There have been periods in the past when the markets have been subject to limited and ill-defined price movements, and such periods may recur. Any factor that may lessen major price trends (such as governmental controls affecting the markets) may reduce the prospect for future trading profitability.  Any factor, which would make it difficult to execute trades, such as reduced liquidity or extreme market developments resulting in limit moves, could also be detrimental to profits.  No assurance can be given that the CTA’s trading techniques and strategies will be profitable.  The specific details of the CTA’s trading method are proprietary; consequently, clients will not be able to determine the full details of those methods, or whether those methods are being followed. The best trading strategy will not be profitable if there are no trends of the kind it seeks to follow.  Increased use of trading methods similar to that used by the CTA could increase the number of traders attempting to establish or liquidate positions at or about the same time, or affect the execution of trades or trading patterns, to the detriment of the trading program.

The trading program may engage in trading options on commodity futures.  Substantial trading in such options has begun only relatively recently.  Although trading in options on futures has been a rapidly growing area of the commodity markets, there can be no assurance that any trading approach can successfully incorporate significant levels of options trading or the variety of new options which have recently, and are expected in the near future to, become available for trading.  Historically, the trading of options on commodity interests in the United States has been subjected to regulatory restrictions.  U.S. futures exchanges have been permitted to trade an unlimited number of such options, subject to C.F.T.C. regulation, for only a relatively short time.  In addition, the C.F.T.C. recently adopted new regulations to govern the offering in the United States of options traded on foreign exchanges.  As such options are approved on a case-by-case basis, the trading program may trade in them pursuant to the CTA’s direction.  Although successful trading in options on futures contracts requires many of the same skills required for successful futures trading, the risks involved are somewhat different.  Options on futures are speculative and highly leveraged.  The purchaser of an option risks losing the entire purchases price of the option.  The seller (writer) of an option risks losing the difference between the premium received for the option and the price of the futures contract underlying the options which the writer must purchase or deliver upon exercise of the option, which could subject the writer to an unlimited risk in the event of an increase in the price of the contract to be purchased or delivered. The CTA may engage in exchanges for physicals. The C.F.T.C. is examining the propriety under its regulations of transactions involving exchanges for physicals. If the CTA were to be prevented from making use of this trading technique, the trading performance of the trading program could be adversely affected. The trading program may engage in the trading of contracts on foreign exchanges, which are not regulated by the C.F.T.C.. In addition, contracts traded on foreign exchanges are typically denominated in the local currency, which introduces an additional price variable not applicable to contracts traded on domestic exchanges.  Therefore, unless the trading program is hedged against fluctuations in exchange rates between the U.S. dollar and the currencies in which trading is done on such foreign exchanges, any profits which the trading program might realize in such trading could be eliminated by adverse changes in exchange rates or the trading program could incur losses as a result of any such changes.  Some foreign exchanges, in contrast to exchanges in the United States, are "principals' markets" in which responsibility for performance is only that of the individual member with whom a trader has entered into a transaction and not of an exchange or exchange clearing house. In some cases, a broker with which the trading program enters into a transaction may in effect take the opposite side of trades made for the trading program.  Some customers of the London Metal Exchange’s market in tin have failed to perform their obligations under outstanding tin contracts.  A prolonged suspension of trading resulted.  Some traders may suffer substantial losses due to such failures.  Because some foreign exchanges generally lack a clearing house system such as that utilized by exchanges in the United States, such market disruptions may be more likely to occur on foreign exchanges.  See Risk Disclosure Statement: "Foreign Futures and Foreign Options." The trading methods utilized by the CTA are proprietary and confidential.  The foregoing description is not intended to be exhaustive.

OFF EXCHANGE TRANSACTIONS

This CTA may trade in Off-Exchange transactions. An exchange is often the most important component of a market. There is usually no compulsion to issue securities via the exchange itself, nor must securities be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that Bonds are traded. Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is the opposite of exchange trading which occurs on futures exchanges or stock exchanges. An over-the-counter contract is a bi-lateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement. An over-the-counter market is a financial market where products are traded over-the-counter. In some jurisdictions, and only then in restricted circumstances, firms are permitted to effect off-exchange transactions. The firm with which you deal may be acting as your counterparty to the transaction. It may be difficult or impossible to liquidate an existing position, to assess the value, to determine a fair price or to assess the exposure to risk. For these reasons, these transactions may involve increased risks. Off-exchange transactions may be less regulated or subject to a separate regulatory regime.

