Wednesday, November 23, 2011

The Futures Trade Process

CFA Level 1 - Derivatives

Most U.S. futures exchanges offer two ways to enact a trade - the traditional floor-trading process (also called "open outcry") and electronic trading. The basic steps are essentially the same in either format: Customers submit orders that are executed - filled - by other traders who take equal but opposite positions, selling at prices at which other customers buy or buying at prices at which other customers sell. The differences are described below. 
Open outcry trading is the more traditional form of trading in the U.S. Brokers take orders (either bids to buy or offers to sell) by telephone or computer from traders (their customers). Those orders are then communicated orally to brokers in a trading pit. The pits are octagonal, multi-tiered areas on the floor of the exchange where traders conduct business. The traders wear different colored jackets and badges that indicate who they work for and what type of traders they are (FCM or local). It's called "open outcry" because traders shout and use various hand signals to relay information and the price at which they are willing to trade. Trades are executed (matches are made) when the traders agree on a price and the number of contracts either through verbal communication or simply some sort of motion such as a nod. The traders then turn their trade tickets over to their clerks who enter the transaction into the system. Customers are then notified of their trades and pertinent information about each trade is sent to the clearing house and brokerages. 

In electronic trading, customers (who have been pre-approved by a brokerage for electronic trading) send buy or sell orders directly from their computers to an electronic marketplace offered by the relevant exchange. There are no brokers involved in the process. Traders see the various bids and offers on their computers. The trade is executed by the traders lifting bids or hitting offers on their computer screens. The trading pit is, in essence, the trading screen and the electronic market participants replace the brokers standing in the pit. Electronic trading offers much greater insight into pricing because the top five current bids and offers are posted on the trading screen for all market participants to see. Computers handle all trading activity - the software identifies matches of bids and offers and generally fills orders according to a first-in, first-out (FIFO) process. Dissemination of information is also faster on electronic trades. Trades made on CME® Globex®, for example, happen in milliseconds and are instantaneously broadcast to the public. In open outcry trading, however, it can take from a few seconds to minutes to execute a trade. 

Price Limit
This is the amount a futures contract's price can move in one day. Price limits are usually set in absolute dollar amounts - the limit could be $5, for example. This would mean that the price of the contract could not increase or decrease by more than $5 in a single day.

Limit Move
A limit move occurs when a transaction takes place that would exceed the price limit. This freezes the price at the price limit.

Limit Up
The maximum amount by which the price of a futures contract may advance in one trading day. Some markets close trading of these contracts when the limit up is reached, others allow trading to resume if the price moves away from the day's limit. If there is a major event affecting the market's sentiment toward a particular commodity, it may take several trading days before the contract price fully reflects this change. On each trading day, the trading limit will be reached before the market's equilibrium contract price is met. 

Limit Down
This is when the price decreases and is stuck at the lower price limit. The maximum amount by which the price of a commodity futures contract may decline in one trading day. Some markets close trading of contracts when the limit down is reached, others allow trading to resume if the price moves away from the day's limit. If there is a major event affecting the market's sentiment toward a particular commodity, it may take several trading days before the contract price fully reflects this change. On each trading day, the trading limit will be reached before the market's equilibrium contract price is met. 

Locked Limit
Occurs when the trading price of a futures contract arrives at the exchange's predetermined limit price. At the lock limit, trades above or below the lock price are not executed. For example, if a futures contract has a lock limit of $5, as soon as the contract trades at $5 the contract would no longer be permitted to trade above this price if the market is on an uptrend, and the contract would no longer be permitted to trade below this price if the market is on a downtrend. The main reason for these limits is to prevent investors from substantial losses that can occur as a result of the volatility found in futures markets.

The Marking to Market Process
  • At the initiation of the trade, a price is set and money is deposited in the account. 
  • At the end of the day, a settlement price is determined by the clearing house. The account is then adjusted accordingly, either in a positive or negative manner, with funds either being drawn from or added to the account based on the difference in the initial price and the settlement price. 
  • The next day, the settlement price is used as the base price. 
  • As the market prices change through the next day, a new settlement price will be determined at the end of the day. Again, the account will be adjusted by the difference in the new settlement price and the previous night's price in the appropriate manner.

If the account falls below the maintenance margin, the investor will be required to add additional funds into the account to keep the position open or allow it to be closed out. If the position is closed out the investor is still responsible for paying for his losses. This process continues until the position is closed out.  

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