FMP 7: Futures Markets

Closing out a futures position is easy, which is why most contracts never reach delivery. The count of contracts still alive at any moment is the open interest, and because every long position is matched by a short position, that figure reads either as the net long contracts held by members or as the net short contracts.

A new contract starts life with an open interest of zero. It builds as members trade with one another, peaks a little before the delivery period opens, and drops away as members unwind. For a single trade only three cases exist. Two members both opening positions add one to the count. One opening while the other closes leaves it alone, since a position has merely changed hands. Two members both closing out take one away.

Trading volume is a different count

Trading volume counts the contracts traded during a day, so it measures activity rather than exposure outstanding. It can run above the open interest at the close, either from the wave of closing trades late in a contract life or from day trading, where positions are opened and shut within a session.

An exchange has to write down in detail exactly what is being traded. Wherever the contract leaves a choice about what is handed over, where it goes and when it arrives, that choice nearly always belongs to the party with the short futures position, the party making delivery. A rare departure is the CME Group live cattle contract, altered in 1995 to give the buyer some delivery options.

The underlying asset

Financial assets are easy to define, and quality never arises because one euro is identical to the next. A euro contract at the CME Group covers 125,000 euros, and a CME Group contract on the S&P 500 Index covers USD 250 for each index point.

Commodities force far more precision, since quality varies and the seller will hand over the poorest grade the wording permits. In its orange juice futures contract, the Intercontinental Exchange requires U.S. Grade A frozen concentrate carrying a Brix value no lower than 62.5 degrees. Several grades are deliverable under some contracts, with the price adjusted to match. CME Group corn futures take “No. 2 Yellow” as standard, accept “No. 1 Yellow” at 1.5 cents per bushel more and “No. 3 Yellow” at 1.5 cents per bushel less. From 2019 the discount on “No. 3 Yellow” instead runs from 2 to 4 cents, settled by the damage grade factors along with broken corn and foreign material.

Getting this wrong kills a contract, since the party with the short futures position delivers the cheapest thing that qualifies and no one is willing to be long.

Contract size

Each exchange sets the size of its own contracts, and the decision is commercial. Too large and retail investors are shut out; too small and a corporation hedging a real exposure trades an awkward number of them. Contracts on financial assets usually carry far more value than contracts on an agricultural product, so exchanges have added smaller versions for investors wanting a modest hedge or speculative position.

The CME Group lists a regular NASDAQ contract worth USD 100 for each point of the NASDAQ 100 index and a mini NASDAQ contract worth USD 20 for each point, the mini being the more actively traded. For the same reason there is an E-mini contract on the S&P 500 struck at USD 50 for each index point.

Where and when delivery happens

Moving a physical commodity costs money, so the delivery location matters as much as the grade. Crude oil futures at the CME Group call for free-on-board delivery in Cushing, Oklahoma, at a storage facility or pipeline connected to Enterprise, Cushing storage or Enbridge. Where a choice of location exists, the one chosen can feed into the price of the asset.

Futures contracts are named by their delivery months, and the days on which delivery may be made differ from one contract to the next. The party with the short futures position picks among the dates the exchange has listed. Crude oil futures at the CME allow delivery on any day of the month, while other contracts use a narrower window.

The exchange also decides which delivery months are listed and when trading in each opens and closes. CME Group corn futures carry delivery months of March, May, July, September and December. Trading in the December 2020 contract opened on October 09, 2017 and ran until December 14, 2020, since corn futures stop trading on the business day before the fifteenth of the delivery month.

How prices are quoted

Traders need the units a price is quoted in and the finest movement allowed, since those fix the smallest change in the value of a position. Corn futures are quoted in cents per bushel with a minimum movement of 0.25 cents per bushel, and one contract covers 5,000 bushels, putting the smallest change in the value of a contract at USD 12.5.

Each day closes with a settlement price, the level at which the contract is marked when trading ends, and that price drives the daily settlement. A settlement price above the previous one moves money from the accounts of traders holding short futures positions to those holding long futures positions, and a lower one sends it the other way.

Most contracts carry a cap on how far the futures price may travel in a single day, and exchanges revise those caps from time to time. A day in which the price runs the full distance is a limit move: limit up when the cap is reached on the way up, limit down on the way down. Trading normally stops for the rest of the day, although the exchange can step in and widen the limit rather than leave the market shut.

For CME Group corn futures a typical limit move is 50 cents, which is 200 times the minimum price movement of 0.25 cents per bushel and, across the 5,000 bushels in a contract, worth USD 2,500. Price limits exist to stop speculation driving very large single-day moves. The cost is that a limit move set off by genuine news gets in the way of the market finding the true price.

Position limits

A position limit caps the size of position a speculator may hold, and it is there to keep any single speculator from pushing the market around. These caps often run to tens of thousands of contracts, well beyond anything an ordinary trader reaches, so they bind on very few participants.

