Getting In and Out of Futures Contracts

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Getting In and Out of Futures Contracts

• Tobin Davilla

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Futures Contracts

• Definition An agreement between a buyer and a
  seller to receive or deliver a product on a
  future date at a price they have negotiated today.

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History

• 19th Century
• Minimal storage facilities to house grain
• Large surplus of grain at harvest time
• Price of grain decreased, farmers forced to sell
• Innovative farmers pre-arranged agreements to
  sell crop at agreed upon price
• Benefit
• Buyers get grain throughout the year
• Sellers minimize spoilage and price volatility
  risk is transferred.

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Types of Future Contracts

• Prior to 1972, only agricultural commodities
  (grain and livestock), imported foodstuffs
  (coffee, cocoa, and sugar) or industrial
  commodities were traded known as Commodity
  futures
• Now there is also Financial Futures which
  include stock index futures, interest rate
  futures, and currency futures.

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Hedgers and Speculators

• Hedgers enter into a futures contracts to
  insure against any future price movements.
• Limits the potential for loss, it also limits the
  potential for gain. (Silversmith)
• Speculators enter into a futures contract in
  the hopes of a price movement in their favor
• Speculating not one of the economic purposes of
  futures markets however, they make futures
  markets better by adding liquidity.

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Price Fluctuation

• Rising price Loss by the seller is offset by
  the increase in inventory value. Gain by the
  buyer is offset by the higher prices paid to
  obtain underlying
• Falling price Gain by the seller is offset by
  the decrease in inventory value. Loss by the
  buyer is offset by the opportunity to purchase
  underlying at lower price

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How to obtain a futures contract

• Futures Commission Merchant (FCM)
• Authorized future broker
• Intermediary between you and floor broker
• Decreased risk due to expertise and vigilance
• Examples Smith Barney, Goldman Sachs,
  Commodity Brokerage Firms
• Locals
• Purchase their own seat on the exchange
• Buy or sell for their own account

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How to obtain a futures contract

• Place an order to buy or sell
• Through FCM to floor broker
• Floor brokers act on behalf of brokerage house,
  investment banks or commercial dealers
• Moving to electronic platforms, most occur in
  ring or pit
• Floor brokers vocally announce bid and use hand
  signs called open outcry.

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How to obtain a futures contract

• Once a contract is agreed upon
• Floor brokers exchange information
• Number of contracts
• Underlying (what is traded, wheat, grain, etc.)
• Settlement date (usually in March, June, Sept,
  Dec.)
• Price
• Name of clearing firm of the member on the
  opposite side of trade
• Initials of trader

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Example Getting into the contract

• Bob (B) wants to buy 500 bundles of wheat at 100
  bundle, to be delivered in December (long)
• Tom (S) wants to sell 500 bundles of wheat at
  100 bundle, to be delivered in December. (short)
• Through their FCM, they work with a floor broker
  to put these two orders together.

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Clearinghouse

• End of trading day, Floor brokers send order to
  clearinghouse.
• Confirm that each order has equal and matching
  order to buy or sell
• Once cleared, Clearinghouse interposes itself as
  the buyer for the seller and the seller for the
  buyer, used to guarantee each contract
• Both parties free to liquidate without the other
  party and without worrying that they will
  default.

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Clearinghouse

• 3 Functions
• Liquidity maintained because all positions can be
  offset by opposite positions.
• Can pick other party to participate when someone
  chooses to deliver underlying.
• Not allow investors to default due to margin
  payments.

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Initial Margin

• Investor deposits minimum amount per contract as
  specified by exchange
• Usually 5-10 of contract value, can depend on
  volatility and other risks.
• To ensure that traders can meet financial
  obligations.
• Small initial investment means high-leverage
  investment
• With high leverage comes huge gains or losses.

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Example Initial Margin

• Exchange states that the initial margin will be
  7 of contract value
• Initial Investment for both parties 3,500

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Maintenance Margin

• Minimum amount that must be maintained in
  customers account as set by futures exchange
• When account falls below this amount the customer
  must put additional money into account to pull
  balance up to initial margin
• Margin call made daily, have 24 hours to meet
  obligation
• If you lose money and cannot meet obligations,
  exchange closes the futures position out.
• If you gain money you may take money out up to
  the level of the initial investment.

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Example Maintenance Margin

• Exchange sets Maintenance Margin at 57 of
  initial margin or above 4
• Investor must maintain an account balance greater
  than 2,000

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Settlement Price

• Value the settlement committee gives to represent
  the final trading price for the day.
• Not closing price, if a lot of activity at the
  end of the day, the committee will take the
  average trading price.
• Uses settlement price to determine if there is a
  loss or gain in each investors account in a
  process called marked to market.

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Example Settlement Price

• Day one Price of Wheat drops to 98/bundle
• Bob (B) loses 1,000, account balance 2,500
• Tom (S) gains 1,000, account balance 4,500
• Day two Price of Wheat drops to 95/bundle
• Bob (B) loses 1,500, account balance 1,000
• Tom (S) gains 1,500, account balance 6,000

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Price Limits

• Exchange sets daily limits what the max and min
  price may be traded at the next day.
• If limit is reached, trading continues only
  within the limits.
• Provides stability in the market if new
  information becomes available that would cause
  severe fluctuations
• Price limits control what a person can lose in
  one day

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Liquidating

• 2 ways to liquidate
• Offsetting position most occurring investor
  takes an offsetting position in the same market
  before settlement date.
• Delivery least occurring investor waits till
  settlement date and recognizes delivery of
  underlying.
• Clearinghouse would pick the other party to
  deliver.

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Example - Liquidating

• Tom (S) wants out
• Must buy an offsetting position
• Buys 500 bundles of Wheat to be delivered in
  December for 95/bundle, 47,500
• Could have sold to market for 47,500 instead he
  sold to Bob for 50,000

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Example - Liquidating

• Bob (B) wants out
• Must sell an offsetting position
• Sells 500 bundles of Wheat to be delivered in
  December for 95/bundle, 47,500
• Could have bought at the market price for 47,500
  instead he bought from Tom for 50,000

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Summary Futures Contracts

• Used primarily to hedge risk
• For the risk inclined, futures markets can be
  seen as great opportunity to exploit the risk and
  leverage to reap potential gains in market

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Questions?
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Yes Aaron?
Where are the exchanges located at?
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Yes Justin?
What are some tips if we wanted to invest in
futures?