Chapter 2 Mechanics of Futures Markets 1 Options

Chapter 2 Mechanics of Futures Markets 1

Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 2

Futures Contracts When you buy or sell a stock future, you're not buying or selling a stock certificate. You're entering into a stock futures contract -- an agreement to buy or sell the stock certificate at a fixed price on a certain date. Unlike a traditional stock purchase, you never own the stock, so you're not entitled to dividends and you're not invited to stockholders meetings Available on a wide range of assets Exchange traded Specifications need to be defined: ◦ What can be delivered, ◦ Where it can be delivered, & ◦ When it can be delivered Settled daily 3

Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 4

Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 5

Specifications of the Future Contract The Asset The Contract Size Delivery Arrangement Delivery Months Price Quotes Daily Price Movement Limits(If the price of a buy order exceeds the sum of the previous day’s settlement price and of the maximum daily price movement, or the price of a sell order is lower than the difference between the previous day’s settlement price and the maximum daily price movement, then the order shall be automatically rejected by the system. ) 6

Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 7

Other Key Points About Futures They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash 8

Convergence of Futures to Spot As the delivery month of a future contract is approached, the futures price converges to the spot price of the underlying asset Futures Price Spot Price Time (a) Future price above the spot price Time (b) Future price below the spot price 9

Newspaper Quotes The asset underlying the futures contract, the exchange it is traded on, the contract size & how the price is quoted are all shown at the top of each section Prices Settlement Price Life Time high/Low Open Interest & Volume of Trading Pattern of Future Prices Price Rising Open Interest Rising Interpretation Market is Strong Rising Falling Market is Weakening Falling Rising Falling Market is Weak Market is Strengthening 10

Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 11

Open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Each trade completed on the exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract. The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change. 12

The Operation of Margins A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract Marking to Market Margin Account Initial Margin Maintenance Margin(75% of initial margin usually) Margin Call Variation Margin 13

A Possible Outcome Table 2. 1, Page 28 Day Futures Price (US$) Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) 600. 00 Margin Account Margin Balance Call (US$) 4, 000 5 -Jun 597. 00. . . (600). . . 13 -Jun 593. 30. . . (740). . . (1, 340). . . 2, 660 + 1, 340 = 4, 000. . . < 3, 000 19 -Jun 587. 00. . . (1, 260). . . (2, 600). . . 2, 740 + 1, 260 = 4, 000. . . (1, 540) 5, 060 26 -Jun 592. 30 1060 3, 400. . . 0 14

Example of a Futures Trade The long futures position is also used when a manufacturer wishes to lock in the price of a raw material that he will require sometime in the future. The short futures position is also used by a producer to lock in a price of a commodity that he is going to sell in the future Suppose June Crude Oil futures is trading at $40 and each futures contract covers 1000 barrels of Crude Oil. A futures trader enters a long /short futures position by buying 1 contract of June Crude Oil futures at $40 a barrel. ◦ Scenario #1: June Crude Oil futures rises to $50 ◦ Scenario #2: June Crude Oil futures drops to $30 15

Trading Pit/ Trading Floor/Dealing Rooms 16

Pit Reporting For each contract month, the board shows: ◦ The range of opening price(The highest and lowest prices of a security during the first few minutes ◦ The highest/lowest price ◦ The estimated trading volume ◦ Recent seven prices/Last recorded Price ◦ Previous day settlement price ◦ The high/low for the year Examples of markets which use this system in the United States are the New York Mercantile Exchange, the Chicago Board of Trade, and the Chicago Board Options Exchange. In the United Kingdom, the London Metal Exchange still makes use of open outcry. Now we are using automated future trading system under which buyer & seller would 17 be matched by a computer(electronic system)

Some Terminology Types of Trader: Commission brokers & Locals Types of Orders: ◦ ◦ ◦ ◦ Market Order Limit Order Stop Loss Order/Stop limit order Market if touched Order(MIT)-profit taken Market not held Order Time-of-day Order Open Order or Good-till-canceled Order Fill or kill Order 18

Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 19

Regulation of Futures At present, there are three tiers of regulations of forward/futures trading system exists in India, namely, Government of India, Forward Markets Commission and Commodity Exchanges. The FC(R) Act, 1952 prohibits options in commodities. For the purpose of forward contracts in certain commodities can be regulated by notifying those commodities u/s 15 of the Act; forward trading in certain other commodities can be prohibited by notifying these commodities u/s 17 of the Act. Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups 20

Forward Contracts vs Futures Contracts TABLE 2. 3 (p. 39) FORWARDS FUTURES Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Settled at end of contract Delivery or final cash settlement usually occurs Some credit risk Range of delivery dates Settled daily Contract usually closed out prior to maturity Virtually no credit risk 21

Questions When a new trade is completed what are the possible effects on the open interest? 22

Answer A trade can increase open interest, decrease open interest, or leave open interest unchanged. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both 23

Questions Can the volume of trading in a day be greater than the open interest? 24

Answer Volume measures the pressure or intensity behind a price trend, Open interest measures the flow of money into the futures market. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day. Open interest can help you determine whethere is unusually high or low volume for any particular option. 25