CREDIT SPREAD TRADING STRATEGY

A primary focus of trading strategy for this commodity trading program will be to utilize a proprietary credit spread trading system developed by the CTA. Credit spreads consist of selling or writing an option and purchasing an option of the same underlying security. The option written is sold at a higher price than the cost of the option that is purchased creating a credit for that transaction. This option writing strategy will be profitable providing the price of the security is below the strike price for a call option or above the strike price of a put option when the spread expires. At expiration if the security is above the strike price for a call option or below the strike price of a put option when the spread expires this trading strategy may produce a loss. The loss would be limited to the difference between the strike prices of the two options in the spread. CTA may write options in the money, at the money and out of the money utilizing various trading strategies including, but not limited to butterfly spreads, straddles and strangles. Unlike trading systems that seek market volatility, this trading strategy tends to be profitable when the price of an underlying security experiences limited price fluctuation and can be unprofitable during periods of high volatility. Credit spreads may be liquidated at any time prior to expiration. Credit spreads allows the CTA to enter trades and manage the maximum risk of loss or gain by pre-determining these factors based on the margin utilized and the credit given for each trade thus eliminating any potential margin or deficit call.

An in the money option is an option that has intrinsic value. A call option is in-the-money if its strike price is below the current price of the underlying futures contract. A put option is in-the-money if its strike price is above the current price of the underlying futures contract. An at the money option is an option whose strike price is equal - or approximately equal - to the current market price of the underlying futures contract. An out of the money option would be a call option with a strike price higher or a put option with a strike price lower than the current market value of the underlying asset, (i.e., an option that does not have any intrinsic value).

The following hypothetical example demonstrates how a credit spread could be utilized in crude oil traded on the New York Mercantile Exchange if such an opportunity were presented and the CTA were to identify and enter into the transaction. Crude oil option contracts on the exchange consist of 1,000 barrels per contract and are priced in US dollars (example $65.87 per barrel). Each penny movement in the price of a barrel of crude oil would be equal to $10 US per long or short contract. Crude oil contracts on the New York Mercantile Exchange are traded on a monthly basis for each month of the each year.

 In this example assuming the CTA were to straddle the crude oil market utilizing a credit spread and the current price for a February 2007 contract of crude oil is $66.00 per barrel and the option premiums for February 2007 crude oil options were as follows ($66 calls -139 $67 calls - 61 $66 puts 128 $65 puts 52).

Using the above numbers a Call Credit Spread could be entered  by writing a $66 call and buying a $67 call with a credit of 78 points x $10 per point for a credit of $780. If at option expiration the price of February 2007 crude oil were at or above $67 per barrel  the maximum loss that could be sustained from the Call Credit Spread would be $1 per barrel x 1,000 barrels ($1,000) minus the credit premium received of $780 for a loss of $345 including all commission and fees.

If at option expiration the price of February 2007 crude oil were at or below $66 per barrel the maximum gain after deducting all commissions and fees that could be sustained from the Call Credit Spread would be the credit premium received of $458.

The break even for this trade after deducting all commissions and fees would be $66.65 per barrel at the expiration of the February 2007 crude oil call option Credit Spread. After deducting all commissions and fees any price below $66.65 per barrel would provide a profit at a rate of $7 per cent per barrel to a maximum obtainable profit of $455.

A Put Credit Spread could be entered  by writing a $66 put and buying a $65 put with a credit of 76 points x $10 per point for a credit of $760. If at option expiration the price of February 2007 crude oil were at or below $66 per barrel  the maximum loss that could be sustained from the Put Credit Spread would be $1 per barrel x 1,000 barrels ($1,000) minus the credit premium received of $760 for a maximum loss of $365 after deducting all commissions and fees.

If at option expiration the price of February 2007 crude oil were at or above $66 per barrel the maximum gain that could be sustained from the Call Credit Spread would be the credit premium received of $444 after deducting all commissions and fees.

