Risks involved with futures trading

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1 Appendix 1: Risks involved with futures trading Before executing any futures transaction, the client should obtain information on the risks involved. Note in particular the risks summarized in the following document. Please be advised that this specific type of investment is not suitable for everyone and limited to investors with sufficient expertise. Please accept the following risk notification by signing on the last page. General risk involved with futures When trading futures, the chances of profit are counterbalanced by high chances of loss. Depending on the contract, the invested capital can be completely lost. Note that the obligations arising from futures can even lead to unlimited loss depending on the price movements. The rights acquired from futures can also purge or lose their value. Generally, contracts with short maturities involve a higher risk than those with longer maturities. Futures transactions are normally based on a leverage effect. This leverage effect makes the investment react disproportionately to price movements and sensitive to the volatility of the underlying asset. Higher leverages will increase the associated risk. During the lifetime of a futures contract, the possibility to close, settle or compensate a position is linked to the market situation. In some cases, it may not be possible to execute a transaction or only at an unfavourable price leading to a loss. Covered futures In the case of covered futures, the provided securities are blocked. The possibility that these securities may lose in value over time is a factor that additionally increases the risk. Margin requirements The size of the margin requirements is determined by the derivatives exchanges and constantly calculated. The margin requirement depends on the price trends of the positions received and cannot be predicted. This means that investors must at all times be capable of providing additional securities within an appropriate deadline to cover new risks. Moreover, the investor must be capable of compensating for losses that result from the continuous assessment of the futures and options. In the event that not all risks are covered, the investor is exposed to the risk that all open positions may be settled and lead to a loss. Irrespective of the securities provided, the execution of uncovered futures and options can lead to obligations that may go beyond the provided securities and extent towards the private capital. Over-the-Counter Derivates (OTC) Other than contracts traded at the stock exchanges, OTC (Over-the-Counter) transactions have no standardized form. This means that quotes will only be available upon request. Compensating for the risks through a contract with a third person is not possible. In some cases, the only option to close a position and limit the risk may be to execute a transaction with a market maker or other OTC market participant. Generally, the market maker is under no such obligation to make a transaction and can strongly influence the market price. This means that if a negative value occurs, the OTC trade may lead to a loss. Securitized futures Rights and obligations from futures contracts can be securitized through warrants or leverage certificates. Note that the general risks involved in the investment are not changed by securitizing the futures contracts. However, the risk on the capital invested is limited. Options Forward transactions with options An option is the right to buy or sell a commodity or asset at a later point of time. The investor has the right but not the obligation to exercise the option and can decide to let it expiry. Depending on the type of option, the right is settled in cash in form of an option premium or by delivering the underlying asset.

2 If European options or Asian options are traded, the right to exercise the option is limited to the expiry date. In contrast, American options can be exercised at point of any time during the option s lifetime. There is no regional restriction for buying these options. If an option is not exercised, it will lapse on the expiry date. The expiry date and the last trading date of an option do not always have to be identical. This means that the holder may already be unable to trade the option prior to the option s expiry date. Cash-settled options The underlying asset of an option can also be non-physical. In this event, the investor will make a cashsettlement instead of delivering the commodities or securities. This is the case, for example, with index options which require an assessment of the corresponding value. Call and put options A call is an option contract that gives the buyer the right to buy the underlying asset at a pre-set rate and volume. Usually, the investor will only exercise this right if the price for the underlying asset is higher than the exercise price. A put is an option contract that gives the owner the right to sell an underlying asset under the same criteria. Different trading options There are four different trading options: Long call: the purchase of a call option, short call: the sale of a call option, long put: the purchase of an option to sell an underlying asset and short put: the sale of an option to sell an underlying asset. Option writer The option writer is a person who sells an option for a specific option premium and keeps the underlying asset until the option may be exercised by the buyer. In the case of American options, the option writer will always depend on the decision of the option buyer during option s lifetime. In the case of European options, the option may only be exercised at the expiry date. Covered and uncovered options Options are either covered or uncovered. In the case of covered options, the option seller will already own the underlying asset at the time the transaction is executed. In the case of uncovered options, the seller does not own the underlying asset. If the seller is an option writer and obligated to deliver, the underlying asset has to be bought and delivered at the time agreed. In this case, the risk is unlimited. The same applies if the buyer is obligated to purchase. Key parameters for options The following parameters apply to all types of options: Underlying asset: All options have an underlying asset, an object that gives value to the derivative. Exercise price: Buyer and seller of an option agree on a pre-set price for the underlying asset and the amount of delivery for the time the option is sold. Lifetime: Describes the period until (American options) or at which (European options) the right to an option may be exercised (expiry date). Option premium The amount of the option premium or the current price of an option is composed of the intrinsic value and the so-called time value.

