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Introduction to Futures

a. Definition of a Futures Contract

What is a Futures Contract?

Forward and futures contracts are financial instruments that allow market participants to offset or assume the risk of a price change of an asset over time.

A futures contract is distinct from a forward contract in two important ways: first, a futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Second, this transaction is facilitated through a futures exchange.

The fact that futures contracts are standardized and exchange-traded makes these instruments indispensable to commodity producers, consumers, traders, and investors.

A Standardized Contract
An exchange-traded futures contract specifies the quality, quantity, physical delivery time and location for the given product. This product can be an agricultural commodity, such as 5,000 bushels of corn to be delivered in the month of March, or it can be financial asset, such as the U.S. dollar value of 62,500 pounds in the month of December.

The specifications of the contract are identical for all participants. This characteristic of futures contracts allows buyer or seller to easily transfer contract ownership to another party by way of a trade. Given the standardization of the contract specifications, the only contract variable is price. Price is discovered by bidding and offering, also known as quoting, until a match, or trade, occurs.

Futures contracts are products created by regulated exchanges. Therefore, the exchange is responsible for standardizing the specifications of each contract.

The exchange also guarantees that the contract will be honored, eliminating counterparty risk. Every exchange-traded futures contract is centrally cleared. This means that when a futures contract is bought or sold, the exchange becomes the buyer to every seller and the seller to every buyer. This greatly reduces the credit risk associated with the default of a single buyer or seller.
The exchange thereby eliminates counterparty risk and, unlike a forward contract market, provides anonymity to futures market participants.
By bringing confident buyers and sellers together on the same trading platform, the exchange enables participants to enter and exit the market with ease, makings futures markets highly liquid and optimal for price discovery.

b. Learn About Contract Specifications

Every futures contract has an underlying asset, the quantity of the asset, delivery location, and delivery date.

For example, if the underlying asset is light sweet crude oil, the quantity is 1,000 barrels, the delivery location is the Henry Hub in Erath, Louisiana and the delivery date is December 2017.
When a party enters into a futures contract, they are agreeing to exchange an asset, or underlying, at a defined time in the future. This asset can be a physical commodity like crude oil, or a financial product like a foreign currency.

When the asset is a physical commodity, to ensure quality, the exchange stipulates the acceptable grades of the commodity.

For example, WTI Crude Oil contracts at CME Group is for 1,000 barrels of a grade of crude oil known as “light, sweet” which refers to the amount of hydrogen sulfide and carbon dioxide the crude oil contains.

Futures contracts for financial products are understandably more straightforward: the U.S. dollar value of 100,000 Australian dollars is the U.S. dollar value of 100,000 Australian dollars.

Each futures contract specifies is the quantity of the product delivered for a single contract, also known as contract size. For example: 5,000 bushels of corn, 1,000 barrels of crude oil or Treasury bonds with a face value of $100,000 are all contract sizes as defined in the futures contract specification.

The exchange defines the contract size to meet the needs of market participants. For example, participants who wish to take a speculative or hedging position in the S&P 500 futures contract but cannot risk the exposure of that size contract ($250 x the S&P 500) can instead use the E-mini S&P 500 futures contract to gain that exposure ($50 x the S&P 500 Index).

Futures contract also specifies where the asset will be delivered upon execution. Delivery is an important consideration for certain physical commodity markets entailing significant transportation costs. For example, the random-length lumber contract at CME Group specifies that delivery must occur in a specific state and in a certain type of boxcar.

Finally, every futures contract is referred to by its delivery month. Traders refer to the March Corn contract or the December WTI contract since this point in the future is germane to the value and execution of the contract position. Depending on the contract market, delivery can be anywhere from one month to several years in the future. The exchange specifies when delivery will occur within the month and when a given contract initiates and terminates trading. Typically, trading for a contract is halted a few days before the specified delivery date.

c. What are Trading Codes?

The display format of futures contract codes is fundamental to understanding pricing across multiple expirations.

Contract display codes are typically one- to three-letter codes identifying the product followed by additional characters indicating the month and year of expiration. The format of a contract code varies according to the asset class and trading platform. Many contract codes originated on the trading floor to convey maximum information with the fewest characters and migrated intact to the electronic environment.

For this exercise, let’s first look at the E-mini S&P 500 futures contract. The CME Globex contract code this product is ES, which is also the contract code used on CME ClearPort. Now let’s look at the Eurodollar futures contract. On CME Globex, this contract is identified by the code GE. On CME ClearPort, this product is identified by the code ED. It is therefore important to be aware that contract codes can vary across platforms.

