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How The Futures Market Works


In a futures contract two parties enter in a legally binding, standardized agreement to sell or buy a given commodity or financial instrument of given quality and quantity at a future date. The price is the only variable which is fixed at the time when the contract is initiated. Some contracts where the underlying asset is a commodity like wheat, corn, cattle require physical delivery whereas others like S&P 500 and Eurodollars are settled in cash. However most of the trades actually do not require final delivery. The contract is offset by an opposite trade before the time of delivery. The registered exchange acts like a third party for both the parties. The buyer is actually purchasing the contract from the exchange and the seller is selling the contract to the exchange. This ensures that both the parties meet their commitment and eliminates the possibility of dishonoring the contract by either party. The exchange in return requires margin payment for every contract by both parties.

Offsetting of a trade takes place before the expiry of the contract. Most of the traders are looking for profit through price fluctuations and do not intend to take delivery of final commodities underlying the contract (They would not be interested in getting delivery of 10,000 bushels of wheat or 60,000 pounds of hog carcasses). When a futures contract is made it is said to have an open position. This can be OFFSET by buying or selling the opposite side of the contract before the expiry date. A simple example is: Suppose trader A enters into a future contract to BUY 5,000 bushels of wheat from trader B six months from now at a given price. Trader A enters into another contract with Trader C to SELL 5,000 bushels of wheat in three months, exactly three months before the expiry of the previous contract with B. In this case it is said that he has offset or closed his position with Trader B. It is possible that this process is repeated several times between various other traders before the actual delivery of the product is required.

The final buyer can be a big manufacturing firm requiring wheat for making cookies for which it is seeking a predetermined fixed price in a futures contract. The seller of the contract can be a farmer in Ohio who is looking to protect against price fluctuations and wants to ensure a given price for his product. Hence between the farmer and the manufacturer the traders act as intermediary who are not looking for final delivery of the product but are looking to take benefit of price fluctuations. Through this manner the risk and the returns get shared between different parties leading to more stable prices and smoother operations. The delivery of the physical commodity is useful for another major reason. As the date of the expiry draws near, the price of the contract converges to the actual cash price paid for the underlying instrument.

In all this operation the clearing house plays a major role.

To function efficiently and viably it needs that all the contracts are honored. It ensures this by the use of margin payments. When a trader enters a contract he does not have to pay the entire amount of the contract. If a contract is for 5,000 bushels of wheat and the price is $8.20 per bushel, the total trade would be $41,000, however the margin payment required by the trader would be much less. Let’s say that the trader is required to deposit $1,500 as initial margin. There is a maintenance margin of $1,100 for this contract. This means that if the trader suffers a loss of more than $400 there would be a margin call for this contract and he will have to bring his deposit back to $1,500 or the initial margin. Example: For 5,000 bushels of wheat contract if the price of wheat drops by 10 cents to $8.10 there would be a notional loss of $500 for the entire contract. After deducting the amount from the trader’s account he is left with only $1,000 which is less than the maintenance margin of $1,100. Hence a margin call is triggered for the trader and he needs to increase the deposit back to $1,500 or he must liquidate his position. This margin call should generally be met within 24 hours of getting it or his position will be liquidated and it helps to ensure that all the individual clients are able to meet their commitment and also ensures the financial integrity of the entire system.

Besides this there are a couple of other functions within the clearing house. The price moves by a minimum amount up or down. This is called as TICK. Ex: Gold has a tick of 10 cents per ounce (Hence movement will be allowed only in the multiples of 10 cents, a single tick movement for a contract for 500 ounces of gold will cause a change in price of $50). For every commodity or instrument there is a different tick defined by the clearing house. There is also a barrier on maximum daily price movement. Ex: If a contract for 100,000 pound live cattle is made. The exchange sets a daily limit of 3 cents per pound and if the current price is 96 cents per pound, the maximum price at the end of the day can be 99 cents and the lowest price can be 93 cents per pound.

The price discovery was initially done through an open outcry method where traders would come to a price by open auction method at the exchange floor. This system has become much more transparent through the use of electronic trading platform. Traders give orders to their brokers for particular contracts or they can do it themselves through the use of broker supplied electronic platforms. The price of any contract depends on supply and demand. If the prices are high there will be more sellers of the contract which would bring the prices down and if the prices are low there will be more buyers which would push the prices up. Finally the prices reach equilibrium depending on the number of buyers and sellers.

The supply and demand curves will change continuously depending on new information which comes in. For example if news of bad weather conditions in the corn producing areas becomes available there will be a shift to higher prices for buying the corn contracts in anticipation that future prices will be much higher due to shortage and hence the traders can reap benefits of lower than market prices for the contracts. Similarly if news of new European Central Bank policies are available this would cause a shift in the Eurodollar futures trading.

NEXT: Difference between a Forward and Futures Contract

Introduction to the Futures Market Tutorial

1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market

 

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