3 Intrinsic value The intrinsic value of an option is the difference between the current price of the underlying asset and the exercise price of the option. For example, a call option on the DAX with an exercise price of 5,600 points at a DAX level of 6,000 points has an intrinsic value of 400 index points. The greater the difference between the current price and the exercise price, i.e. the greater the intrinsic value gets, the more expensive the option will become. Time value The second important factor besides the intrinsic value is the option s time value. The time value describes the difference between the price that has to be paid for the option at a certain point of time and its intrinsic value. The option s time value depends on three factors: The option's remaining lifetime: Options with a longer lifetime remaining have a higher time value than options with a shorter lifetime remaining, as the option right still extends over a longer period of time. Volatility of the underlying asset: Volatility refers to the fluctuation intensity. In the money, at the money or out of the money: Another key factor that affects the time value of an option is the question whether the option is in the money, at the money or out of the money. In the money: For call options, the option is said to be in-the-money when the market price of the underlying asset is above the option's strike price. A put option is in-the-money if the market price of the underlying asset is below the strike price. At the money: The option is said to be at the money, if the strike price and the market price of the underlying asset are the same. Out of the money: In this constellation, the strike price of the call option is above the market price of the underlying asset. A put option is out of the money if the strike price is below the market price of the asset. This means that the option has no intrinsic value. The option is said to be out of the money. Basket, turbo and exotic warrants There is a range of special cases that must be considered if the option is securitized (warrant). Basket warrants A basket warrant authorizes the owner to buy (call) the pre-set basket of underlying assets or a cash settlement in the case that the option is exercised. Turbo warrants Turbo warrants entitle the owner to other options. This redoubles the leverage effect. The same effects as described before and in particular the risks are increased. Exotic warrants Exotic warrants differ from standard options insofar as the specific option rights are subject to different conditions pursuant to the agreement between the contract parties. There exists a broad variety of possibilities, which means that the terms of the option should be carefully read and understood prior to buying an option. The most important are the following: Barrier warrants: Options are either extinguished (knock-out) or they spring into existence (knock-in) upon the occurrence of the price of the underlying asset breaching a pre-set barrier level. There are four different types of main barrier options. The investor should obtain detailed information on the structure of the option to be able to analyze the concrete chance-risk situation.

