The Futures Contract
A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price. All of the terms under which the commodity, service or financial instrument is to be transferred are established before active trading begins, so neither side is hampered by ambiguity. The price for a futures contract is what’s determined in the trading pit of a futures exchange
Random Length Lumber
Take the Random Length Lumber futures contract which trades at the Chicago Mercantile Exchange (CME) as an example. The contract quantity is already determined (110,000 board feet). So is the quality of the Lumber (grade stamped Construction and Standard, Standard and Better, or #1 or #2 2X4’s of random lengths from 8 feet to 20 feet).
The delivery date of the contract is already decided too. That’s when the contract matures. There are six different Lumber futures contracts traded each year, each with a specified delivery date — February, March, May, July, September and November. So when you buy a March Lumber contract, you know the contract matures in March.
The delivery points for Random Length futures contracts are also known. That means if you make or take delivery of 1 Lumber contract (equivalent to 80,000 board feet of Lumber) when the delivery date arrives, you know exactly to which warehouses you can send your truck. (For many commodities, there’s a cash settlement instead of delivery of the actual commodity.)
Here’s an interesting point to remember. Most people who buy and sell Random Length Lumber futures don’t deliver or pick up a load of lumber when the contract matures. They usually offset the trade and get out of the market before that point. They don’t really want the Lumber. They’ve traded the futures contracts for other reasons such as protection against rising or falling lumber prices or simply earning a profit on the trade.
The Futures Exchange
Futures contracts are traded at a futures exchange and only at a futures exchange. The Chicago Mercantile Exchange (CME), like the other exchanges in the U.S., is an organization that provides a place to trade, formulates rules for trading and supervises trading practices.
Chicago’s continued innovation has been a major reason for the growth of its exchanges. This innovation has not only taken the form of new products but includes new technologies. For example, since 1992, the CME extended overnight trading sessions for CME financial futures through GLOBEX® Trading System. CME members and CME-approved traders around the world can trade CME financial and selected currencies and equity index instruments on this computerized system throughout the night until the next day’s pit session opens again.
The Clearing Function
One of the most important functions of a futures exchange is to provide a clearing operation. At the CME, this operation is called the Clearing House. The Clearing House is responsible for clearing trades and for the day-to-day settlement. What does that mean? Well, the Clearing House records all the trades happening in the trading pits each day. At the end of the trading session, it matches or reconciles contracts bought and sold.
The Clearing House also settles the traders’ accounts to the market each day. When you buy or sell a futures contract, the exchange requires you to put up a performance bond. That’s a cash deposit to cover any loss your investment may incur. Money is added to your performance bond balance if your position earned a profit that day. However, if your position lost money that day, money is subtracted from the balance. And you may get a call to put more money into the account. The Clearing House figures that out.
Is trading at the exchanges regulated?
Yes, the federal government and the exchange both play a role in regulating trading. Federal law started regulating futures trading in 1923. The Trade Commission Act of 1974 created the Commodity Futures Trading Commission (CFTC), an independent federal body that oversees all futures trading. The National Futures Association (NFA) was created to regulate the activities of brokerage houses and their agents. These measures guarantee the integrity of the markets.
Contracts Traded
The Chicago Mercantile Exchange (CME) actually started out in 1874 as the Chicago Produce Exchange, which traded in butter, eggs, poultry and other farm products. By 1919, the CME had grown and gotten its current name. Since then the commodities traded have changed. Many products have been added and others are no longer traded.
Agricultural Commodity Futures
One group of commodities traded at the CME are agricultural. Modern expansion of the CME started in 1961 when Frozen Pork Bellies futures were introduced, soon to be followed by Live Cattle and Live Hog futures. Today, there are futures contracts for Feeder Cattle, Lean Hogs, and Random Length Lumber too. The latest agricultural futures contracts to be introduced include the Fluid Milk and Butter contracts.
Foreign Currency Futures
A number of foreign currency futures are traded at the CME. Currency futures are quoted as U.S. dollars against the currency. That tells you the number of dollars it takes to buy one unit of foreign currency. For example, dollars per Japanese yen, dollars per Deutsche mark or dollars per British pound. In addition to those foreign currencies just named, futures on the Australian dollar, Canadian dollar, French franc and Swiss franc are also traded. The latest foreign currency futures added to the CME are those from emerging nations such as the Mexican peso and the Brazilian real.
