Mechanics of Trading in Futures -3
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Transcript of Mechanics of Trading in Futures -3
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Mechanics of Futures Trading
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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
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Mechanics of Trading Futures Contracts
The Order Flows: Floor Trading
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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 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
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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 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
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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 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.
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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.
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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-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.
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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 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.
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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
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Mechanics of Trading Futures Contracts
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
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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 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.
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Mechanics of Trading Futures Contracts
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
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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 requiredperformance bonds are paid (withdrawn) the next morning
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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) 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
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Mechanics of Trading Futures Contracts
The Clearinghouse: An Example
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.
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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 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
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
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Mechanics of Trading Futures Contracts
The Clearinghouse: An Example
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.
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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
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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
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
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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 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.
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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 hewill receive if his order is executed.
However, the trader is not assured of execution, as with a market order.
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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 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.
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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-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.
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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 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.
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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
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
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Mechanics of Trading Futures Contracts
Liquidating or Settling a Futures Position
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
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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) 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.