You are on page 1of 5


Derivatives - Futures vs. Forwards

Futures differ from forwards in several instances: 1. A forward contract is a private transaction - a futures contract is not. Futures contracts are reported to the future's exchange, the clearing house and at least one regulatory agency. The price is recorded and available from pricing services. 2. A future takes place on an organized exchange where the all of the contract's terms and conditions, except price, are formalized. Forwards are customized to meet the user's special needs. The future's standardization helps to create liquidity in the marketplace enabling participants to close out positions before expiration. 3. Forwards have credit risk, but futures do not because a clearing house guarantees against default risk by taking both sides of the trade and marking to market their positions every night. Mark to market is the process of converting daily gains and losses into actual cash gains and losses each night. As one party loses on the trade the other party gains, and the clearing house moves the payments for the counterparty through this process. 4. Forwards are basically unregulated, while future contract are regulated at the federal government level. The regulation is there to ensure that no manipulation occurs, that trades are reported in a timely manner and that the professionals in the market are qualified and honest.

Characteristics of Futures Contracts In a futures contract there are two parties: 1. The long position, or buyer, agrees to purchase the underlying at a later date or at the expiration date at a price that is agreed to at the beginning of the transaction. Buyers benefit from price increases. 2. The short position, or seller, agrees to sell the underlying at a later date or at the expiration date at a price that is agreed to at the beginning of the transaction. Sellers benefit from price decreases.

Prices change daily in the marketplace and are marked to market on a daily basis. At expiration, the buyer takes delivery of the underlying from the seller or the parties can agree to make a cash settlement.

Futures Markets Margin

In the stock market, a margin is a loan that is made to the investor. It helps the investor to reduce the amount of her own cash that she uses to purchase securities. This creates leverage

for the investor, causing gains and losses to be amplified. The loan must be paid back with interest.

Margin % = Market Value of the stock - Market value of the debt divided by the market value of the stock An initial margin loan in the U.S can be as much as 50%. The market value of the securities minus the amount borrowed can often be less than 50%, but the investor must keep a balance of 25-30% of the total market value of the securities in the margin account as a maintenance margin.

A margin in the futures market is the amount of cash an investor must put up to open an account to start trading. This cash amount is the initial margin requirement and it is not a loan. It acts as a down payment on the underlying asset and helps ensure that both parties fulfill their obligations. Both buyers and sellers must put up payments. Initial Margin This is the initial amount of cash that must be deposited in the account to start trading contracts. It acts as a down payment for the delivery of the contract and ensures that the parties honor their obligations. Maintenance Margin This is the balance a trader must maintain in his or her account as the balance changes due to price fluctuations. It is some fraction - perhaps 75% - of initial margin for a position. If the balance in the trader's account drops below this margin, the trader is required to deposit enough funds or securities to bring the account back up to the initial margin requirement. Such a demand is referred to as a margin call. The trader can close his position in this case but he is still responsible for the loss incurred. However, if he closes his position, he is no longer at risk of the position losing additional funds. Futures (which are exchange-traded) and forwards (which are traded OTC) treat margin accounts differently. When a trader posts collateral to secure an OTC derivative obligation such as a forward, the trader legally still owns the collateral. With futures contracts, money transferred from a margin account to an exchange as a margin payment legally changes hands. A deposit in a margin account at a broker is collateral. It legally still belongs to the client, but the broker can take possession of it any time to satisfy obligations arising from the client's futures positions Variation Margin This is the amount of cash or collateral that brings the account up to the initial margin amount once it drops below the maintenance margin. Settlement Price Settlement price is established by the appropriate exchange settlement committee at the close of each trading session. It is the official price that will be used by the clearing house to determine net gains or losses, margin requirements and the next day's price limits. Most often, the settlement price represents the average price of the last few trades that occur on the day. It is the official price set by the clearing house and it helps to process the day's gains and loses in marking to market the accounts. However, each exchange may have its own particular methodology. For example, on NYMEX (the New York Mercantile Exchange) and COMEX (The New York Commodity Exchange) settlement price calculations depend of the level of

trading activity. In contract months with significant activity, the settlement price is derived by calculating the weighted average of the prices at which trades were conducted during the closing range, a brief period at the end of the day. Contract months with little or no trading activity on a given day are settled based on the spread relationships to the closest active contract month, while on the Tokyo Financial Exchange settlement price is calculated as the theoretical value based on the expected volatility for each series set by the exchange.
Look Out! Remember that settlement price is NOT the closing price.

Derivatives - The Futures Trade Process

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.