Features Of A Futures Contract

• Long Position – The buyer of a futures contract takes a long position. The long has an obligation to buy the underlying asset at the contract price at contract expiration.
• Short Position – The seller of a futures contract takes a short position. The short has an obligation to sell the underlying asset at the contract price at contract expiration.
• For each contract traded, there is a buyer and a seller.
• Hedgers – Futures contracts are used by hedgers to reduce exposure to price changes in the asset.
• Speculators – Futures contracts are used by speculators to gain exposure to changes in the price of the asset underlying a futures contract.

Features Of A Futures Contract – Specifications

• Quality of the underlying asset : When the underlying asset for the contract is a financial asset, such as a stock, the definition of the asset is simple. If the asset is a commodity, the exchange specifies the asset in complete detail including grade, quality, size, shape, color, etc.
• Contract size : The amount of the asset to be delivered to settle the contract is specified by the exchange (for example, 1 contract of crude oil = 100 barrels).
• Delivery arrangement : Place of delivery is specified by the exchange.
• Delivery month : Futures contracts are referred to by the month in which delivery is to take place (for example, August 2018 crude oil contract).
• Price quotations and tick size : The exchange determines how the price of a contract will be quoted as well as the minimum price fluctuation for the contract, which is referred to as the tick size.
• Daily price limits : The exchange sets the maximum price movement for a contract during a day. A contract is said to be limit down if it moves down by its daily price limit. A contract is said to be limit up if it moves up by its daily price limit.
• Position limits : The exchange sets a maximum number of contracts that a speculator can hold so that their actions don’t dictate terms in the market. Position limits are not applicable for hedgers.

Futures And Spot Convergence

• The difference between the spot price and the futures price is termed basis, i.e. basis = spot price – futures price.
• As the futures contract approaches maturity, the basis moves toward zero.
• At expiration, the futures price will be equal to the spot price because the futures price is today’s price today for delivery to be done today, which is actually the spot price.
• The futures price and the spot price will be the same at contract expiration because of the principle of arbitrage.

For Example: If the futures price is above the spot price during the maturity, then there will be a clear arbitrage opportunity by executing the following:

1. Sell (i.e., short) a futures contract
2. Buy the asset.
3. Make delivery.

The Operation Of Margin Accounts

• Margin is cash or highly liquid collateral placed in an account to ensure that any trading losses will be met.
• Margin account: Investor deposits a certain amount of money with the broker in the margin account.
• Marking to market is the daily procedure of adjusting the margin account balance for daily movements in the futures price.
• Initial margin: the initial amount deposited in the margin account.
• Maintenance margin: It is the minimum amount required to maintain the futures position, after which a margin call is sent to the investor. It is less than the initial margin.
• Variation Margin: It is the amount necessary to bring the margin account balance back to the initial margin amount, after the investor gets a margin call.

The Operation Of Margin Accounts – Example

Current Futures Price of August 2019 contract (on 9^th July 2019): $52/barrel
Contract size: 100 barrels
Total Number of Contracts being traded: Long position in 4 contracts
Initial Margin is 40% and Maintenance margin is 30%

DATE	OMAB	OP (Crude)	CP (Crude)	PROFIT (Per Barrel)	TOTAL PROFIT	CMAB	MC	VARIATION MARGIN
Monday, July 08, 2019	8320	52	53	1	400	8720	X	0
Tuesday, July 09, 2019	8720	53	53.5	0.5	200	8920	X	0
Wednesday, July 10, 2019	8920	53.5	50	-3.5	-1400	7520	X	0
Thursday, July 11, 2019	7520	50	44.5	-5.5	-2200	5320	✔	3000
Friday, July 12, 2019	8320	44.5	37.5	-7	-2800	5520	✔	2800
Monday, July 15, 2019	8320	37.5	33	-4.5	-1800	6520	X	0

• An investor purchased 450 shares of a company X, at a price of $32. The initial margin requirement is 40% and the maintenance margin requirement is 25%.
  1. At what price would the investor be getting a margin call?
  2. What would be the variation margin if the stock price goes down to $23?

