Mechanics of trading

Trading in futures is more complex than trading in stocks. Interalia, it involves intermediation by a clearing house, marking to market and margins.

Clearing House: In a traded futures contract, the clearing house of the exchange interposes itself between the buyer (the long position) and the seller (the short position). This means that the clearing house becomes the seller to the buyer and the buyer to the seller as shown. Because the clearing house is obligated to perform on its side of each contract, it is the only party that can be hurt if any trader fails to fulfill his obligation. The clearing house protects its interest by imposing margin requirements on traders and by marking-to-market described below.

Thanks to the intermediation by the clearing house, traders can liquidate their positions easily. If you have a long position and you want to unwind it, simply instruct your broker to do the short side of the contract. Likewise if you have a short position and you want to undo it, simply instruct your broker to do the long side of the contract. Such trades, meant to close out a position are called reverse traders.

The open interest in a contract is simply the number of contracts outstanding. Because long and short positions are not counted separately, open interest is defined as either the number of long or short contracts outstanding. Since the position of the clearing house nets out to zero, it is not counted in computing the open interest. At the beginning of trading cycle, open interest is zero. As time passes, open interest builds up. However as most traders close out their positions before the contract maturity date open interest declines sharply when the maturity date nears.

Margins: When you execute a futures trade, you have to provide the initial margin which may be about 10 percent of the value of contract – it is fixed by the exchange. The margin, consisting of cash or cash equivalents, is to ensure that traders will honor the obligations a arising out of the futures contract. The margin has to be posted by both the parties to the futures contract as both are exposed to losses.

If you incur sustained losses from daily marking-to-market, your margin amount may fall below a critical level called the maintenance or variation margin which may be around 5 percent – this too is fixed by the exchange. Should that happen, you will receive a margin call asking you to replenish the margin amount. If you do not replenish the margin amount, the broker will close out enough of your trading position, so that the amount in your margin suffices for your balance trading position.

Marking to Market: While forward contracts are settled on the maturity date, futures contacts are marked to market on a periodic basis. This means that the profits and losses on futures contacts are settled on a periodic basis.

The marking to market features of a futures contract may be illustrated with an example. Suppose on Monday morning you take a long position in a futures contact that matures on Friday afternoon but is marked to market on a daily basis. The agreed upon price is, say Rs 100. At the close of trading on Monday, the futures price rises to Rs 105. Now the marking-to-market features means that three things would occur. First, you will receive a cash profit of Rs 5. Second the existing futures contract with a price of Rs 100 would be cancelled. Third, you will receive a new futures contract at Rs 105. In essence, the marking-to-market feature implies that the value of the futures contract is set to zero at the end of each trading day.

Note that although forward contracts and futures contract are similar in their final outcomes, the settlement mechanisms are different. This may lead to different patterns of cash flow.

Price Limits:

In general, futures exchanges impose limits on price movements of futures contracts. For example, the limit on the daily price movement on orange juice futures contracts on the CBOT is 5 cents per pound or $750 per contract of 15,000 pounds. If the price of the contract moves by $750 the trading is generally suspended for the day. The exchange of course, has the discretion to reopen trading later in the day.

What is the rationale for price limits? Price limits are meant to prevent panic buying or selling, triggered by rumors, and to prevent overreaction to real information It is based on the premise that if investors have more time to respond to extreme information the price reaction is likely to be more rational.