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Futures Trading
EXAMPLE:
Exchange
Trading of
Futures
Contracts:
Order
Placement
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Gold
futures
trading
on CME:
A regular contract is for 100 troy ounces of
gold
Closest maturities available: August or October
Ms. Long and Mr. Short select October contract
Today is
May 1.
Ms. Long and Mr. Short want to do a
transaction: trade 50 ounces of gold at a fixed
price on September 30
Only possible in a forward market
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EXAMPLE (Cont’d): Order Placement
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• Margin account must have margin or security deposits in the form of cash or
securities.
• A Futures Commission Merchant (an FCM) provides a one-stop service for futures
trading.
A futures trader must open a
margin account with an FCM.
• Phones his FCM and dictates a market order
• Sells one October gold futures
Old-fashioned Shorty:
• Order is forwarded from FCM’s processing center to a floor broker.
Technologically savvy Longina
submits her market order
through an FCM’s website.
FIGURE: Open
Outcry Pit
Trading of
Futures Contract
Outcry pit has been replaced for most
futures contracts (SP500 index futures
is the exception)
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◦A floor broker is a trader’s agent and has a fiduciary responsibility
to protect a client’s interests.
◦A floor broker earns a commission for his service.
EXAMPLE (Cont’d): Exchange Trading of Futures: Order
Placement
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EXAMPLE
(Cont’d): On the
Exchange Floor
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Market structured for greater transparency and better price
discovery.
A trading pit or a ring has a circular or a polygonal shape
with concentric rings of steps flowing inward to a central
place.
People in the pit
Open outcry trading—
the trader must shout
the bid or ask so that
others may participate.
Conveying trade
information
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EXAMPLE (Cont’d): Trade Execution
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In an outcry pit:
Shorty’s broker senses the market and cries out an
offer to sell one contract at $1,001.
Standing in the crowd is Longina’s broker, who
signals the desire to be the counterparty.
The trade is executed when the brokers agree on
terms.
In an electronic market, trades are
executed by algorithms
EXAMPLE (Cont’d): Trade Execution
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Display and dissemination of
relevant information
Electronic quote boards
Ticker tapes
Traders pay their brokers
commissions on a round-trip basis.
Fee is collected only when the futures
transaction is closed.
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Before the market reopens, representatives of the clearing
members take the trade records to the exchange’s
clearinghouse.
◦Clearing trade
◦Guaranteeing contract performance
◦Margins to minimize default risk
EXAMPLE (Cont’d): Clearing
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FIGURE: Role of a Clearinghouse in a Derivative
Transaction
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A futures trade has a special feature called daily settlement, by which profits and losses
are paid out daily.
◦ Marked to market
◦ If the futures price goes up, Long wins and Short loses.
EXAMPLE (Cont’d): Daily Settlement
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Profit for
long position
Futures price
Long entered in a contract to buy 100 ounces of gold from Short in October for
$1,001 per ounce.
The next day’s settlement price is $1,004.
◦ Long refuses to buy gold in October at $1,004 because she had agreed to buy for $1,001!
Pay her today?
EXAMPLE (Cont’d): An Example of Marking-To-Market and Daily
Settlement
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EX. (Cont’d): An Example of Marking-To-
Market and Daily Settlement
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Long would agree to buy at $1,004 if she is paid the
new price minus the old price.
To handle this, ($3 / ounce) × 100 ounces = $300 is
taken from Short’s margin account and deposited
into Long’s margin account.
Marking-to-market
◦ Resets the delivery price at maturity for outstanding futures contracts to
the current futures price in freshly minted futures.
◦ It also resets the value of a futures contract to zero at the end of each
trading day.
EXAMPLE (Cont’d): Marking-To-Market
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EXAMPLE (Cont’d): Exchange Trading of
Futures: Closing the Contract
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Two months later, Longina sells one October
gold futures and closes out her position.
July
Shorty decides to physically deliver the gold
during the contract’s delivery period in
October.
October.
Futures
Contracts –
General
Characteristics
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Available on a wide
range of
underlyings
Exchange traded
Specifications need
to be defined:
• What can be delivered,
• Where it can be
delivered,
• When it can be
delivered
Settled daily
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Margin
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Margin is cash or marketable securities deposited by an investor
with his or her broker
The balance in the margin account is adjusted to reflect daily
settlement
Margin minimizes the possibility of a loss through a default on a
contract
Retail traders provide initial margin and, when the balance in the
margin account falls below a maintenance margin level, they must
provide variation margin bringing balance back up to initial
margin level.
Example of a Futures Trade
A retail investor takes a long position in 2 December gold futures
contracts
◦ contract size is 100 oz.
◦ futures price is US$1250
◦ initial margin requirement is US$6,000/contract (US$12,000 in total)
◦ maintenance margin is US$4,500/contract (US$9,000 in total)
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A
Possible
Outcome
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Day Trade
Price ($)
Settle
Price ($)
Daily
Gain
($)
Cumul.
Gain ($)
Margin
Balance
($)
Margin
Call ($)
1 1,250.00 12,000
1 1,241.00 −1,800 − 1,800 10,200
2 1,238.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,236.20 −780 −2,760 9,240
7 1,229.90 −1,260 −4,020 7,980 4,020
8 1,230.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,226.90 780 −4,620 15,180
Key Points
About Futures
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They are settled daily
Closing out a futures position is
easy. It involves entering into an
offsetting trade
Most contracts are closed out
before maturity
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Exchange
Clearing
House
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Brokers who are not members must channel
their business through a member. The
member will then require margin from the
broker
The exchange clearing house has members
who provide initial margin and daily
variation margin
Margin Cash Flows When Futures Price Increases
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Margin Cash Flows When Futures Price Decreases
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Some
Terminology
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Open interest: the total number of
contracts outstanding
• equal to number of long positions or number of
short positions
Settlement price: the price just before
the final bell each day
• used for the daily settlement process
Volume of trading: the number of trades
in one day
• total amount of trading activity or contracts that
have changed hands
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Crude Oil Trading:
May 15, 2020 vs. May 18 2021
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Delivery
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If a futures contract is not closed out before maturity, it is
usually settled by delivering the assets underlying the
contract. When there are alternatives about what is
delivered, where it is delivered, and when it is delivered,
the party with the short position chooses.
A few contracts (for example, those on stock indices and
Eurodollars) are settled in cash
When there is cash settlement, contracts are traded until a
predetermined time. All are then declared to be closed out.
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Futures Price Patterns
Futures prices can be
◦ an increasing function of maturity: normal market
◦ a decreasing function of maturity: inverted market
◦ partly normal, partly inverted
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Convergence of Futures to Spot
Time Time
(a) (b)
Futures
Price
Futures
Price
Spot Price
Spot Price
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