4 Digital options Digital options securitize the right of the buyer to receive a fixed payment if the price for the underlying asset either falls below or is above the contractual exercise price during the option s lifetime or at the option s expiry date (depending on the terms of the option). Range warrants Range warrants provide the buyer with the right to a specific payout at the end of the option s lifetime whose size depends on whether the price of the underlying asset was above or below or between the pre-set limits during the lifetime of the option. Single range warrants In this type of warrant, the investor receives a fixed payment for each day that the price for the underlying asset is either above the lower limit or below the upper limit of an allowable range of price fluctuation. The total amount collected during the option s lifetime is paid out at the expiry date. Dual range warrants For each day that the price for underlying asset is above the lower or below the upper limit of an allowable range of price fluctuation, the investor is paid out a fixed amount. For each day the price leaves the range, a fixed amount is debited. Payment entitlements and obligations will be offset after the option expires. The investor must fulfil outstanding obligations if the amount is negative at the option s expiry date, which is usually not the case. Bottom-up or top-down warrants With this type of warrant, the investor is paid out a fixed amount for each day that the price of the underlying asset is above (bottom-up) or below (top-down) the limits determined in the option s terms and conditions. The amount is paid out cumulatively after the option s expiry date. Knock-Out-Range warrants This warrant follows the same principle as the range warrants. Depending on the terms of the option, the option right held by the investor is extinguished if the price for the underlying asset leaves or depending on the terms falls within an allowable range of price fluctuation. Depending on the terms of the option, the investor may either receive no payout at all or the specific amount that has accumulated by the time the limit has been reached. Important note: More information on the details of these products, their structure and the specific risks involved when using complex warrants or when combining different options or warrants is only possible in view of individual cases and a thorough description of the transaction. Risks of option contracts Due to their specific structures, option contracts involve a very high risk of loss that has to be considered by all investors trading this type of derivate. Consequences of costs All option contracts can lead to additional costs such as minimum commissions, percentage fees or fixed fees for each transaction (when buying or selling). In extreme cases, the additional costs may even exceed the option s value by several times over. Exercising an option often generates further costs, which can amount considerably in comparison to the option premium. Note that these costs change or worsen the profit expectations of the option buyer, as a much higher price increase than usually considered realistic on the market will be necessary to enter the profit zone.

5 As can be taken from the information so far given on the structure and the specific risks involved with futures, the option contract is a bet on the future price development. In order to conclude the bet, the option buyer has to pay a so-called option premium. Whether the option owner will make a profit depends on whether exercising or settling the option will lead to a differential amount between the exercise price and the price achieved by exercising or settling the option. Profits are generated if the difference is higher than the option premium that was initially paid. This means that the option premium first has to be earned again before the investor enters the profit zone. As long as the differential amount is below the price paid for the option premium, the holder will remain in partial loss zone. If the underlying asset does not gain in value or if it loses value before the option s expiry date, the investor will lose the entire premium. Note that the premium corresponds to the price that is considered to be realistic on the market even though the price expectations at the exchange may be speculative. The option premium will balance off as offer and counter-offer approximate and therefore marks the risk zone considered to be reasonable on the market. Any additional costs as well as possible payments and fees on top of the option premium will affect the chance/risk ratio in a negative way as these costs will first have to be recovered before the investor enters the profit zone. Depending on the amount of additional costs that must be added to the option premium, the chance/risk ratio will change and the profit expectations reduce to a minimum or zero. The costs and fees that must be added on top of the option premium will reduce the profit expectations with each new transaction and may even lead to no profits at all. Note that only costs and fees amounting to less than 10 % of the option premium are considered to have no such negative long-term effect on the chance/risk ratio. Risk of price fluctuation The price for an option is subject to fluctuation depending on a range of different factors (see above). Note that these factors can even make an option worthless. Since options have an expiry date, the investor has no reliable basis to expect an improvement of the potential profits for the option over time. Leverage effect Price fluctuations affecting the underlying asset always have a disproportionate effect on the price of the option. This is refereed to as the leverage effect. Call-options may lose in value as a result of price decreases for the underlying asset. Put-options may lose in value as a result of price increases. But not every price increase for the underlying asset has to lead to a better price for the option. The price for the option can even drop, for example, when the price for the underlying asset is overly compensated based on the negative effects of a falling volatility or in view of an approaching expiry date. The leverage effect leads to high chances as well as high risks for the investor. Investors must take into account that the leverage works into both directions, which means that the effect can be both to the advantage and disadvantage of the investor. The effect can therefore be to the benefit as much as to the disadvantage of the option holder. The higher the leverage, the riskier the transaction will become. As the expiry date of the option approaches, the leverage effect tends to increase. Risk of expiration, depreciation and total loss It has already been pointed out that options have an expiry date and that they can therefore become entirely worthless or can lose in value. As the option s expiry date draws closer, the risk of partial loss or even total loss increases. The option will loose in value if the price expectations remain unfulfilled by the option s expiry date. Since options have only a limited lifetime, the investor is never given a guarantee that the price for the option will recover before the expiry date.