Interest Rate Futures
The CME also trades interest rate products like 13-week and 1-year U.S. Treasury Bills. People can profit from trading interest rate futures by correctly predicting upward or downward interest rate changes.
The CME also trades Eurodollars, which are U.S. dollars on deposit with banks outside the country. The futures contract reflects the offered interest rate for a 3-month $1 million deposit.
Other interest rate products include the Brady Bonds (Mexican Par, Argentine FRB, Brazilian C, and Brazilian EI Bonds), Federal Funds Rate, and LIBOR futures. LIBOR stands for London Interbank Offered Rate, an interest rate dealing in Eurodollars between commercial banks in the London Interbank Market. The CME’s LIBOR contract is for a 1-month $3 million deposit.
Equity Index Futures
The fourth type of futures contracts at the CME is made up of equity index futures. One example is the Standard & Poor’s 500 Stock Index futures contract. The actual S&P Stock Index is based on 500 companies, about 80% of the value of all the stocks listed on the New York Stock Exchange. The CME’s contract size is $500 times the S&P Stock Index. People can trade these futures contracts to protect stock investments.
As you can see from the great number and variety of contracts traded at the CME, a lot has changed since 1874.
There are other financial and commodity futures vehicles traded as well on various exchanges throughout the world. They include: ENERGY (crude oil, heating oil, natural gas, unleaded gas, ect.), METALS (gold, silver, copper, platinum, palladium, ect.), GRAINS (soybean complex, corn, wheat, oats, rice, ect.), SOFTS (cotton, coffee, sugar, cocoa, orange juice, ect.).
Supply & Demand
The price of agricultural commodities fluctuate, foreign exchange rates change from minute to minute, interest rates and equity indexes rise and fall. Nothing stays the same.
Supply
Supply is defined as the quantity of a product that sellers are willing to provide to the market at a given price. When prices are high, sellers are willing to provide larger amounts of their products to the market. It’s human nature. When prices are low, sellers are willing to provide smaller amounts to the market. This relationship between product supply and its price is called the law of supply.
Many economic factors can cause supply to increase or decrease, and that causes the supply curve to shift. But let’s talk real life. When cattle prices are low, there’s not much incentive for cattle producers to provide cattle to the market. If cattle prices rise, so does the incentive to provide more cattle. Other things can happen to affect supply. The price of feed may be low, encouraging more cattle production, or too high, causing producers to cut back on production. Each commodity has its own supply factors — even currency, interest rate and equity stock index products. But supply is only half the story.
Demand
Demand is defined as the quantity of a product that buyers are willing to purchase from the market at a given price. When prices are high, buyers are willing to buy less of the product. When prices are low, buyers are willing to buy greater quantities of the product. This relationship between product demand and its price is called the law of demand.
Many economic factors can cause demand for a product to increase or decrease, causing the demand curve to shift. You can imagine how the demand for beef can change depending on its supermarket price or how people feel about eating beef. And it’s fairly easy to see how economic conditions could change the demand for credit or the demand for a foreign currency. Each commodity has its own demand factors.
And the market price?
The price of a product or a commodity depends on the relationship between supply and demand. If the supply and demand curves are placed on the same graph, the point where they intersect is the product’s market price. Based on all the supply and demand factors, this is the price discovered as people buy and sell the commodity or trade futures.
Fundamental Analysis
Fundamental analysis is the study of the factors that effect supply and demand. The key to fundamental analysis is to gather and interpret this information and then to act before this information is incorporated into the futures price. This lag time between an event and its resulting market response presents a trading opportunity for the fundamentalist.
Agricultural Fundamentals
For livestock, the fundamental trader studies both supply and demand. The U.S. Department of Agriculture releases several monthly and quarterly reports that supply statistics. Inflation, consumer tastes, consumption patterns and population numbers all affect the demand for meat. The fundamental trader puts all these factors into sophisticated models to try to determine where livestock prices are going.
Financial Fundamentals
As you would expect, trading financial futures calls for a study of entirely different supply and demand factors. The overall health of the economy is a key factor to watch. Economic reports such as the Leading Indicator Index, Consumer Price Index, Gross National Product and the Employment Situation are only a few of the reports providing information.
