Lecture 2

Mechanics of Trading

Primary Texts
Edwards and Ma: Chapter 2
CME: Chapters 2 & 3

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

The Order Flows: Floor Trading
Buyer/Seller: Place long/short orders to FCM
FCM: Receives orders, sends to Floor Broker
Floor Broker: Receives orders and takes to the floor
Trading Pits: Orders executed by open Outcry
Floor Broker: Confirms transaction to the FCM
FCM: Confirms transaction to the buyer/seller
Buyer/Seller: Has Long/Short position on the contract

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. FCMs are regulated by Commodity Futures
Trading Commission (CFTC) under the Commodity Exchange Act
(CEA).
Futures traders first have to open an account at a 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

Mechanics of Trading Futures Contracts

Margins or Performance Bonds

Before trading a futures contract, the prospective trader must deposit funds
with an FCM the deposit serves as a performance bond and is referred to
as initial margin.
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 + 3
An initial margin is a deposit to cover losses the trader may incur on a
futures contract as it is marked-to-market.
A maintenance margin is a minimum amount of money that must be
maintained on deposit in a traders account. Maintenance margin is a
lesser amount than the initial margin - typically 75% of the initial margin
A margin call is a demand for an additional deposit to bring a traders
account up to the initial performance bond level.
Traders post the funds for performance bond with their FCMs

Mechanics of Trading Futures Contracts

Initial Margin

Initial Margin- An Example

Each Gold futures contract is for 100 ounces of gold
Assume that the current market price of gold is $400 an ounce
The average daily absolute price change over the last 4 weeks is $10 an
ounce
= $10 100 = $1,000
The standard deviation of the last 4 weeks daily absolute price change is
$3 an ounce

= $3 100 = $300
Thus, the initial margin for 1 gold futures contract will be
+ 3 = $1,000 + 3 $300 = $1,900
For most futures contracts, the initial margin may be 5 percent or less of the
contracts face value.

Mechanics of Trading Futures Contracts

Maintenance Margin

Maintenance Margin- An Example

In general, maintenance margin is a lesser amount than the initial margin

- typically 75% of the initial margin
For example, the initial margin and maintenance margin for CBT Corn
futures are $1,000 and $800 per contract.
The maintenance margin is used as a threshold for the traders account
with her/his FCM.
Whenever the deposit in traders account reaches or falls below the
maintenance margin, the trader is required to replenish the account,
bringing it back to its initial level (initial margin).
The demand (from the FCM) for additional funds to replenish the traders
account is known as margin call.

Mechanics of Trading Futures Contracts

Variation Margin

To maintain customer deposits at the level of the initial margin (or at the
maintenance margin level), clearinghouses require the member FCMs to
make daily adjustments to customer accounts in response to changes in the
value of customer positions.

To maintain initial margin levels, FCMs require customers to make daily

payments equal to the losses on their futures positions, while FCMs in turn
pay to customers the gains on their positions.

These daily payments are calculated by marking-to-market customer

accounts revaluing accounts based on daily settlement prices

These daily payments are called variation margins, and must generally be
made before the market opens on the next trading day.

For example, if a trader losses (gains) $150 after marking-to-market,

the amount will be subtracted (deposited) to the traders account.

Mechanics of Trading Futures Contracts

Margin Call

Margin Call - An Example

Suppose that the initial margin and maintenance margin for CBT Corn
futures are $1,000 and $800 per contract.
Now suppose that, due to an adverse price change, the traders account
incurs a loss of $250 after marking-to-market.
The trader will receive a margin call from her/his FCM to deposit
additional $250 to her/his account that brings the account to its initial
deposit level.
However, as long as the deposit level is above the maintenance margin
after marking-to-market (e.g., above $800), the trader will not receive the
margin call.

Mechanics of Trading Futures Contracts

Exchanges

In order to execute customer orders, FCMs must transmit such

orders to an exchange (or contract market)
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

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

Mechanics of Trading Futures Contracts

Full Membership and Seat prices in Major exchanges
Exchanges
Chicago Mercantile Exchange (CME)
Chicago Board of Trade (CBOT)
New York Mercantile Exchange (NYMEX)

New York Board of Trade (NYBOT)

Full Members

Seat Prices

625

$ 400,000

1,402

$ 935,000

765

$1,650,000

$ 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

Exchange floors are organized into several different pits

(physical locations), where different futures contracts are
traded.