The break even for this trade after deducting all commissions and fees would be $65.36 per barrel at the expiration of the February 2007 crude oil put option Credit Spread. After deducting all commissions and fees any price above $65.36 per barrel would provide a profit at a rate of $7 per cent per barrel to a maximum obtainable profit of $444.

By straddling the market with both a Call and Put Credit Spread the total credit would be $780 for the Call Credit Spread plus $760 for the Put Credit Spread for a combined total credit of $1,540. After deducting all commissions and fees the minimum performance from straddling this trade with both Call and Put Credit Spreads would be a profit of $203 as the risk exposure would be limited to $1,000 being a loss could only be sustained on one side of this Credit Spread straddle. After deducting all commissions and fees the maximum gain could be $903 if the price of February 2007 crude oil were to close at exactly $66.00 per barrel. After deducting all commissions and fees any price above or below $66.00 per barrel for February 2007 crude oil would decrease the maximum potential profit by a rate of $7 per cent to a minimum performance of $203 profit.

Exchange For Physicals (EFP)

Offset is the transaction of a reversing trade on the exchange. If you are short 20 March soybean futures traded on the Chicago Board of Trade, you can close the position by taking an offsetting long position in 20 March soybean contracts on the same exchange. There will be a final margining at the end of the day, and then the position will be closed. Cash settlement is simply the holding of a cash settled future until expiration. At that time, there is a final margin payment, and the contract expires. Delivery is the holding of a physically settled future until it physically settles according to exchange rules. Exchange for physicals (EFP) is a form of privately negotiated physical settlement of long and short futures positions held by two parties.

Every futures contract has a last trade date and a delivery period specified by the exchange. In the case of a cash settled future, the delivery period is the last trade date. On that date, the settlement price is set equal to the cash price of the underlier. There is a final margining based on that settlement price, and then the contract expires.

For physically settled futures, exchange rules depend upon the specific underlier. Usually, there is an entire month—called the delivery month—during which delivery may occur. The last trading day for the future falls towards the end of that month. A party that is short a future may elect to deliver the underlier on any business day in the delivery month. Typically, notice of delivery must be made to the exchange two business days prior to delivery. The date on which notice is given is called the notice date. The first possible date for notice comes towards the end of the month preceding the delivery month. It is called the first notice date. Upon receiving notice of delivery, the exchange selects a party that is long the future to take the delivery. This may be the party with the largest long position in the future. Alternatively, the party to take delivery may be selected by lot.

The vast majority of futures contracts are traded by hedgers or speculators with no interest in taking or delivering the underlier. Such parties holding long futures will offset them prior to the first notice date. Those with short positions will offset them by the last trade date. Most futures are closed out by offset.

Exchanges specify conditions of delivery. These include acceptable locations for delivery, in the case of commodities or energies. It includes specifics about the quality, grade or nature of the underlier to be delivered. For example, only certain Treasury bonds may be delivered under the Chicago Board of Trade's Treasury bond future. Only certain growths of coffee may be delivered under the Coffee, Sugar and Cocoa Exchange's coffee future.

In many commodity or energy markets, parties want to settle futures by delivery, but exchange rules are too restrictive for their needs. For example, the New York Mercantile Exchange requires that natural gas be delivered at the Henry Hub in Louisiana. Suppose two parties need to buy/sell gas at some other hub and have transacted futures to hedge against price movements prior to the transaction.

To accomplish their objectives they could privately negotiate the trade and then reverse their futures positions by offset. This requires that they take price risk during the period between closing the physical trade and offsetting their respective futures positions. Many exchanges offer an alternative called exchange for physicals (EFP). The mechanics of EFP vary by exchange. Generally, the parties privately negotiate their physical trade. Then, instead of offsetting their futures hedges with trades on the exchange, they inform the exchange that they want to transfer the futures from one party to the other, closing out their respective positions. Essentially, EFP is customizable physical delivery.

SECURITY FUTURES PRODUCTS - Click here for full SFP risk disclosure

A security futures contract is a legally binding agreement between two parties to purchase or sell in the future a specific quantity of shares of a security or of the component securities of a narrow-based security index, at a certain price. At that time, the account of each buyer and seller reflects the amount of any gain or loss on the security futures contract based on the contract price established at the end of the day for settlement purposes (the “daily settlement price”). An open position, either a long or short position, is closed or liquidated by entering into an offsetting transaction (i.e., an equal and opposite transaction to the one that opened the position) prior to the contract expiration. Traditionally, most futures contracts are liquidated prior to expiration through an offsetting transaction and, thus, holders do not incur a settlement obligation.  