The Operation Of Margin Accounts

• Minimum levels for the initial and maintenance margin are set by the exchange clearing house. Individual brokers may require greater margins from their clients than the minimum levels specified by the exchange clearing house. Minimum margin levels are determined by the variability of the price of the underlying asset and are revised when necessary. The higher the variability, the higher the margin levels. The maintenance margin is usually about 75% of the initial margin.
• Margin requirements may depend on the objectives of the trader. A bona fide hedger, such as a company that produces the commodity on which the futures contract is written, is often subject to lower margin requirements than a speculator. The reason is that there is deemed to be less risk of default. Day trades and spread transactions often give rise to lower margin requirements than do hedge transactions. In a day trade the trader announces to the broker an intent to close out the position in the same day. In a spread transaction the trader simultaneously buys (i.e., takes a long position in) a contract on an asset for one maturity month and sells (i.e., takes a short position in) a contract on the same asset for another maturity month.
• Margin requirements are the same on short futures positions as they are on long futures positions. It is just as easy to take a short futures position as it is to take a long one. The spot market does not have this symmetry. Taking a long position in the spot market involves buying the asset for immediate delivery and presents no problems. Taking a short position involves selling an asset that you do not own. This is a more complex transaction that may or may not be possible in a particular market. It is discussed further in a later topic.

The Operation Of Margin Accounts – Clearinghouse

• A clearing house acts as an intermediary in futures transactions. It guarantees the performance of the parties to each transaction. The clearing house has a number of members. Brokers who are not members themselves must channel their business through a member and post margin with the member. The main task of the clearing house is to keep track of all the transactions that take place during a day, so that it can calculate the net position of each of its members.
• Initial Margin or Clearing Margin: The clearing house member is required to provide to the clearing house initial margin (sometimes referred to as clearing margin), reflecting the total number of contracts that are being cleared.
• No maintenance margin is applicable to the clearing house member.
• Variation Margin: After daily settlement, if the transactions have lost money overall, the member is required to provide variation margin to the exchange clearing house, whereas the member receives variation margin from the clearing house, if there has been an overall gain. Intraday variation margin payments may also be required by a clearing house from its members in times of significant price volatility or changes in position.
• In determining margin requirements, the number of contracts outstanding is usually calculated on a net basis rather than a gross basis. This means that short positions the clearing house member is handling for clients are netted against long positions. Suppose, for example, that the clearing house member has two clients: one with a long position in 20 contracts, the other with a short position in 15 contracts. The initial margin would be calculated on the basis of 5 contracts.
• The calculation of the margin requirement is usually designed to ensure that the clearing house is about 99% certain that the margin will be sufficient to cover any losses in the event that the member defaults and has to be closed out.
• Clearing house members are required to contribute to a guaranty fund. This may be used by the clearing house in the event that a member defaults and the member’s margin proves insufficient to cover losses.
• Account balance to be maintained at all times = number of contracts × original margin

Marginal System And Credit Risk

• The whole purpose of the margining system is to ensure that funds are available to pay traders when they make a profit. Overall the system has been very successful. Traders entering into contracts at major exchanges have always had their contracts honored.
• Futures markets were tested on October 19, 1987, when the S&P 500 index declined by over 20% and traders with long positions in S&P 500 futures found they had negative margin balances with their brokers. Traders who did not meet margin calls were closed out but still owed their brokers money. Some did not pay and as a result, some brokers went bankrupt because, without their clients’ money, they were unable to meet margin calls on contracts they entered into on behalf of their clients. However, the clearing houses had sufficient funds to ensure that everyone who had a short futures position on the S&P 500 got paid.

Over The Counter (OTC) Markets

• Over-the-counter (OTC) markets, are markets where companies agree to derivatives transactions without involving an exchange.
• Credit risk has traditionally been a feature of OTC derivatives markets. Consider two companies, A and B, that have entered into a number of derivatives transactions. If A defaults when the net value of the outstanding transactions to B is positive, a loss is likely to be taken by B. Similarly, if B defaults when the net value of outstanding transactions to A is positive, a loss is likely to be taken by company A.
• In an attempt to reduce credit risk, the OTC market has borrowed some ideas from exchange-traded markets.