As the delivery period draws near, the futures price and the spot price of the underlying asset come together. The two can sit some way apart while months remain, and the gap can open in either direction, but arbitrage closes it by the time delivery is at hand.

Why the gap cannot survive delivery

Suppose the futures price sits above the spot price once the delivery period has been reached. A trader can sell futures, buy the asset in the spot market and deliver it against the contract, banking the difference with no exposure taken on. That selling of futures alongside buying of the asset pulls the prices back together.

The other case works through demand rather than a completed arbitrage. Where the futures price sits under the spot price with delivery at hand, anyone wanting the asset does better to take a long futures position and wait for delivery than to buy in the spot market, and that buying interest lifts the futures price.

Daily settlement moves the money

Daily settlement decides how gains and losses reach the trader. At each close the exchange compares the new settlement price with the previous one and moves variation margin between accounts, so profit and loss turns into cash day by day instead of waiting until the end.

Very few futures contracts end in delivery, because traders would rather close out beforehand and use the spot market if they want the asset. Delivery still matters, since it is the possibility of final delivery that ties the futures price to the spot price.

Notices, allocation and the price paid

The process opens when a member holding a short futures position sends the exchange CCP a notice of intention to deliver, giving the number of contracts and, for a commodity, the place of delivery and the grade where a choice exists among grades. The exchange picks members holding long futures positions to receive the goods, normally those whose net long positions have been held longest, though some exchanges allocate at random. A member cannot refuse a notice, but is sometimes given a short window in which to pass the contracts on.

Payment is made at the latest settlement price, adjusted in some cases for the grade and the location. Taking delivery of a commodity brings costs of its own, warehousing among them, and livestock has to be fed and looked after, an unwelcome surprise for a trader who held a long futures position into the delivery period by accident. Financial assets are delivered electronically and raise no such problem.

The three dates that matter

The first notice day is the earliest date on which a notice can be lodged with the CCP, and the last notice day is the latest. Trading generally finishes a few days ahead of that closing date, which leaves a member holding a position after trading has stopped exposed to a notice. For the December 2020 corn contract, notices ran between November 30, 2020 and December 15, 2020, delivery following one business day later, while trading ended on December 14, 2020.

Cash settlement

Contracts can instead be written to settle in cash, which spares everybody an inconvenient delivery process. Regulators are not keen on that, since cash settlement gives futures the look of a wager, and they prefer physical settlement wherever it is workable.

Some assets defeat the preference. CME Group futures on the S&P 500 settle in cash, because physical settlement would mean handing over a portfolio of the 500 underlying stocks. Each contract is settled instead on the third Friday of the delivery month through one last exchange of variation margin, and the opening level of the S&P 500 that morning fixes the final settlement price. Contracts on the weather and on real estate prices are cash settled because nothing exists to deliver, and the Eurodollar futures contract of the CME Group settles in cash as well.

Line up the settlement prices of every listed maturity of one contract on a single day and a shape appears. A futures price that rises with time to maturity makes a normal market, and one that falls makes an inverted market. Gold and crude oil on June 25, 2018 show both.

Source: www.cmegroup.com for the settlement prices. The step column is calculated here and measures the gap to the row above, so it reflects the interval between the maturities shown.

June 2018 delivery settled at USD 1,256.6, close to the spot price, which is what the approach of delivery does to a futures price, and the curve climbs to USD 1,480.1 for December 2023 delivery. A gold contract can be delivered on any day of its delivery month, with notice given one day earlier.

Source: www.cmegroup.com for the settlement prices. The step column is calculated here.

Crude oil ran the other way that day, from USD 68.08 for August 2018 delivery down to USD 53.57 for December 2025, the decline flattening as maturities lengthen. Neither shape is fixed. Oil futures have shown a normal market at other times, and soybean futures on June 25, 2018 rose for maturities out to July 2019 and fell after that.

Participants divide in two: those who take orders from clients, and those who trade with their own money at stake.

Brokers and locals

The first group are the futures commission merchants and the introducing brokers, both of which must register and satisfy minimum capital rules under the U.S. Commodity Exchange Act. Custody of money separates them, since a futures commission merchant handles customer funds, margin requirements included, while an introducing broker does not. Those outside the exchange membership clear client trades through a member.

Participants trading for their own account are known as locals. They are not usually exchange members either, but they keep a close relationship with the member who clears for them. Some exchanges also use market makers, who supply liquidity by quoting a bid price and an ask price at all times.

Both groups sort further by how long they stay in a position. Scalpers chase very short-lived moves and are sometimes in and out within minutes, much as a market maker is. Day traders also hunt intra-day movements and mean to be flat by the close, but hold considerably longer. Position traders take a view over a much longer horizon.