Security futures contracts that are not liquidated prior to expiration must be settled in accordance with the terms of the contract. Some security futures contracts are settled by physical delivery of the underlying security. At the expiration of a security futures contract that is settled through physical delivery, a purchaser that is long the contract must pay the final settlement price set by the regulated exchange or the clearing organization and take delivery of the underlying shares. Conversely, a purchaser that is short the contract must make delivery of the underlying shares in exchange for the final settlement price. Other security futures contracts are settled through cash settlement. In this case, the underlying security is not delivered. Instead, any positions in such security futures contracts that are open at the end of the last trading day are settled through a final cash payment based on a final settlement price determined by the exchange or clearing organization. Once this payment is made, neither party has any further obligations on the contract. Security futures contracts can be used for speculation, hedging, and risk management. Security futures contracts do not provide capital growth or income.

Speculators are individuals or firms who seek to profit from anticipated increases or decreases in futures prices. A speculator who expects the price of the underlying instrument to increase will buy the security futures contract. A speculator who expects the price of the underlying instrument to decrease will sell the security futures contract. Speculation involves substantial risk and can lead to large losses as well as profits. The most common trading strategies involving security futures contracts are buying with the hope of profiting from an anticipated price increase and selling with the hope of profiting from an anticipated price decrease.

Speculators may also enter into spreads with the hope of profiting from an expected change in price relationships. Spreaders may purchase a contract expiring in one contract month and sell another contract on the same underlying security expiring in a different month (e.g., buy June and sell September XYZ single stock futures). This is commonly referred to as a “calendar spread.” Spreaders may also purchase and sell the same contract month in two different but economically correlated security futures contracts. For example, if ABC and XYZ are both pharmaceutical companies and an individual believes that ABC will have stronger growth than XYZ between now and June, he could buy June ABC futures contracts and sell June XYZ futures contracts.  

Speculators can also engage in arbitrage, which is similar to a spread except that the long and short positions occur on two different markets. An arbitrage position can be established by taking an economically opposite position in a security futures contract on another exchange, in an options contract, or in the underlying security.

Hedging involves the purchase or sale of a security future to reduce or offset the risk of a position in the underlying security or group of securities (or a close economic equivalent). A hedger gives up the potential to profit from a favorable price change in the position being hedged in order to minimize the risk of loss from an adverse price change.

Some institutions also use futures contracts to manage portfolio risks without necessarily intending to change the composition of their portfolio by buying or selling the underlying securities. The institution does so by taking a security futures position that is opposite to some or all of its position in the underlying securities. This strategy involves more risk than a traditional hedge because it is not meant to be a substitute for an anticipated purchase or sale.

By law, security futures contracts must trade on a regulated U.S. exchange. Each regulated U.S. exchange that trades security futures contracts is subject to joint regulation by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). A holder of a position in a security futures contract who seeks to liquidate the position must do so either on the regulated exchange where the original trade took place or on another regulated exchange, if any, where a fungible security futures contract trades. Security futures contracts traded on one regulated exchange might not be fungible with security futures contracts traded on another regulated exchange for a variety of reasons. Security futures traded on different regulated exchanges may be non-fungible because they have different contract terms (e.g., size, settlement method), or because they are cleared through different clearing organizations. Moreover, a regulated exchange might not permit its security futures contracts to be offset or liquidated by an identical contract traded on another regulated exchange, even though they have the same contract terms and are cleared through the same clearing organization. Regulated exchanges that trade security futures contracts are required by law to establish certain listing standards. Changes in the underlying security of a security futures contract may, in some cases, cause such contract to no longer meet the regulated exchange’s listing standards. Each regulated exchange will have rules governing the continued trading of security futures contracts that no longer meet the exchange’s listing standards. These rules may, for example, permit only liquidating trades in security futures contracts that no longer satisfy the listing standards.