For example, changes in the economy’s direction normally signals major interest rate turning points. This is obviously important to anyone trading interest rate futures such as U.S. Treasury Bills. The demand for money rises during economic expansion, causing interest rates to rise. Likewise, the demand for money falls during economic recession, causing interest rates to fall. The fundamentalist can also study the relationship of long-term and short-term interest rates to predict the direction of interest rate movement.
Technical Analysis
This approach to price prediction is based on the premise that price movements follow consistent historical patterns. Those who engage in technical analysis study charts or statistics that measure price movements and try to find repetitive patterns. They start with the basic bar chart that plots high, low and closing prices of a futures contract over the life of the contract. Current activity is watched carefully for familiar patterns of price movement.
The up-trend, down-trend and sideways trend patterns experienced in the past can alert a chartist to such a movement forming in the current market.
The chartist also watches daily volume numbers (the number of contracts traded each day) and open interest numbers (the number of contracts not yet offset). These numbers are used to assess the strength of a trend.
What patterns does a chartist look for?
As the days during the life of a futures contract pass, the chartist watches for price reversal patterns and price continuation patterns. That is, if prices are headed up, are they going to reverse themselves and head down? If prices are headed down, are they going to start moving up? Or will prices keep heading in the same direction ?
Orders in the Pit
A brokerage firm (“house”) that is a member of the Chicago Mercantile Exchange (CME) places orders to buy or sell futures or options contracts for companies or individuals and earns a commission on each transaction. Everyone who trades futures and options contracts must have an account with a brokerage house.
Placing the Order
When you call in an order, you specify the futures contract you want to buy or sell, including the contract month. Each commodity has more than one contract, each one with a different maturity date. For example, there are four Eurodollar futures with maturity dates of March, June, September and December. So if you want June Eurodollars, you have to let the brokerage firm know that. You also say whether you’re buying or selling and how many contracts you want bought or sold. Sometimes you even dictate the price.
The market order is one type of order. When you place a market order, you are asking that order to be filled at the best available price immediately after receipt of the order. You might say, “Buy 2 December Deutsche marks at the market.” After the brokerage firm writes up this order, it’s rushed to the floor broker in the pit who executes it right away.
If you place a limit order, you’re asking the broker to fill the order at a specified price. If you say, “Buy 20 January Lumber at 395 even” ($395.00/thousand board feet), the floor broker can fill the order at 395.00 or any price lower, but not at a higher price. Likewise, if you say “Sell 10 May Lumber at 40 even” ($400.00/thousand board feet), the floor broker can fill the order at 400.00 or any price higher, but not at a lower price.
If the price you state in your limit order isn’t reached during the trading session, your order wouldn’t be filled at all.
A Spread trade is a specialized type of trade involving the simultaneous purchase and sale of two different but related futures contracts. The spread is the price difference between the two contracts.
Spread trading can include trading different delivery months of the same commodity (March Lumber vs. July Lumber) or trading the same months of different futures contracts.
The Trading Pit
This is where it all happens. Futures contracts are traded in trading pits (or transitioning to electronic trade) at the Chicago Mercantile Exchange (CME) and other exchanges. That’s where traders determine futures prices, which change from minute to minute as trading goes on.
What is trading?
In the futures industry, trading means buying and selling futures contracts. If you buy a futures contract at one price and sell it at a higher price, you make money. If you sell it at a lower price than what you paid for it, you lose money. Some people who trade futures are in it to make a profit by trading. Others are producers or users of commodities who are trading futures to protect a sale or purchase price.
The highest bid or lowest offer (the most competitive price) sets the true market value. A trader must “best” or beat that price in order to set a new “best” bid or offer. The seemingly frantic nature of the open outcry system is really about brokers and traders constantly bidding or offering prices that the market will perceive as the true value; and trades will then occur.
Hand signals, as well as vocal open outcry, relay quantity and price information between traders and brokers across the pit. As in any auction situation, a trader’s action or word is a bond. With billions of dollars at stake, each action in the pits is actually a carefully recorded and executed trade agreement. Though seemingly chaotic, what you are witnessing in a futures trading pit are market professionals conducting business at lightning speed for either customers or for personal profit. In markets where prices move rapidly within short periods of time, the speed of trade execution and timely delivery of orders to customers is essential.
Risk Management
The Chicago Mercantile Exchange provides and regulates a marketplace where futures and options on futures are traded. The CME clears, settles and guarantees all matched transactions in CME contracts occurring through its facilities. Furthermore, it establishes and monitors financial requirements for clearing members and sets minimum “performance bond” levels for all CME-traded products. The financial integrity of the CME marketplace is a foremost consideration of the Exchange’s Board of Directors and management.