For contract expiration, additional characters added to the right of the contract code indicate month and year.
Each calendar month expiration is identified by a single letter as follows:
January – F
February - G
March -H
April -J
May - K
June - M
July - N
August - Q
September -U
October - V
November -X
December -Z

Available contract expiration months may vary by product, but the letter following the contract code always indicates expiration month. The expiration year is indicated following the month as a numeric value.
Let’s construct the display code for the E-mini S&P 500 futures contract expiring January 2019. The first determining factor is trading platform and for this example we will use CME Globex. For CME Globex the E-mini S&P contract code is ES. Following ES, we add the expiration month, which for January is the letter F. Finally, we add a 9 for 2019. Therefore the display code for the E-mini S&P 500 futures contract expiring in January 2019 is: ESF9.

These general rules apply to the format of futures contract codes, but it is important to be aware that codes and available expirations can vary across platforms.

d. Get to Know Futures Expiration and Settlement

All futures contracts have a specified date on which they expire. Prior to the expiration date, traders have a number of options to either close out or extend their open positions without holding the trade to expiration, but some traders will choose to hold the contract and go to settlement.

Settlement is the fulfillment of the legal delivery obligations associated with the original contract. For some contracts, this delivery will take place in the form of physical delivery of the underlying commodity. For example, a food producer looking to acquire grain may be looking to take delivery of physical corn or wheat, and a farmer may be looking to deliver his grain to that producer. Although physical delivery is an important mechanism for certain energy, metals and agriculture products, only a small percent of all commodities futures contracts are physically delivered.

In most cases, delivery will take place in the form of cash settlement. When a contract is cash-settled, settlement takes place in the form of a credit or debit made for the value of the contract at the time of contract expiration. The most commonly cash-settled products are equity index and interest rate futures, although precious metals, foreign exchange, and some agricultural products may also be settled in cash.
For traders choosing to go to settlement, the form of delivery will be highly dependent on the needs of each trader, as well as the unique characteristics of the product being traded.

e. What is Mark-to-Market?

One of the defining features of the futures markets is daily mark-to-market (MTM) prices on all contracts. The final daily settlement price for futures is the same for everyone.
MTM was a distinctive difference between futures and forwards until the regulatory reform enacted after the financial crises of 2007-2008. Prior to those reforms most OTC forwards and swaps did not have an official daily settlement price so clients never knew their daily variation except as described by a theoretical pricing model.

Futures markets have an official daily settlement price set by the exchange. While contracts may have slightly different closing and daily settlement formulas established by the exchange, the methodology is fully disclosed in the contract specifications and the exchange rulebook.

f. Margin: Know What's Needed

Understanding Margin
Securities margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond, or ETF. This practice is often referred to as buying on margin.

Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.

Futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.

Margins Move with the Markets
When markets are changing rapidly and daily price moves become more volatile, market conditions and the clearinghouses' margin methodology may result in higher margin requirements to account for increased risk.
When market conditions and the margin methodology warrant, margin requirements may be reduced.

Types of Futures Margin
Initial margin is the amount of funds required by CME Clearing to initiate a futures position. While CME Clearing sets the margin amount, your broker may be required to collect additional funds for deposit.
Maintenance margin is the minimum amount that must be maintained at any given time in your account.

If the funds in your account drop below the maintenance margin level, a few things can happen:
You may receive a margin call where you will be required to add more funds immediately to bring the account back up to the initial margin level.

If you do not or can not meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account.

Your position may be liquidated automatically once it drops below the maintenance margin level.

Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment, and you do not own the underlying commodity.

The term margin is used across multiple financial markets. However, there is difference between securities margins and futures margins. Understanding these differences is essential, prior to trading futures contracts.

g. Price Discovery
Price discovery refers to the act of determining a common price for an asset. It occurs every time a seller and buyer interact in a regulated exchange. Because of the efficiency of the futures markets and the ability for the instant dissemination of information, bid and ask prices are available to all participants and are instantly updated across the globe.

Price discovery is the result of the interaction between sellers and buyers, or in other words, between supply and demand and occurs thousands of times per day in the futures markets.

This auction type environment means that a trader can find trades that they feel are fair and efficient. For example, a trader in Europe trading Corn futures (ZC) contract and a trader in Australia trading the same contract will see the same bid and ask quotes on their trading platforms at the same time, meaning that the transaction is transparent.

The bids and offers on the futures market constantly change with supply and demand, and with news from around the world. Since every piece of news could potentially impact the supply or demand of a specific asset, buyers and sellers adjust their prices to reflect these changing factors with every trade that is made in that market, hence why price is always fluctuating.

What does this all mean to a trader?

It means that you can rely on the quotes you are seeing on your screen, and trade with the knowledge that you are getting the best price, and the same price, as all others trading the same product at the same time. The one-lot order of a retail trader is treated the same as a 100-lot order from an institutional trader, and they will both pay or receive the same price for their contracts.

The open auction system means that all available information has been assimilated in to the current price of the product, increasing market efficiency and improving the reliability of price from one trade to the next.
The result is a global marketplace for the fair, efficient and transparent discovery of market price.

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