Security Futures differ from the underlying security. Shares of common stock represent a fractional ownership interest in the issuer of that security. Ownership of securities confers various rights that are not present with positions in security futures contracts. For example, persons owning a share of common stock may be entitled to vote in matters affecting corporate governance. They also may be entitled to receive dividends and corporate disclosure, such as annual and quarterly reports. The purchaser of a security futures contract, by contrast, has only a contract for future delivery of the underlying security. The purchaser of the security futures contract is not entitled to exercise any voting rights over the underlying security and is not entitled to any dividends that may be paid by the issuer. Moreover, the purchaser of a security futures contract does not receive the corporate disclosures that are received by shareholders of the underlying security, although such corporate disclosures must be made publicly available through the SEC’s EDGAR system, which can be accessed at www.sec.gov. All security futures contracts are marked-to-market at least daily, usually after the close of trading. At that time, the account of each buyer and seller is credited with the amount of any gain, or debited by the amount of any loss, on the security futures contract, based on the contract price established at the end of the day for settlement purposes (the “daily settlement price”). By contrast, the purchaser or seller of the underlying instrument does not have the profit and loss from their investment credited or debited until the position in that instrument is closed out. Naturally, as with any financial product, the value of the security futures contract and of the underlying security may fluctuate. However, owning the underlying security does not require the trading program to settle profits and losses daily. By contrast, as a result of the mark-to-market requirements discussed above, a holder of a position that is long a security futures contract maybe required to deposit additional funds into their account as the price of the security futures contract decreases. Similarly, if the trading program is short a security futures contract often will be required to deposit additional funds into the trading programs account as the price of the security futures contract increases. Another significant difference is that security futures contracts expire on a specific date. Unlike an owner of the underlying security, the trading program cannot hold a long position in a security futures contract for an extended period of time in the hope that the price will go up. If the trading program does not liquidate the trading programs security futures contract, the trading program will be required to settle the contract when it expires, either through physical delivery or cash settlement. For cash-settled contracts in particular, upon expiration, the trading program will no longer have an economic interest in the securities underlying the security futures contract.

Although security futures contracts share some characteristics with options on securities (options contracts), these products are also different in a number of ways. Below are some of the important distinctions between equity options contracts and security futures contracts. If the trading program purchases an options contract, you have the right, but not the obligation, to buy or sell a security prior to the expiration date. If the trading program sells an options contract, the trading program has the obligation to buy or sell a security prior to the expiration date. By contrast, if the trading program has a position in a security futures contract (either long or short), the trading program has both the right and the obligation to buy or sell a security at a future date. The only way that the trading program can avoid the obligation incurred by the security futures contract is to liquidate the position with an offsetting contract.

Each regulated exchange can choose the terms of the security futures contracts it lists, and those terms may differ from exchange to exchange or contract to contract. Some of those contract terms are discussed below.

Each security futures contract has a set size. The size of a security futures contract is determined by the regulated exchange on which the contract trades. For example, a security futures contract for a single stock may be based on 100 shares of that stock. If prices are reported per share, the value of the contract would be the price times 100. For narrow-based security indices, the value of the contract is the price of the component securities times the multiplier set by the exchange as part of the contract terms.

Security futures contracts expire at set times determined by the listing exchange. For example, a particular contract may expire on a particular day, e.g., the third Friday of the expiration month. Up until expiration, the trading program may liquidate an open position by offsetting the trading programs contract with a fungible opposite contract that expires in the same month. If the trading program does not liquidate an open position before it expires, the trading program will be required to make or take delivery of the underlying security or to settle the contract in cash after expiration.

Although security futures contracts on a particular security or a narrow-based security index may be listed and traded on more than one regulated exchange, the contract specifications may not be the same. Also, prices for contracts on the same security or index may vary on different regulated exchanges because of different contract specifications.

Prices of security futures contracts are usually quoted the same way prices are quoted in the underlying instrument. For example, a contract for an individual security would be quoted in dollars and cents per share. Contracts for indices would be quoted by an index number, usually stated to two decimal places.

Each security futures contract has a minimum price fluctuation (called a tick), which may differ from product to product or exchange to exchange. For example, if a particular security futures contract has a tick size of 1¢, you can buy the contract at $23.21 or $23.22 but not at $23.215.

