Getting In and Out of Futures Contracts Tobin Davilla

Futures Contracts Definition: An agreement between a buyer and a seller to receive or deliver a product on a future date at a price they have negotiated today.

History 19 th Century Minimal storage facilities to house grain Large surplus of grain at harvest time Price of grain decreased, farmers forced to sell Innovative farmers pre-arranged agreements to sell crop at agreed upon price Benefit:  Buyers get grain throughout the year  Sellers minimize spoilage and price volatility risk is transferred.

Types of Future Contracts Prior to 1972, only agricultural commodities (grain and livestock), imported foodstuffs (coffee, cocoa, and sugar) or industrial commodities were traded – known as Commodity futures Now there is also Financial Futures – which include: stock index futures, interest rate futures, and currency futures.

Hedgers and Speculators Hedgers – enter into a futures contracts to insure against any future price movements.  Limits the potential for loss, it also limits the potential for gain. (Silversmith) Speculators – enter into a futures contract in the hopes of a price movement in their favor  Speculating not one of the economic purposes of futures markets; however, they make futures markets better by adding liquidity.

Price Fluctuation Rising price – Loss by the seller is offset by the increase in inventory value. Gain by the buyer is offset by the higher prices paid to obtain underlying Falling price –Gain by the seller is offset by the decrease in inventory value. Loss by the buyer is offset by the opportunity to purchase underlying at lower price

How to obtain a futures contract Futures Commission Merchant (FCM)  Authorized future broker  Intermediary between you and floor broker  Decreased risk due to expertise and vigilance  Examples: Smith & Barney, Goldman Sachs, Commodity Brokerage Firms Locals  Purchase their own seat on the exchange  Buy or sell for their own account

How to obtain a futures contract Place an order to buy or sell  Through FCM to floor broker Floor brokers act on behalf of brokerage house, investment banks or commercial dealers  Moving to electronic platforms, most occur in ring or pit Floor brokers vocally announce bid and use hand signs called “open outcry.”

How to obtain a futures contract Once a contract is agreed upon:  Floor brokers exchange information Number of contracts Underlying (what is traded, wheat, grain, etc.) Settlement date (usually in March, June, Sept, Dec.) Price Name of clearing firm of the member on the opposite side of trade Initials of trader

Example – Getting into the contract Bob (B) wants to buy 500 bundles of wheat at $100 bundle, to be delivered in December (long) Tom (S) wants to sell 500 bundles of wheat at $100 bundle, to be delivered in December. (short) Through their FCM, they work with a floor broker to put these two orders together.

Clearinghouse End of trading day, Floor brokers send order to clearinghouse.  Confirm that each order has equal and matching order to buy or sell Once cleared, Clearinghouse interposes itself as the buyer for the seller and the seller for the buyer, used to guarantee each contract Both parties free to liquidate without the other party and without worrying that they will default.

Clearinghouse 3 Functions  Liquidity maintained because all positions can be offset by opposite positions.  Can pick other party to participate when someone chooses to deliver underlying.  Not allow investors to default due to margin payments.

Initial Margin Investor deposits minimum amount per contract as specified by exchange  Usually 5-10% of contract value, can depend on volatility and other risks.  To ensure that traders can meet financial obligations.  Small initial investment means high-leverage investment  With high leverage comes huge gains or losses.

Example – Initial Margin Exchange states that the initial margin will be 7% of contract value Initial Investment for both parties: $3,500

Maintenance Margin Minimum amount that must be maintained in customers account as set by futures exchange When account falls below this amount the customer must put additional money into account to pull balance up to initial margin Margin call made daily, have 24 hours to meet obligation If you lose money and cannot meet obligations, exchange closes the futures position out. If you gain money you may take money out up to the level of the initial investment.

Example – Maintenance Margin Exchange sets Maintenance Margin at 57% of initial margin or above $4 Investor must maintain an account balance greater than $2,000

Settlement Price Value the settlement committee gives to represent the final trading price for the day. Not closing price, if a lot of activity at the end of the day, the committee will take the average trading price. Uses settlement price to determine if there is a loss or gain in each investors account in a process called “marked to market.”

Example – Settlement Price Day one: Price of Wheat drops to $98/bundle  Bob (B) loses $1,000, account balance $2,500  Tom (S) gains $1,000, account balance $4,500 Day two: Price of Wheat drops to $95/bundle  Bob (B) loses $1,500, account balance $1,000  Tom (S) gains $1,500, account balance $6,000

Price Limits Exchange sets daily limits what the max and min price may be traded at the next day.  If limit is reached, trading continues only within the limits.  Provides stability in the market if new information becomes available that would cause severe fluctuations  Price limits control what a person can lose in one day

Liquidating 2 ways to liquidate  Offsetting position: most occurring; investor takes an offsetting position in the same market before settlement date.  Delivery: least occurring; investor waits till settlement date and recognizes delivery of underlying. Clearinghouse would pick the other party to deliver.

Example - Liquidating Tom (S) wants out  Must buy an offsetting position  Buys 500 bundles of Wheat to be delivered in December for $95/bundle, $47,500  Could have sold to market for $47,500 instead he sold to Bob for $50,000

Example - Liquidating Bob (B) wants out  Must sell an offsetting position  Sells 500 bundles of Wheat to be delivered in December for $95/bundle, $47,500  Could have bought at the market price for $47,500 instead he bought from Tom for $50,000

Summary – Futures Contracts Used primarily to hedge risk For the risk inclined, futures markets can be seen as great opportunity to exploit the risk and leverage to reap potential gains in market

Questions?

Yes Aaron? Where are the exchanges located at?

Yes Justin? What are some tips if we wanted to invest in futures?