Mechanics of Trading in Futures -3

8/3/2019 Mechanics of Trading in Futures -3

1/28

Mechanics of Futures Trading


2/28

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


3/28


The Order Flows: Floor Trading


4/28


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 FuturesTrading 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


5/28


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 alesser 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


6/28


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 anounce

= $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.


7/28


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.


8/28


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-marketcustomer

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.


9/28


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 aftermarking-to-market.

The trader will receive a margin callfrom 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

aftermarking-to-market(e.g., above $800), the trader will not receive the

margin call.


10/28


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


11/28


Full Membership and Seat prices in Major exchanges

Exchanges Full Members Seat Prices

Chicago Mercantile Exchange (CME) 625 $ 400,000

Chicago Board of Trade (CBOT) 1,402 $ 935,000

New York Mercantile Exchange (NYMEX) 765 $1,650,000

New York Board of Trade (NYBOT) - $ 205,000

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


12/28


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 agentsfor 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.


13/28


The Clearinghouse

Every futures exchange has a clearing house associated with itwhich clears all transactions of that exchange. The clearinghouse regulates, monitors, and protects the clearing members

Exchange members provide daily reports of all futures trades tothe 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 theaccount in gain

Collects security deposits (margins or performance bonds) fromthe members and customers

Regulates, monitors, and protects each trader


14/28


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 requiredperformance bonds are paid (withdrawn) the next morning


15/28



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

Trader 1 Member of FCM(A) 100 Long

Trader 2 Member of FCM(A) 90S

hort 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

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

Trader 5 Member of FCM(B) 20 Short

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

FCM(A) 20 Long

FCM(B) 20S

hort


16/28



The Clearinghouse A central activity of the clearing house is tocollect performance bonds (security deposits or margins) on the futurecontracts 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 isalso $1

The FCMs collect performance bonds from their customers on a grossbasis

The clearinghouse collects performance bonds from FCM(A) andFCM(B) on a net basis

All contracts are marked to the market daily, and variation performancebonds are paid (or withdrawn) in the next morning.


17/28



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 longsand $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


FCM (B)Collects $20 as initial performance bond



18/28



Suppose that the market value of the futures contract increases by $1 during thesame 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 theircustomers 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 toFCM(A)

Thus, the original level of total deposit is maintained.


19/28


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


20/28


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

CME Commodity Ticker CME Globex

CME Live Cattle LC LE

CME Feeder Cattle FC GF

CME Lean Hogs LH HE

CME Pork Bellies PB GPB

CME Corn C GC

CME Wheat W ZW

CME Soybeans S ZS

Month Sym. Month Sym.

January F July N

February G August QMarch H September U

April J October V

May K November X

June M December Z


21/28


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 thecustomer.

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.


22/28



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 hewill receive if his order is executed.

However, the trader is not assured of execution, as with a market order.


23/28



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 periodfor 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.


24/28



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-stoporderis placed at a price above thecurrent market price, and a sell-stoporderis 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 thedesignated 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.


25/28



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 itsexecution 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.


26/28


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

Physical delivery takes place at certain locations at certain times under

rules specified by a futures exchange.

Imposes certain costs to traders Storage costs

Insurance costs

Shipping cost, and

Brokerage fees


27/28



Cash Settlement

Instead of making physical delivery, traders make payments at theexpiration of the contract to settle any gains or losses.

At the close of trading in a futures contract, the difference betweenthe cash price of the underlying commodity at that time and thebuying/selling price is debited/credited to the account of thelong/short trader, via the clearing house and FCMs.

Available only for futures contracts that specifically designate cashsettlement as the settlement procedure

Most financial futures contracts allows completion through cashsettlement

Cash settlement avoids the problem of temporary shortage of supply

It also makes it difficult for traders to manipulate or influence futuresprices by causing an artificial shortage of the underlying commodity


28/28



Offsetting

The most common way of liquidating an open futures position

The initial buyer (long) liquidates his position by selling (short) anidentical 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. Exchange-for-Physicals (EFP)

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.

Mechanics of Trading in Futures -3

Documents

Transcript of Mechanics of Trading in Futures -3