The value of the trading programs positions in security futures contracts could be affected if trading is halted in either the security futures contract or the underlying security. In certain circumstances, regulated exchanges are required by law to halt trading in security futures contracts. For example, trading on a particular security futures contract must be halted if trading is halted on the listed market for the underlying security as a result of pending news, regulatory concerns, or market volatility. Similarly, trading of a security futures contract on a narrow-based security index must be halted under such circumstances if trading is halted on securities accounting for at least 50 percent of the market capitalization of the index. In addition, regulated exchanges are required to halt trading in all security futures contracts for a specified period of time when the Dow Jones Industrial Average (“DJIA”) experiences one-day declines of 10-, 20- and 30-percent. The regulated exchanges may also have discretion under their rules to halt trading in other circumstances – such as when the exchange determines that the halt would be advisable in maintaining a fair and orderly market. A trading halt, either by a regulated exchange that trades security futures or an exchange trading the underlying security or instrument, could prevent the trading program from liquidating a position in security futures contracts in a timely manner, which could prevent the trading program from liquidating a position in security futures contracts at that time.

Each regulated exchange trading a security futures contract may open and close for trading at different times than other regulated exchanges trading security futures contracts or markets trading the underlying security or securities. Trading in security futures contracts prior to the opening or after the close of the primary market for the underlying security may be less liquid than trading during regular market hours. 

Every regulated U.S. exchange that trades security futures contracts is required to have a relationship with a clearing organization that serves as the guarantor of each security futures contract traded on that exchange. A clearing organization performs the following functions: matching trades; effecting settlement and payments; guaranteeing performance; and facilitating deliveries. Throughout each trading day, the clearing organization matches trade data submitted by clearing members on behalf of their customers or for the clearing member’s proprietary accounts. If an account is with a brokerage firm that is not a member of the clearing organization, then the brokerage firm will carry the security futures position with another brokerage firm that is a member of the clearing organization. Trade records that do not match, either because of a discrepancy in the details or because one side of the transaction is missing, are returned to the submitting clearing members for resolution. The members are required to resolve such “out trades” before or on the open of trading the next morning. When the required details of a reported transaction have been verified, the clearing organization assumes the legal and financial obligations of the parties to the transaction. One way to think of the role of the clearing organization is that it is the “buyer to every seller and the seller to every buyer.” The insertion or substitution of the clearing organization as the counterparty to every transaction enables a customer to liquidate a security futures position without regard to what the other party to the original security futures contract decides to do. The clearing organization also effects the settlement of gains and losses from security futures contracts between clearing members. At least once each day, clearing member brokerage firms must either pay to, or receive from, the clearing organization the difference between the current price and the trade price earlier in the day, or for a position carried over from the previous day, the difference between the current price and the previous day’s settlement price. Whether a clearing organization effects settlement of gains and losses on a daily basis or more frequently will depend on the conventions of the clearing organization and market conditions. Because the clearing organization assumes the legal and financial obligations for each security futures contract, you should expect it to ensure that payments are made promptly to protect its obligations. Gains and losses in security futures contracts are also reflected in each customer’s account on at least a daily basis. Each day’s gains and losses are determined based on a daily settlement price disseminated by the regulated exchange trading the security futures contract or its clearing organization. If the daily settlement price of a particular security futures contract rises, the buyer has a gain and the seller a loss. If the daily settlement price declines, the buyer has a loss and the seller a gain. This process is known as “marking-to-market” or daily settlement. As a result, individual customers normally will be called on to settle daily. The one-day gain or loss on a security futures contract is determined by calculating the difference between the current day’s settlement price and the previous day’s settlement price. The cumulative gain or loss on a customer’s open security futures positions is generally referred to as “open trade equity” and is listed as a separate component of account equity on the trading programs account statement.

When a broker-dealer lends a customer part of the funds needed to purchase a security such as common stock, the term “margin” refers to the amount of cash, or down payment, the customer is required to deposit. By contrast, a security futures contract is an obligation and not an asset. A security futures contract has no value as collateral for a loan. Because of the potential for a loss as a result of the daily marked-to-market process, however, a margin deposit is required of each party to a security futures contract. This required margin deposit also is referred to as a “performance bond.” In the first instance, margin requirements for security futures contracts are set by the exchange on which the contract is traded, subject to certain minimums set by law. The basic margin requirement is 20% of the current value of the security futures contract, although some strategies may have lower margin requirements.

