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
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.
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).
Mechanics of Trading Futures Contracts
Exchanges
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
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 (NYME) 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
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 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
Mechanics of Trading Futures Contracts
The 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
Mechanics of Trading Futures Contracts
The Order Flows: Floor Trading
Display Board [LC]
Aug Oct
Open Range 7267 7230
7275
High 7282 7232
Low 7210 7170
Est. Vol. 18,629 9,443
7 7230 90
6 32B 92
5 32A 95
4 30 97
3 35 7200
2 32A 7197
Last 32 7195
Net Change - 35 - 17
Prev. Settle 7265 7212
Year High 7490 7505
Year Low 6580 6250
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
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
Mechanics of Trading Futures Contracts
Initial 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
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
Mechanics of Trading Futures Contracts
Liquidating 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
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) 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.
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 Month Sym. Month Sym.
CME Live Cattle LC LE January F July N
CME Feeder Cattle FC GF February G August Q
CME Lean Hogs LH HE
March H September U
CME Pork Bellies PB GPB
April J October V
CME Corn C GC
CME Wheat W ZW May K November X
CME Soybeans S ZS June M December Z
Mechanics of Trading Futures Contracts
Types 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.
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 he
will receive if his order is executed.
However, the trader is not assured of execution, as with a market order.
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 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.
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-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.
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 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.