Central Counterparties (CCPs)

• Central Counterparties are clearing houses for standard OTC transactions that perform much the same role as exchange clearing houses. Members of the CCP, similarly to members of an exchange clearing house, have to provide both initial margin and daily variation margin. Like members of an exchange clearing house, they are also required to contribute to a guaranty fund.
• Once an OTC derivative transaction has been agreed between two parties A and B, it can be presented to a CCP. Assuming the CCP accepts the transaction, it becomes the counterparty to both A and B. For example, if the transaction is a forward contract where A has agreed to buy an asset from B in one year for a certain price, the clearing house agrees to (a) Buy the asset from B in one year for the agreed price, and (b) Sell the asset to A in one year for the agreed price. It takes on the credit risk of both A and B.
• If an OTC market participant is not itself a member of a CCP, it can arrange to clear its trades through a CCP member. It will then have to provide margin to the CCP member. Its relationship with the CCP member is similar to the relationship between a broker and a futures exchange clearing house member. After the credit crisis of 2007, most standard OTC transactions between financial institutions have been handled by CCPs.

Bilateral Clearing

• Those OTC transactions that are not cleared through CCPs are cleared bilaterally. In the bilaterally cleared OTC market, two companies A and B usually enter into a master agreement covering all their trades. This agreement usually includes an annex, referred to as the credit support annex or CSA, requiring A or B, or both, to provide collateral. This collateralization is like a marked-to-market mechanism for the OTC market where gains and losses are settled in cash at the end of the trading day. A cash payment is made by the party with the negative account balance to the counterparty with the positive account balance.
• Although earlier not required, but from 2016, regulations require both initial margin and variation margin to be provided for bilaterally cleared transactions between financial institutions. The initial margin is posted with a third party and calculated on a gross basis (no netting).
• Collateral significantly reduces credit risk in the bilaterally cleared OTC market.

Bilateral Clearing Versus Central Clearing

• This figure illustrates the way bilateral and central clearing work. It makes the simplifying assumption that there are only eight market participants and one CCP. Under bilateral clearing there are many different agreements between market participants, as indicated in (a). If all OTC contracts were cleared through a single CCP, we would move to the situation shown in (b). In practice, because not all OTC transactions are routed through CCPs and there is more than one CCP, the market has elements of both (a) and (b).

Futures Market Quotes

Volume Versus Open Interest

• The trading volume is the number of contracts traded in a day. It can be contrasted with the open interest, which is the number of contracts outstanding, that is, the number of long positions or, equivalently, the number of short positions. If there is a large amount of trading by day traders (i.e., traders who enter into a position and close it out on the same day) the volume of trading in a day can be greater than either the beginning-of-day or end-of-day open interest.

Let’s consider an extremely simplified example.

Day	Trading Activity	Volume	Open Interest
1	A buys 1 options contract and B sells 1 options contract	1	1
2	C buys 5 option contracts and D sells 5 option contracts	5	6
3	A sells his 1 options contract and D buys 1 options contract	1	5
4	E buys 5 options contracts and C sells 5 options contracts	5	5

Normal Versus Inverted Futures Market

• In a normal market, futures prices increase with the maturity of the contracts. The prices of the distant-term futures contracts are higher than the prices of the near-term futures contract. Generally in this case, the futures price is greater than the spot price, which is known as contango (discussed in a later topic in detail).
• In an inverted market, futures prices decrease with the maturity of the contracts. The prices of the distant-term futures contracts are lower than the prices of the near-term futures contract. Generally in this case, the futures price is less than the spot price, which is known as backwardation (discussed in a later topic in detail).