Who regulates the market

In the United States the regulator is the Commodity Futures Trading Commission (CFTC), a government agency whose purpose is to keep futures markets open, transparent, competitive and financially sound. It licenses individuals offering their services to the public, handles complaints from market participants and supervises the setting of position limits.

Part of that workload has passed to the National Futures Association (NFA), a self-regulatory organisation whose members are themselves participants in futures markets. It protects investors and holds members to their obligations by monitoring trading, resolving disputes and taking disciplinary action. The over-the-counter reforms that followed the 2007-2008 crisis added to the load of the CFTC, which now sees that standard over-the-counter derivatives such as swaps are traded and cleared under the new rules.

Market orders and limit orders

Orders come in a long menu, and the plainest is the market order: a request to take a long futures position or a short futures position as fast as possible at whatever price is available. Speed is bought at a cost, since the trader may buy well above, or sell well below, the price expected.

A limit order is the main alternative. The trader names a price, and execution may happen only there or somewhere more favourable: on a buy order the limit is the most the trader will pay, on a sell order the least the trader will accept. Unless the trader says otherwise it lasts one day. With the futures price at USD 32.5, a buy limit at USD 32.3 fills only if the price slips a little, while a buy limit at USD 32.6 is far more likely to fill, because an exchange working on price-time priority executes higher priced buy orders first.

Orders triggered by a price

A stop-loss order, also called a stop order, turns into a market order once the asset trades at a named price or at one less favourable, and its job is to cap the loss on a position. Take a trader holding a short futures position with the price at USD 50. A stop-loss instruction to buy at USD 52 becomes a market order the moment the futures price touches USD 52. A price that carries on rising might give a fill at USD 53, while one that touches USD 52 and falls back might fill at USD 51.

A stop-limit order triggers in the same way but turns into a limit order, so it needs two prices. With a stop price of USD 52 and a limit price of USD 52.5, reaching USD 52 creates a limit order that fills at USD 52.5 or lower, and nothing fills if the price gaps straight through. Set the two prices equal and the instruction is a stop-and-limit order.

A market-if-touched (MIT) order, also known as a board order, converts into a market order as soon as a trade prints at the nominated price or better, which makes it the profit-taking counterpart to the stop-loss order. For the trader holding a short futures position at USD 50, an MIT order at USD 45 says that a fall of that size is profit enough.

Discretion and duration

A discretionary order, or market-not-held order, leaves the timing to the broker, who may hold off in the hope of a better price. Every order also carries a life, one trading day by default, after which anything unfilled is cancelled. A fill-or-kill order dies unless it executes in full within seconds, while an open order, also called a good-till-cancelled order, survives until the contract expires or the trader withdraws it.

Under normal accounting rules, gains and losses on futures are recognised as they arise. The valuation behind them is called marking to market, and because futures settle daily the cash turns up in the same period as the accounting entry.

For a company hedging, that creates a problem. Booking the futures result year by year while the hedged item is still absent from the accounts can push reported earnings around more than they would have moved with no hedge at all.

When hedge accounting is available

Hedge accounting is the exception that lets the gain or loss on a hedging transaction be recognised in the same period as the loss or gain on the hedged item, and it applies above because the company is hedging gold it expects to produce in two years. The Financial Accounting Standard Board (FASB) sets out when companies in the United States may use it in FAS 133 and ASC 815, and the International Accounting Standards Board (IASB) has issued IAS 39 and IFRS 9. IFRS 9 has replaced IAS 39 and relaxes some requirements, as ASC 815 relaxes some rules in FAS 133.

Qualifying is demanding. The hedge must be fully documented, with the hedged item and the hedging instrument clearly identified, and classified as effective, which calls for an economic relationship between the two that is not dominated by credit risk effects. Effectiveness is tested periodically.

Tax follows a similar logic with different rules

Many jurisdictions tax futures contracts as though every position were closed at the tax year end, which produces the same year-by-year recognition. Hedging transactions in the United States escape that rule, but the tax definition differs from the accounting one: a transaction is a hedging transaction for tax purposes when it is entered into as part of ordinary business, mainly to cut risk exposures. So a transaction can qualify as a hedge for tax and fail for accounting.

A forward contract is the over-the-counter answer to the same problem, since both instruments fix today the terms of a trade that happens later. The differences lie in where they trade, how they are settled and how they end.

Source: the differences set out in the chapter, arranged by feature.

The advantage each holds is the mirror image of the other. A forward contract can be written with the delivery date the client actually needs, which is why it survives beside a cheaper and safer exchange-traded alternative. A futures contract trades that flexibility for standardisation, a deep market and a central counterparty.

Daily settlement changes when the money arrives

Because a futures position settles every day while a forward position does not, two traders can finish with the same profit and still not be equally well off.