If the trading program does not liquidate the trading programs position prior to the end of trading on the last day before the expiration of the security futures contract, the trading program will be obligated to either 1) make or accept a cash payment (“cash settlement”) or 2) deliver or accept delivery of the underlying securities in exchange for final payment of the final settlement price (“physical delivery”). The terms of the contract dictate whether it is settled through cash settlement or by physical delivery. The expiration of a security futures contract is established by the exchange on which the contract is listed. On the expiration day, security futures contracts cease to exist. Typically, the last trading day of a security futures contract will be the third Friday of the expiring contract month, and the expiration day will be the following Saturday. This follows the expiration conventions for stock options and broad-based stock indexes. Please keep in mind that the expiration day is set by the listing exchange and may deviate from these norms.

In the case of cash settlement, no actual securities are delivered at the expiration of the security futures contract. Instead, the trading program you must settle any open positions in security futures by making or receiving a cash payment based on the difference between the final settlement price and the previous day’s settlement price. Under normal circumstances, the final settlement price for a cash-settled contract will reflect the opening price for the underlying security. Once this payment is made, neither the buyer nor the seller of the security futures contract has any further obligations on the contract.

Settlement by physical delivery is carried out by clearing brokers or their agents with National Securities Clearing Corporation (“NSCC”), an SEC-regulated securities clearing agency. Such settlements are made in much the same way as they are for purchases and sales of the underlying security. Promptly after the last day of trading, the regulated exchange’s clearing organization will report a purchase and sale of the underlying stock at the previous day’s settlement price (also referred to as the “invoice price”) to NSCC. If NSCC does not reject the transaction by a time specified in its rules, settlement is effected pursuant to the rules of NSCC within the normal clearance and settlement cycle for securities transactions, which currently is three business days. If the trading program holds a short position in a physically settled security futures contract to expiration, the trading program will be required to make delivery of the underlying securities. If the trading program already own the securities, the trading program may tender them to your brokerage firm. If the trading program does not own the securities, the trading program will be obligated to purchase them. Some brokerage firms may not be able to purchase the securities for the trading program. If the trading programs brokerage firm cannot purchase the underlying securities to fulfill a settlement obligation, the trading program will have to purchase the securities through a different firm.

Positions in security futures contracts may be held either in a securities account or in a futures account. The trading programs brokerage firm may or may not permit the trading program to choose the types of account in which the trading programs positions in security futures contracts will be held. The protections for funds deposited or earned by the trading programs in connection with trading in security futures contracts differ depending on whether the positions are carried in a securities account or a futures account. If the trading programs positions are carried in a securities account, the trading program will not receive the protections available for futures accounts. Similarly, if the trading programs positions are carried in a futures account, the trading program will not receive the protections available for securities accounts.

Regulatory protections applicable to the trading programs account are not intended to insure the trading program against losses the trading program may incur as a result of a decline or increase in the price of a security futures contract. As with all financial products, the trading program is solely responsible for any market losses in the trading programs account.

If the trading programs positions in security futures contracts are carried in a securities account, they are covered by SEC rules governing the safeguarding of customer funds and securities. These rules prohibit a broker/dealer from using customer funds and securities to finance its business. As a result, the broker/dealer is required to set aside funds equal to the net of all its excess payables to customers over receivables from customers. The rules also require a broker/dealer to segregate all customer fully paid and excess margin securities carried by the broker/dealer for customers. The Securities Investor Protection Corporation (SIPC) also covers positions held in securities accounts. SIPC was created in 1970 as a non-profit, non-government, membership corporation, funded by member broker/dealers. Its primary role is to return funds and securities to customers if the broker/dealer holding these assets becomes insolvent. SIPC coverage applies to customers of current (and in some cases former) SIPC members.

