Mechanics of Trading Futures Contracts

1. 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

2. 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).

3. 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

4. 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

5. 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

6. 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

7. Mechanics of Trading Futures ContractsThe Order Flows: Floor Trading

9. 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 CME’s electronically traded products • All trades are guaranteed by a clearing member firm and CME’s clearing house • One contract, two platforms • Find a complete list of products offered on the CME Globex platform at • www.cme.com/globexproducthours

10. 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 + 3σ • 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 trader’s account. • A performance bond call is a demand for an additional deposit to bring a trader’s account up to the initial performance bond level. • Traders post the funds for performance bond with their FCMs

11. 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

12. 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

13. 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.

14. 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

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.