Mechanics of Futures Trading

Mechanics of Trading Futures Contracts

       

Futures Commission Merchants (FCM) Exchanges Floor Brokers Clearinghouse The Order Flow Liquidation or settling a futures position The performance bond Various Types of Futures Orders

Mechanics of Trading Futures Contracts

The Order Flows: Floor Trading

Mechanics of Trading Futures Contracts

Futures Commission Merchants (FCM)


The FCM is a central institution in the futures industry, that performs functions similar to a brokerage house in the securities industry. FCMs are regulated by Commodity Futures
Trading Commission (CFTC) under the Commodity Exchange Act (CEA).  Futures traders first have to open an account at a FCM  Futures traders with FCM accounts give their trading orders to an account executive employed at the FCM  The FCM executives give customer orders to floor brokers to execute the orders on the floor of an exchange  The FCM collects margin balance from the customers (traders), maintains customer money balance, and records and reports all trading activity of its customers

Mechanics of Trading Futures Contracts

Margins or Performance Bonds


Before trading a futures contract, the prospective trader must deposit funds with an FCM the deposit serves as a performance bond and is referred to as initial margin. The requirements are not set as a percentage of contract value. Instead they are a function of the price volatility of the commodity.  An initial margin is a deposit to cover losses the trader may incur on a futures contract as it is marked-to-market.  A maintenance margin is a minimum amount of money that must be maintained on deposit in a traders account. Maintenance margin is a lesser amount than the initial margin - typically 75% of the initial margin  A margin call is a demand for an additional deposit to bring a traders account up to the initial performance bond level. Traders post the funds for performance bond with their FCMs

Mechanics of Trading Futures Contracts

Initial Margin


Initial Margin- An Example

Each Gold futures contract is for 100 ounces of gold  Assume that the current market price of gold is $400 an ounce  The average daily absolute price change over the last 4 weeks is $10 an ounce  = $10 100 = $1,000  The standard deviation of the last 4 weeks daily absolute price change is $3 an ounce  = $3 100 = $300  Thus, the initial margin for 1 gold futures contract will be  + 3 = $1,000 + 3 $300 = $1,900 For most futures contracts, the initial margin may be 5 percent or less of the contracts face value.


Mechanics of Trading Futures Contracts

Maintenance Margin


Maintenance Margin- An Example



In general, maintenance margin is a lesser amount than the initial margin - typically 75% of the initial margin The maintenance margin is used as a threshold for the traders account with her/his FCM. Whenever the deposit in traders account reaches or falls below the maintenance margin, the trader is required to replenish the account, bringing it back to its initial level (initial margin). The demand (from the FCM) for additional funds to replenish the traders account is known as margin call.

Mechanics of Trading Futures Contracts

Variation Margin


To maintain customer deposits at the level of the initial margin (or at the maintenance margin level), clearinghouses require the member FCMs to make daily adjustments to customer accounts in response to changes in the value of customer positions. To maintain initial margin levels, FCMs require customers to make daily payments equal to the losses on their futures positions, while FCMs in turn pay to customers the gains on their positions. These daily payments are calculated by marking-to-market customer accounts revaluing accounts based on daily settlement prices These daily payments are called variation margins, and must generally be made before the market opens on the next trading day.


For example, if a trader losses (gains) $150 after marking-to-market, the amount will be subtracted (deposited) to the traders account.

Mechanics of Trading Futures Contracts

Margin Call


Margin Call - An Example



Suppose that the initial margin and maintenance margin for Corn futures are $1,000 and $800 per contract. Now suppose that, due to an adverse price change, the traders account incurs a loss of $250 after marking-to-market. The trader will receive a margin call from her/his FCM to deposit additional $250 to her/his account that brings the account to its initial deposit level. However, as long as the deposit level is above the maintenance margin after marking-to-market (e.g., above $800), the trader will not receive the margin call.

Mechanics of Trading Futures Contracts

Exchanges


In order to execute customer orders, FCMs must transmit such orders to an exchange (or contract market) Exchanges perform three functions:
  

Provide and maintain a physical marketplace the floor Police and enforce financial and ethical standards Promote the business interests of members

Exchanges are membership organizations whose members are either individuals or business organizations


Membership is limited to a specified number of seats the seat price rises with the trading volume Members receive the right to trade on the floor of the exchange, without having to pay FCM commissions

Mechanics of Trading Futures Contracts

Full Membership and Seat prices in Major exchanges
Exchanges
Chicago Mercantile Exchange (CME) Chicago Board of Trade (CBOT)
New York Mercantile Exchange (NYMEX)

Full Members
625 1,402 765 -

Seat Prices
$ 400,000 $ 935,000 $1,650,000 $ 205,000

New York Board of Trade (NYBOT)

 

Other than full members, there may be other type of members At CME, there are three other kinds of memberships:
  

International Monetary Market (IMM) members 813 Index and Option Market (IOM) members 1,278 Growth and Emerging Markets (GEM) members 413

Mechanics of Trading Futures Contracts

Floor Brokers


Floor brokers take the responsibility for executing the orders to trade futures contracts that are accepted by FCMs.


