C06 FUTURES MARKET

BASICS OF FUTURES MARKET #

A contract for assets bought at an agreed price but delivered & paid at a later date.

LONG POSITION: The purchaser of a futures contract is said to have gone long or taken a long position.

SHORT POSITION: The seller of a futures contract is said to have gone short or taken a short position

CHARACTERSTICS OF FUTURES CONTRACT #

1. Quality of the underlying asset: Specifies the quality of the goods that will be acceptable.
2. Contract size: Specifies the quantity of the asset that must be delivered.
3. Delivery location: place where the delivery will take place.
4. Delivery time: Month in which delivery will take place.
5. Price quotations & tick size: How the price of a contract will be quoted as well as the minimum price fluctuation for the contract, known as tick size.
6. Daily price limits: Max price movement for a contract during a day.
7. Position limits: Max number of contracts that a speculator may hold.

CONVERGENCE FOR FUTURES & SPOT PRICES #

The spot price is the price for immediate delivery.

The futures price is the price today for delivery  at some future point in time.

At expiration, the spot price must equal the futures price.

OPERATION OF MARGINS #

1. Margin: Cash/high liquid collateral placed in an a/c to meet trading losses.
2. Mark-to-market: Determination of asset value according to market prices at the end of each day.
3. Initial margin: Amount required to open a futures position.
4. Maintenance margin: Minimum margin account balance required to retain the futures position.
5. Variation margin: Variation margin is the daily payment of profits & losses.

MARGIN REQUIREMENTS #

Margin is cash or highly liquid collateral placed in an account to ensure that any trading losses will be met. MTM is daily procedure of adjusting the margin account balance for daily moments in the future price. Look for margin requirements illustrations in main book.

CLEARING HOUSES IN FUTURES & OTC MARKET #

Clearing house guarantees that traders in the futures market will honour their obligations by acting as the counter party to the traders. It acts as a buyer to every seller & seller to every buyer.

OTC Market is subject to great deal of credit risk and hence requires collateralization. Some OTC transaction uses clearing houses. Arguments for the use of clearing houses in OTC market includes:

1. Automatic posting of collateral.
2. Reduction of financial system credit risk.
3. Increased transparency of OTC trade.

NORMAL AND INVERTED FUTURES MARKET #

Settlement price is the average of the price of the trade during the last period of trading.

• Increasing settlement prices over time indicates normal market.
• Decreasing settlement prices over time indicates an inverted market.

DELIVERY PROCESS #

1. Actual delivery: Actual delivery of goods is accepted by the long by paying the contract price to the short.
2. Cash settlement: Futures contract is marked to market based on the settlement price on the last day of trading.
3. Reverse or offsetting the trade by entering the exact opposite option.
4. Exchange for physicals: Here the futures contract on a commodity is exchanged for the actual physical good.

TYPES OF ORDERS #

1. Market orders: orders to buy or sell at the best price available.
2. Discretionary orders: market orders where the broker has the option to delay transaction in search of a better price.
3. Limit orders: orders to buy below the current price (limit buy order) or sell above the current price (limit sell order).
4. Stop loss order: orders used to prevent losses or to protect profit.
5. Stop limit order: combination of stop & limit orders.
6. MIT order: orders that would become market orders once a specific price is reached in the market place.
7. GTC/Open order: orders that remain open until they are either transact or cancelled.
8. Fill or kill: Should be executed immediately or the trade will not take place.