If the trading programs security futures positions are carried in a futures account, they must be segregated from the brokerage firm's own funds and cannot be borrowed or otherwise used for the firm’s own purposes. If the funds are deposited with another entity (e.g., a bank, clearing broker, or clearing organization), that entity must acknowledge that the funds belong to customers and cannot be used to satisfy the firm’s debts. Moreover, although a brokerage firm may carry funds belonging to different customers in the same bank or clearing account, it may not use the funds of one customer to margin or guarantee the transactions of another customer. As a result, the brokerage firm must add its own funds to its customers’ segregated funds to cover customer debits and deficits. Brokerage firms must calculate their segregation requirements daily. The trading program may not be able to recover the full amount of any funds in the trading programs account if the brokerage firm becomes insolvent and has insufficient funds to cover its obligations to all of its customers. However, customers with funds in segregation receive priority in bankruptcy proceedings. Furthermore, all customers whose funds are required to be segregated have the same priority in bankruptcy, and there is no ceiling on the amount of funds that must be segregated for or can be recovered by a particular customer. The trading programs brokerage firm is also required to separately maintain funds invested insecurity futures contracts traded on a foreign exchange. However, these funds may not receive the same protections once they are transferred to a foreign entity (e.g., a foreign broker, exchange or clearing organization) to satisfy margin requirements for those products.

An equity security represents a fractional ownership interest in the issuer of that security. By contrast, the purchaser of a security futures contract has only a contract for future delivery of the underlying security. Treatment of dividends and other corporate events affecting the underlying security may be reflected in the security futures contract depending on the applicable clearing organization rules. The specific adjustments to the terms of a security futures contract are governed by the rules of the applicable clearing organization.

Corporate issuers occasionally announce stock splits. As a result of these splits, owners of the issuer’s common stock may own more shares of the stock, or fewer shares in the case of a reverse stock split. The treatment of stock splits for persons owning a security futures contract may vary according to the terms of the security futures contract and the rules of the clearing organization. For example, the terms of the contract may provide for an adjustment in the number of contracts held by each party with a long or short position in a security future, or for an adjustment in the number of shares or units of the instrument underlying each contract, or both. Corporate issuers also occasionally issue special dividends. A special dividend is an announced cash dividend payment outside the normal and customary practice of a corporation. The terms of a security futures contract may be adjusted for special dividends. The adjustments, if any, will be based upon the rules of the exchange and clearing organization. In general, there will be no adjustments for ordinary dividends as they are recognized as a normal and customary practice of an issuer and are already accounted for in the pricing of security futures. Corporate issuers occasionally may be involved in mergers and acquisitions. Such events may cause the underlying security of a security futures contact to change over the contract duration. The terms of security futures contracts may also be adjusted to reflect other corporate events affecting the underlying security.

All security futures contracts trading on regulated exchanges in the United States are subject to position limits or position accountability limits. Position limits restrict the number of security futures contracts that any one person or group of related persons may hold or control in a particular security futures contract. In contrast, position accountability limits permit the accumulation of positions in excess of the limit without a prior exemption. In general, position limits and position accountability limits are beyond the thresholds of most retail investors. Whether a security futures contract is subject to position limits, and the level for such limits, depends upon the trading activity and market capitalization of the underlying security of the security futures contract. Position limits apply are required for security futures contracts that overlie a security that has an average daily trading volume of 20 million shares or fewer. In the case of a security futures contract overlying a security index, position limits are required if any one of the securities in the index has an average daily trading volume of 20 million shares or fewer. Position limits also apply only to an expiring security futures contract during its last five trading days. A regulated exchange must establish position limits on security futures that are no greater than 13,500 (100 share) contracts, unless the underlying security meets certain volume and shares outstanding thresholds, in which case the limit may be increased to 22,500 (100 share) contracts. For security futures contracts overlying a security or securities with an average trading volume of more than 20 million shares, regulated exchanges may adopt position accountability rules. Under position accountability rules, a trader holding a position in a security futures contract that exceeds 22,500 contracts (or such lower limit established by an exchange) must agree to provide information regarding the position and consent to halt increasing that position if requested by the exchange. Brokerage firms must also report large open positions held by one person (or by several persons acting together) to the CFTC as well as to the exchange on which the positions are held. The CFTC’s reporting requirements are 1,000 contracts for security futures positions on individual equity securities and 200 contracts for positions on a narrow-based index. However, individual exchanges may require the reporting of large open positions at levels less than the levels required by the CFTC. In addition, brokerage firms must submit identifying information on the account holding the reportable position (on a form referred to as either an “Identification of Special Accounts Form” or a “Form 102”) to the CFTC and to the exchange on which the reportable position exists within three business days of when a reportable position is first established.