 

Self-employed individual members of the exchange who act as agents for FCMs and other exchange members May trade customer accounts as well as their own accounts Dual trading Floor brokers specialize in particular commodities Floor brokers are subject to CFTC regulations

Exchange floors are organized into several different pits (physical locations), where different futures contracts are traded.

Mechanics of Trading Futures Contracts

The Clearinghouse


Every futures exchange has a clearing house associated with it which clears all transactions of that exchange. The clearing house regulates, monitors, and protects the clearing members Exchange members provide daily reports of all futures trades to the clearing house, which matches shorts against longs and provide a daily reconciliation For each member, the clearing house computes daily net gain and loss and transfer funds from the account in loss to the account in gain Collects security deposits (margins or performance bonds) from the members and customers Regulates, monitors, and protects each trader

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example


Nine parties:
   

1 Clearinghouse 2 clearing member FCMs FCM(A) and FCM(B) 1 non-clearing FCM(C) Omnibus Account 5 individual customers (future traders)
  

2 are members of FCM(A) 1 is member of FCM(B) 2 are members of FCM(C)

    

All transactions are assumed to be on the same futures contract The FCMs collect performance bonds on a gross basis The clearinghouse collects performance bond on a net basis The clearinghouse always has a balanced position All contracts are marked to the market daily, and variation in required performance bonds are paid (withdrawn) the next morning

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example


FCM (A) 250 Long and 230 Short Net 20 Long

  

Trader 1 Member of FCM(A) 100 Long Trader 2 Member of FCM(A) 90 Short FCM(C) Member of FCM(A) 150 Long and 140 Short  Trader 3 Member of FCM(C) 150 Long  Trader 4 Member of FCM(C) 140 Short Trader 5 Member of FCM(B) 20 Short

FCM (B) 0 Long and 20 Short Net 20 Short



The Clearinghouse 2 Members: FCM(A) and FCM(B)

 

FCM(A) 20 Long FCM(B) 20 Short

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example


The Clearinghouse A central activity of the clearing house is to collect performance bonds (security deposits or margins) on the future contracts that it clears.
 

Assume that the current value of a futures contract is $10 The initial performance bond required by the clearinghouse for each contract is $1 The initial performance bond required by the FCMs for each contract is also $1 The FCMs collect performance bonds from their customers on a gross basis The clearinghouse collects performance bonds from FCM(A) and FCM(B) on a net basis All contracts are marked to the market daily, and variation performance bonds are paid (or withdrawn) in the next morning.

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example


The Clearinghouse Collects a total of $40 as initial performance bonds  FCM(A) deposits $20 for net 20 long contracts  FCM(B) deposits $20 for net 20 short contracts FCM (A) Collects $480 as initial performance bond $250 from the longs and $230 from the shorts  Trader 1 100 Long deposits $100 for 100 long positions  Trader 2 90 Short deposits $90 for 90 short positions  FCM(C) Collects $290 from Traders 3 and 4 and deposits to FCM(A)  Trader 3 150 Long deposits $150 for 150 long positions  Trader 4 140 Short deposits $140 for 140 short positions FCM (B) Collects $20 as initial performance bond  Trader 5 20 Short deposits $20 for 20 short positions

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example


Suppose that the market value of the futures contract increases by $1 during the same day (changes from $10 to $11). As a result,
 

the longs will have a profit of $1 on each contract, and The shorts will have a loss of $1 on each contract

Thus, FCMs will require a variation performance bond of $1 from each of their customers holding short positions
 

FCM(A) will require additional $230: $90 from Trader 2 and $140 from FCM FCM(B) will require additional $20 from Trader 5

The collected funds will be passed through to customers holding long positions
  

FCM(A) will transfer $100 to the account of Trader 1 holding 100 long positions FCM(A) will transfer $150 to the account of Trader 3 holding 150 longs through FCM FCM(B) will transfer $20 to the clearinghouse, which in turn will transfer the fund to FCM(A)

Thus, the original level of total deposit is maintained.

Mechanics of Trading Futures Contracts

Electronic Trading


CME Globex Electronic Trading Platform

  

Accounts for 70% of total CME volume Open Access: No membership is required for trading All customers who have an account with a FCM or IB (Introducing Broker) can view the book prices and directly execute transactions in CMEs electronically traded products All trades are guaranteed by a clearing member firm and CMEs clearing house One contract, two platforms

Find a complete list of products offered on the CME Globex platform at



www.cme.com/globexproducthours

Mechanics of Trading Futures Contracts

CME Product Codes


Futures contracts are assigned symbols for faster and easier references purposes called the product codes or Ticker.
 