6 Unlimited loss risk Negative market trends, the effects of obligations or the option s expiry date may lead to a total investment loss when opening option positions. Note that there is theoretically an unlimited loss risk depending on the position. The risk is not limited to securities and can exceed them considerably. Limited or impossible loss restriction Transactions to exclude or limit the risk involved with options may not be possible or only at an unfavourable price leading to a loss situation. Issuer risk Investors are exposed to the issuer risk, which is the risk of insolvency of the issuer of the warrant. Higher risk when utilizing credits The risk of loss may increase if the obligations associated with the futures transaction can only be fulfilled based on a credit line. Higher risk when utilizing foreign currency The risk of loss may increase if the claims and obligations associated with the futures transaction or the counter-performance to be claimed are denominated in a foreign currency or unit of account. The reason for this is the exchange rate that has to be taken into account. Same risk when utilizing securities Securitizing the rights and obligations described so far, particularly to a warrant, does not affect the rights and obligations that have been described. Since futures contracts can differ, each transaction may involve additional risks depending on the specific terms that apply. Investors should open a position only if they have fully understood how the contract works and which risks are involved. Short-selling options Short-selling an option means that a security is sold that the seller does not own. Note that this is an extremely risky strategy that produces a highly unfavourable chance/risk ratio for the short-seller. Short-sellers of options receive the option premium from the buyer. This option premium describes the maximum profit potential for the seller. It is important to note that the seller is at the same time exposed to an unlimited risk of loss. Short-selling an option means that the seller is not the owner of the option. The seller does not even have to own the underlying asset. Investors should take into account that when short-selling a call-option the profit potential is limited to the amount of the option premium while the risk remains unlimited. When short-selling put-options, the profit potential is also limited to the option premium and the loss risk remains unlimited in the event that falling prices occur (even though the value of the underlying asset cannot drop below zero). Investors should be advised that the profit expectations connected to these transactions are therefore always limited while the risk of loss remains unlimited. Such an unbalanced chance/risk ratio requires a careful and efficient risk management. Margin Futures contracts expose the investor to an unlimited risk of loss - in particular, when short-selling options - and require securities to cover potential depreciation. Every exchange has its own regulations that have to be taken into account and followed by the investor. Investors who wish to trade options at the EUREX exchange must also take into account the difference between the so-called premium margin and the additional margin (a regulation specific to the Eurex that does not apply to all exchanges).

7 Premium margin The premium margin for short-selling options is recalculated on a daily basis. The exchanges will determine the premium for each option based on the official closing price. When short-selling options, the premium corresponds to the repurchase or liquidation price that a short-seller would have to pay when repurchasing the option for the official closing price. This margin is referred to as the premium margin and debited from the client s account to cover open repurchasing obligations. This works as follows: The premium gained from short-selling an option is credited to the client s margin account. When the position is opened, the option s repurchasing value (at official closing price) is at the same time debited from the account as premium margin. This means that the profit or loss of the position will be the difference between the option premium and the repurchasing value. On the next trading day, the new repurchasing value will be debited as new premium margin and the margin debited the previous day will be paid back to the client s account. This way, the difference between the old and the new premium margin represents the profit or loss of the option position as against the previous trading day. The daily fluctuation corresponds to the daily profits or losses in the open option position. Additional margin Besides the premium margin, the investor will also be charged an additional margin. To calculate the additional margin, the exchange will set a margin parameter for the largest possible price change of the commodity or underlying asset. The size of the margin parameter is based on historical data. Based on this model, the exchange will calculate the expected worst-case scenario for the short-seller as regards the price development of the underlying asset within a 24-hour period. By use of option-theoretical models, the exchange will then calculate the worst-case loss for an option in correlation to the worst-case loss of the underlying asset. This amount of potential loss equals the additional margin that would be required by the client to cover the maximum expected depreciation on the next day. The client s account must provide coverage for at least this additional margin in order to be able to keep the short sale position on options until the next trading day. Please remember that the potential loss is not limited to the additional margin or the margin as a whole and can always be substantially higher. When short-selling an option, the margin is the sum of the premium margin and the additional margin. This regulation is specific to EUREX. Note that each exchange has its own regulations that must be taken into account. Investors are advised to make themselves familiar with the specific regulations prior to trading in any of the markets or exchanges. Financial and commodities futures Financial and commodities futures are contracts where one party is obligated to sell a stock and the other party agrees to buy the stock at a specific time. Delivery, purchasing, amount and payment of the underlying asset are agreed upon conclusion of the contract. If the transaction is standardized and processed through the exchange, the procedure will have a standard form. Transactions involving financial instruments and commodities are generally referred to as futures. These futures are often merely speculative. Frequently, the contract parties have no economic interest in buying or selling the underlying asset. Margins When trading futures contracts, the transaction usually requires a security or so-called margin payment.