Delivery

• Very few futures contracts lead to a delivery of the underlying asset as most are closed out earlier than expiration.
• Even though the period of delivery is specified by the exchange, the exact date of delivery is at the discretion of the holder of the short position.
• Notice of intention to deliver is given by the broker on behalf of the short position to the clearing house. The number of contracts and particulars of the delivery (grade, type, quality, location, etc.) are mentioned in the notice of intention to deliver.
• Exchange identifies a party with a long position to accept delivery, who is generally the one with the oldest outstanding long position, and passes on the notice of intention to deliver to that party.
• In the case of a commodity, taking delivery usually means accepting a warehouse receipt in return for immediate payment. The party taking delivery is then responsible for all warehousing costs. In the case of livestock futures, there may be costs associated with feeding and looking after the animals.
• In the case of financial futures, delivery is usually made by wire transfer. For all contracts, the price paid is usually the most recent settlement price. If specified by the exchange, this price is adjusted for grade, location of delivery, and so on. The whole delivery procedure from the issuance of the notice of intention to deliver to the delivery itself generally takes about two to three days.
• There are three critical days for a contract. These are the first notice day, the last notice day, and the last trading day.
  • The first notice day is the first day on which a notice of intention to make delivery can be submitted to the exchange.
  • The last notice day is the last such day.
  • The last trading day is generally a few days before the last notice day.

To avoid the risk of having to take delivery, a trader with a long position should close out his or her contracts prior to the first notice day.

Cash Settlement

• Some financial futures, such as those on stock indices, are settled in cash because it is inconvenient or impossible to deliver the underlying asset. In the case of the futures contract on the S&P 500, for example, delivering the underlying asset would involve delivering a portfolio of 500 stocks.
• When a contract is settled in cash, all outstanding contracts are declared closed on a predetermined day. The final settlement price is set equal to the spot price of the underlying asset at either the open or close of trading on that day. For example, in the S&P 500 futures contract traded by the CME Group, the predetermined day is the third Friday of the delivery month and final settlement is at the opening price on that day.

Types Of Orders

• Market order: Order placed at current market rate, to be executed immediately.
• Limit order: A limit order specifies a particular price. The order can be executed only at this price or at one more favorable to the trader. Thus, if the limit price is $30 for a trader wanting to buy, the order will be executed only at a price of $30 or less. There is, of course, no guarantee that the order will be executed at all, because the limit price may never be reached.
• Stop order: A stop order or stop-loss order also specifies a particular price. The order is executed at the best available price once a bid or offer is made at that particular price or a less- favorable price. Suppose a stop order to sell at $30 is issued when the market price is $35. It becomes an order to sell when and if the price falls to $30. In effect, a stop order becomes a market order as soon as the specified price has been hit. The purpose of a stop order is usually to close out a position if unfavorable price movements take place. It limits the loss that can be incurred.
• Stop Limit order: A stop-limit order is a combination of a stop order and a limit order. The order becomes a limit order as soon as a bid or offer is made at a price equal to or less favorable than the stop price. Two prices must be specified in a stop-limit order: the stop price and the limit price. Suppose that at the time the market price is $35, a stop-limit order to buy is issued with a stop price of $40 and a limit price of $41. As soon as there is a bid or offer at $40, the stop-limit becomes a limit order at $41. If the stop price and the limit price are the same, the order is sometimes called a stop-and-limit order.
• Market-if-touched order: A market-if-touched (MIT) order is executed at the best available price after a trade occurs at a specified price or at a price more favorable than the specified price. In effect, an MIT becomes a market order once the specified price has been hit. An MIT is also known as a board order. Consider a trader who has a long position in a futures contract and is issuing instructions that would lead to closing out the contract. A stop order is designed to place a limit on the loss that can occur in the event of unfavorable price movements. By contrast, a market-if-touched order is designed to ensure that profits are taken if sufficiently favorable price movements occur.
• Discretionary order: A discretionary order or market-not-held order is traded as a market order except that execution may be delayed at the broker’s discretion in an attempt to get a better price.
  • Some orders specify time conditions. Unless otherwise stated, an order is a day order and expires at the end of the trading day.
• Time-of-day order: A time-of-day order specifies a particular period of time during the day when the order can be executed.
• Open order: An open order or a good-till-canceled order is in effect until executed or until the end of trading in the particular contract.
• Fill-or-kill order: A fill-or-kill order, as its name implies, must be executed immediately on receipt or not at all.

Futures Versus Forward

FORWARDS	FUTURES
Trade over-the-counter (OTC)	Traded on an Exchange (ET)
Customized	Standardized contracts
One delivery date for each contract	Range of delivery dates
Settlement at expiration of the contract	Daily Settlement
Settlement generally done via delivery or cash	Settlement generally done via offsetting
Less basis risk because of customization	More basis risk
Less liquid	Very liquid because of standardization