Instead of writing December CME Live Cattle, traders use the code LCZ LC Live Cattle, Z - December
Ticker CME Globex LC FC LH PB C W S LE GF HE GPB GC ZW ZS April May June J K M October November December V X Z Month January February March Sym. F G H Month July August September Sym. N Q U

CME Commodity CME Live Cattle CME Feeder Cattle CME Lean Hogs CME Pork Bellies CME Corn CME Wheat CME Soybeans

Mechanics of Trading Futures Contracts Types of Futures Orders



A futures order refers to a set of instructions given to a FCM (or introducing broker) by a customer requesting that the broker take certain actions in the futures market on behalf of the customer.

Most frequently used orders:  Market Order (MKT) BUY 1 Oct 2009 Live Cattle MKT


An order placed to buy or sell at the market means that the order should be executed at the best possible price immediately following the time it is received by the floor broker on the trading floor. In this case, the customer is less concerned about the price s/he will receive, and more concerned with the speed of execution.

Mechanics of Trading Futures Contracts Types of Futures Orders



Limit Orders

BUY 1 Oct 2009 Live Cattle at 86.50 Sell 1 Oct 2009 Live Cattle at 87.10

A limit order is used when the customer wants to buy (sell) at a specified price below (above) the current market price. The order must be filled either at the price specified on the order or at a better price. The advantage of a limit order is that a trader knows the worst price he will receive if his order is executed. However, the trader is not assured of execution, as with a market order.

Mechanics of Trading Futures Contracts Types of Futures Orders



Market If Touched (MIT) Sell 1 Oct 2009 LC 87.10 MIT



  

When the market reaches the specified limit price, an MIT order becomes a market order for immediate execution. The actual execution may or may not be at the limit price An MIT buy order is placed at a price below the current market price An MIT sell order is placed at a price above the current market price

Market-on-Close (MOC) BUY 1 Oct 2009 LC MOC



A MOC order instructs the floor broker to buy or sell an specified contract for the customer at the market during the official closing period for that contract. The actual execution price need not be the last sale price which occurred, but it must fall within the range of prices traded during the official closing period for that contract on the exchange that day.

Mechanics of Trading Futures Contracts Types of Futures Orders



Stop Order


Buy 1 Oct 2009 Live Cattle 86.50 Stop Sell 1 Oct 2009 Live Cattle 87.10 Stop

In contrast to limit orders, a buy-stop order is placed at a price above the current market price, and a sell-stop order is placed at a price below the current market price Stop orders become market orders when the designated price limit is reached The execution of simple stop orders, however, is not restricted to the designated limit price They may be executed at any price subsequent to the designated stop order price being touched Stop orders are often used to limit losses on open futures positions.

Mechanics of Trading Futures Contracts Types of Futures Orders



Stop-Limit Order BUY 1 Oct 2009 LC 86.50 Stop Limit SELL 1 Oct 2009 LC 87.10 Stop Limit


A stop-limit order is similar to a regular stop order except that its execution is limited to the specified limit price or better A broker may not be able to execute a stop-limit order in a fast market, because of the restrictions placed on the execution price.

Spread Order


Spread BUY 1 Oct 2009 LC SELL 1 Dec 2009 LC, Oct 10 cents premium

A spread order directs the broker to buy and sell simultaneously two different futures contracts, either at the market or at a specified spread premium. It is necessary to specify the order as Spread at the beginning, and it is customary to write BUY side of each spread order first.

Mechanics of Trading Futures Contracts

Liquidating or Settling a Futures Position


Three ways to close a futures position

  

Physical delivery or cash settlement Offset or reversing trade Exchange-for-Physicals (EFP) or ex-pit transaction Physical delivery takes place at certain locations at certain times under rules specified by a futures exchange. Imposes certain costs to traders
   

Physical Delivery


Storage costs Insurance costs Shipping cost, and Brokerage fees

Mechanics of Trading Futures Contracts

Liquidating or Settling a Futures Position


Cash Settlement


 

Instead of making physical delivery, traders make payments at the expiration of the contract to settle any gains or losses.  At the close of trading in a futures contract, the difference between the cash price of the underlying commodity at that time and the buying/selling price is debited/credited to the account of the long/short trader, via the clearing house and FCMs. Available only for futures contracts that specifically designate cash settlement as the settlement procedure  Most financial futures contracts allows completion through cash settlement Cash settlement avoids the problem of temporary shortage of supply It also makes it difficult for traders to manipulate or influence futures prices by causing an artificial shortage of the underlying commodity

Mechanics of Trading Futures Contracts

Liquidating or Settling a Futures Position


Offsetting
 

 

The most common way of liquidating an open futures position The initial buyer (long) liquidates his position by selling (short) an identical futures contract (same commodity and same delivery month) The initial seller (short) liquidates his position by buying (long) an identical futures contract (same commodity and same delivery month) The clearinghouse plays a vital role in facilitating settlement by offset Offsetting entails only the usual brokerage costs. A form of physical delivery that may occur prior to contract maturity An EFP transaction involves the sale of a commodity off the exchange by the holder of the short contracts to the holder of long contracts, if they can identify each other and strike a deal.

Exchange-for-Physicals (EFP)