Display Board
Open Range

[LC]
Aug

Oct

7267

7230

7275

High

7282

7232

Low

7210

7170

18,629

9,443

7230

90

32B

92

32A

95

30

97

35

7200

32A

7197

7230

7195

Net Change

- 35

- 17

Prev. Settle

7265

7212

Year High

7490

7505

Year Low

6580

6250

Est. Vol.

Last

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 trader

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example

Nine parties:

1 Clearinghouse
2 clearing member FCMs FCM(A) and FCM(B)
1 non-clearing FCM(C) Omnibus Account
5 individual customers (future traders)

2 are members of FCM(A)

1 is member of FCM(B)
2 are members of FCM(C)

All transactions are assumed to be on the same futures contract

The FCMs collect performance bonds on a gross basis
The clearinghouse collects performance bond on a net basis
The clearinghouse always has a balanced position
All contracts are marked to the market daily, and variation in required
performance bonds are paid (withdrawn) the next morning

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example

FCM (A) 250 Long and 230 Short Net 20 Long

FCM (B) 0 Long and 20 Short Net 20 Short

Trader 1 Member of FCM(A) 100 Long

Trader 2 Member of FCM(A) 90 Short
FCM(C) Member of FCM(A) 150 Long and 140 Short
Trader 3 Member of FCM(C) 150 Long
Trader 4 Member of FCM(C) 140 Short
Trader 5 Member of FCM(B) 20 Short

The Clearinghouse 2 Members: FCM(A) and FCM(B)

FCM(A) 20 Long
FCM(B) 20 Short

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example

The Clearinghouse A central activity of the clearing house is to

collect performance bonds (security deposits or margins) on the future
contracts that it clears.

Assume that the current value of a futures contract is $10

The initial performance bond required by the clearinghouse for each
contract is $1
The initial performance bond required by the FCMs for each contract is
also $1
The FCMs collect performance bonds from their customers on a gross
basis
The clearinghouse collects performance bonds from FCM(A) and
FCM(B) on a net basis
All contracts are marked to the market daily, and variation performance
bonds are paid (or withdrawn) in the next morning.

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example

The Clearinghouse Collects a total of $40 as initial performance bonds

FCM(A) deposits $20 for net 20 long contracts
FCM(B) deposits $20 for net 20 short contracts
FCM (A) Collects $480 as initial performance bond $250 from the longs
and $230 from the shorts
Trader 1 100 Long deposits $100 for 100 long positions
Trader 2 90 Short deposits $90 for 90 short positions
FCM(C) Collects $290 from Traders 3 and 4 and deposits to FCM(A)
Trader 3 150 Long deposits $150 for 150 long positions
Trader 4 140 Short deposits $140 for 140 short positions
FCM (B) Collects $20 as initial performance bond
Trader 5 20 Short deposits $20 for 20 short positions

Mechanics of Trading Futures Contracts

The Clearinghouse: An Example

Suppose that the market value of the futures contract increases by $1 during the
same day (changes from $10 to $11). As a result,

Thus, FCMs will require a variation performance bond of $1 from each of their
customers holding short positions

FCM(A) will require additional $230: $90 from Trader 2 and $140 from FCM
FCM(B) will require additional $20 from Trader 5

The collected funds will be passed through to customers holding long positions

the longs will have a profit of $1 on each contract, and

The shorts will have a loss of $1 on each contract

FCM(A) will transfer $100 to the account of Trader 1 holding 100 long positions
FCM(A) will transfer $150 to the account of Trader 3 holding 150 longs through FCM
FCM(B) will transfer $20 to the clearinghouse, which in turn will transfer the fund to
FCM(A)

Thus, the original level of total deposit is maintained.

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
CMEs electronically traded products
All trades are guaranteed by a clearing member firm and CMEs
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

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

July

CME Feeder Cattle

FC

GF

February

August

CME Lean Hogs

LH

HE

March

September

CME Pork Bellies

PB

GPB

CME Corn

GC

April

October

CME Wheat

ZW

May

November

CME Soybeans

ZS

June

December

Mechanics of Trading Futures Contracts

Types of Futures Orders

A futures order refers to a set of instructions given to a FCM (or

introducing broker) 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 SELL 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.

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.