Getting In and Out of Futures Contracts By Peter Lang and Chris Schafer

Futures Contracts A contractual agreement, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future –Commodity: wheat, oats, sugar, crude oil, heating oil, natural gas etc –Financial: treasury notes, bonds, etc

Futures Positions Long Position: the holder agrees to buy the contract's underlying asset at a specified price, with the payment and delivery to occur on the expiration date Short Position: holder agrees to sell an asset at a specific price, with delivery and payment occurring at expiration.

Futures Positions If both the long and short parties hold their contracts to the expiration date, their profits or losses would be determined by the price of the asset on the spot market –If spot price increases long party would profit –If spot price decreases short party would profit Futures contracts are a “zero sum game” –When one side profits the other looses money

Investment Reasons Speculation –Investors speculate on the price changes of the underlying assets in futures contracts –It is an alternative to buying or short selling the commodity itself

Investment Reasons Hedging –Investors are able to hedge against adverse price movements with futures contracts –True hedging is done to reduce price risk, not to make a profit –If an investor loses money from their investment in the underlying commodity, then they make up for it with profits from their futures contracts and vice-versa

Futures Exchanges Futures contracts are traded on exchanges. Exchanges are set up as membership organizations with a fixed number of seats with a seat being a precondition for direct trading on the exchange.

Futures Exchanges There are two main types of members on most exchanges –Commission Brokers: Buy and sell futures contracts for their customers. Responsible for most of the trading on the exchanges –Locals: Trade on the exchange from their own account. Normally involved in speculation or arbitrage situations

Futures Exchanges Each exchange is responsible for standardizing the commodities for which it offers futures contracts on The underlying assets must have a standardized grade or type as well as a standardized amount

Futures Exchanges Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) Commodity Exchange(COMEX) (NY) Kansas City Board of Trade (KCBT) Mid ‑ American Commodity Exchange (MidAm) Minneapolis Grain Exchange (MGE) New York Mercantile Exchange (NYMEX) Philadelphia Exchange (PHLX)

Getting In to a Futures Contract Choose a commodity Decide on your position Find the exchange your chosen commodity is traded on Deal with the Clearinghouse

Clearinghouse To give futures marketability, exchanges use clearinghouses –Act as an intermediary Most exchanges have their own clearinghouse –Makes futures contracts more attractive to invest in

Clearinghouse Purposes Make it easier to get in and out of contracts Guarantee that both parties will live up to their end of the contract Collects and manages funds posted by parties Helps with delivery process at expiration

Clearinghouse Position $$ April Oil ACHB

Initial Margin Is the amount that must be deposited by the investor on the day the futures position is established. –Can be in the for of cash or cash equivalents The trader does this by setting up a margin account with the broker and depositing the required amount with them The amount of the margin is determined by the exchanges margin requirement –Usually between 3%-5% Is a percentage of the total contract value Reduce the chance of default.

Marking to Market When there is a decrease in the account value, the futures trader’s broker has to transfer money through the clearing firm equal to the loss on the position to the broker and clearinghouse with the gain.

Maintenance Margin Is the amount of additional funds that futures traders must deposit to keep the equity in their account equal to a certain percentage of the initial margin value. This insures that the balance in the trader’s account does not drop too low –This is required by brokerage firms

Margin Call If one did not deposit the required margin when their equity fell below the required amount, they would then receive a margin call, and would be required to add additional funds to their account If one failed to post the additional funds their position in the contract would be closed

Margins Investors often deposit more funds than required by margin requirements –Reduces the responsibility involved with constantly managing a futures position Can be done by depositing more cash or investing in other future funds

Getting Out of Futures Contracts Settlement –Delivery of physical asset of contract or cash in the case of stock index futures –Each exchange has their rules and procedures governing the deliveries of contracts and delivery dates –Very few futures contracts ever reach delivery

Getting Out of Futures Contracts Cover Position –Same number of contracts on the same commodity but with the opposite position of the original futures contracts –Clearinghouse takes care of the hassle for the investors

Questions?

Review Question 1 Which position benefits if the spot price increases? Long Position or Short Position?

Review Answer Long Position

Review Question 2 What is one function of the clearinghouse?

Review Answer Gives futures contracts marketability Acts as an intermediary Makes it easier to get in and out of futures contracts Guarantees both parties will live up to their side of the contract

Review Question 3 What percentage is normally required for an initial margin?

Review Answer 3% - 5%

Review Question 4 What is the amount of additional funds that futures traders must deposit to keep the equity in their account equal to a certain percentage of the initial margin value known as?

Review Answer Maintenance Margin

Review Question 5 What are the two main reasons investors trade in futures contracts?

Review Answer Speculation Hedging

Review Question 6 Who is responsible for standardizing the commodities traded on each exchange?

Review Answer The exchange that the commodity is traded on

Review Question 7 What position are you taking when you want to get out of a futures contract?

Review Answer Cover position