Mechanics of Trading Futures Contracts

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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 ContractsFutures
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.
• Futures traders first have to open an account at
  an 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
• FCMs are regulated by Commodity Futures Trading
  Commission (CFTC) under the Commodity Exchange
  Act (CEA).

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Mechanics of Trading Futures ContractsExchanges

• In order to execute customer orders, FCMs must
  transmit such orders to an exchange (or contract
  market)
• 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
• 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

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Mechanics of Trading Futures ContractsFull
Membership and Seat prices in Major exchanges

• 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 ContractsFloor
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

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Mechanics of Trading Futures ContractsThe
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

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Mechanics of Trading Futures ContractsThe Order
Flows Floor Trading
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Mechanics of Trading Futures ContractsElectronic
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 ContractsInitial
Margin or Performance Bond

• Futures contracts require a performance bond
  (previously called margin) in an amount
  determined by the exchange itself
• The requirements are not set as a percentage of
  contract value. Instead they are a function of
  the price volatility of the commodity. A common
  method is to set IPF equal to µ 3s
• An initial performance bond is a deposit to cover
  losses the trader may incur on a futures contract
  as it is marked-to-market.
• A maintenance performance bond is a minimum
  amount of money (a lesser amount than the
  initial performance bond) that must be maintained
  on deposit in a traders account.
• A performance bond 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 ContractsLiquidating
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 ContractsLiquidating
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

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Mechanics of Trading Futures ContractsLiquidating
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.
• 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.

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Mechanics of Trading Futures ContractsCME
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

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Mechanics of Trading Futures ContractsTypes of
Futures Orders

• A futures order refers to a set of instructions
  given to a broker (FCM) 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.

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Mechanics of Trading Futures ContractsTypes 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.

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Mechanics of Trading Futures ContractsTypes 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.

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Mechanics of Trading Futures ContractsTypes 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.

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Mechanics of Trading Futures ContractsTypes 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 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.