8 Margin requirement Futures transactions usually require a security or margin. The broker will book the margin as initial deposit on the client s account. This account is used to process all the client s futures transactions. Profits, losses and fees incurred from transactions will be debited or credited to this account. The holder is required to provide sufficient coverage for the margin requirement. If the obligations from futures contracts are at disadvantage for the client, the respective losses will be debited. If the funds on the margin account as a consequence fall below the margin requirement, the client will be requested to provide further funds and offset these losses (a so-called margin-call ). The deadline for offsetting losses may be as short as a few hours. If the client does not comply with the request, the broker may liquidize the client s open positions in whole or in part or offset transactions. Minimum margins are set by the exchange and recalculated on a daily basis according to the volatility of the futures. Note that the broker can require a margin payment higher than the minimum requirement of the exchange. The regulation of the security requirements and obligations to provide further securities to offset losses are subject to the terms and conditions of the broker. Note on risks There are specific risks involved when concluding futures contracts over physical commodities that result as a consequence of the obligation to deliver or buy the underlying asset. Investors should remember that sellers of futures can insist on the acceptance of the underlying asset from the first notice day specified in the terms. The delivery of the underlying asset to the specific location determined by the exchange has to be announced and carried out in amounts and quality under the terms of the contract. The seller is free to choose the precise time of delivery (within a period of one month) but must announce the time of delivery in written form and one working day in advance. If the contract is not offset in time, the buyer will be exposed to a risk from the first notice day until the end of the last trading month to be suddenly obligated to purchase. Sellers risk that they will suddenly be obligated to deliver an underlying asset at the end of the contract if the transaction was not settled. If the seller was unable to settle the option in time and is under obligation to sell, the underlying asset has to be bought, stored and delivered in quantity and quality of the terms of contract. Note that there may be further costs that will have to be considered. It may not be possible to determine the entire risk of loss. The liabilities from obligations may affect assets in excess of the securities provided by the client and may even exceed the investor s entire private capital. Covered and uncovered obligation to sell Investors under an obligation to deliver an underlying asset on the basis of a futures contract that do not own the underlying asset when entering the contract are exposed to a higher risk than investors who already own the asset. If the investor owns the underlying asset at the time the contract is entered, the risk is limited to the current expenses and costs for delivery. Special case: cash-settled futures Futures contracts do not always have a physical commodity as underlying asset. Non-physical assets serving as underlying asset are settled in cash, in particular, financial futures contracts on an index or an equity basket, i.e. on a changing variable, which is calculated from specific criteria and the changes that reflect the market price movements of the underlying assets. All other notes and descriptions apply accordingly for these contract types. Options on futures It is also possible to trade options on futures. In this case, the transaction is an option contract subject to the same risks and procedures described under A.

9 Futures trading with currency risk If the obligation from a futures contract is to sell or to buy an underlying asset in a foreign currency or unit of account or if the value of the underlying asset is calculated on such a basis, the risk is not limited to the transaction itself but extends also to the exchange rate risk. In this case, the trends on the foreign exchange markets and the exchange rate fluctuation can have a negative effect on the value of the option, or increase the price for the underlying asset that the investor will have to deliver in order to fulfil your obligation from the futures contract or reduce the value or profits. Place, date Signature of all account holders

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