Risk management and financial surveillance are the two primary functions of the CME’s financial safeguard system. The system is designed to provide the highest level of safety and the early detection of unsound financial practice on the part of any clearing member. The system is constantly being updated to reflect the most advanced risk management and financial surveillance techniques.
The Clearing House is an operating division of the Exchange, and all rights, obligations and/or liabilities of the Clearing House are rights, obligations and/or liabilities of the CME.
The Safeguards – The techniques employed by the CME are comprehensive and specifically designed to:
* prevent the accumulation of losses
* ensure that sufficient resources are available to cover future obligations
* result in the prompt detection of financial and operational weaknesses
* allow swift and appropriate action to be taken to rectify any financial problems and protect the clearing system
Performance Bonds – The CME establishes minimum initial and maintenance performance bond levels for all products traded through its facilities. The CME bases these requirements on historical price volatilities, current and anticipated market conditions, and other relevant information. Levels vary by product and are adjusted to reflect change in price volatility and other factors. Both initial and maintenance performance bonds are good faith deposits to guarantee performance on futures and options contracts. Should performance bonds on deposit at the customer level fall below the maintenance level, Exchange rules require that the account be re-margined at the required initial performance bond level.
The Speculators / The Hedgers
Speculators are people who analyze and forecast futures price movement, trading contracts with the hope of making a profit. Speculators put their money at risk and must be prepared to accept outright losses in the futures market.
Are there different kinds of speculators?
Often times, speculators specialize in particular commodities. If the speculator is a CME member, you’ll find them in their favorite trading pits at the exchange. For example, a private speculator may specialize in Eurodollars and trade only in the Eurodollar pit day after day. Each speculator will trade according to his or her own style. Some traders are scalpers who buy and sell futures contracts quickly when prices move only a fraction of a cent. Others are day traders who will buy and sell throughout the day, closing their position before the session ends. Others are position traders who may hold their positions for days, weeks or months at a time.
Of course, speculators don’t have to be CME members. There are thousands of individuals who trade speculatively through brokerage firms.
The Role of the Speculator
Speculators enter the futures market when they anticipate prices are going to change. While they put their money at risk, they won’t do so without first trying to determine to the best of their ability whether prices are moving up or down.
Speculators analyze the market and forecast futures price movement as best they can. They may engage in the study of the external events that affect price movement or apply historical price movement patterns to the current market. In any case, the smart speculator doesn’t operate blind.
A speculator who anticipates upward price movement would want to take advantage by buying futures contracts.
If predictions are correct, then the contracts can be sold later at a profit. If it’s expected that prices were going to move downward, the speculator would want to sell now and, if all goes as planned, buy back later at a lower price.
Hedger vs. Speculator
All people who trade futures contracts are not speculators. People who buy and sell the actual commodities can use the futures markets to protect themselves from commodity prices that move against them. They’re called hedgers.
The Hedgers
There’s a futures contract for a commodity or financial product because there are people who conduct an active business in that commodity. For example, there’s a Lumber futures contract because there are lumber producers who sell lumber and companies that buy lumber. The hedger plans to buy (sell) a commodity, such as lumber or live cattle, and buys (sells) a futures contract to lock in a price and protect against rising (falling) prices.
Hedging
The producers and users of commodities who use the futures market are called hedgers. Buying and selling futures as a risk management tool is called hedging.
Commodity prices in the cash markets have a fundamental relationship to the futures prices. When the forces of supply and demand shift and drive prices up and down in the cash markets, futures prices tend to rise and fall in a parallel fashion. So, for example, if cattle prices in the cash markets started to rise, the live cattle futures would start to rise in roughly the same way. But not exactly. They don’t tend to move in exact amounts. Hedgers take advantage of this relationship between cash and futures prices.
Hedging is buying or selling futures contracts as a temporary substitute for buying or selling the commodity at a later date in the cash market. We’ll show how that works.
Here’s how hedging works. Let’s take a look at the meat packer. Suppose a meat packer needs to buy cattle in October. Today’s cash price is okay, but what if prices rise? The meat packer can lock in a price on the cattle today, just in case the cash prices do go up between now and October. Protecting an October purchase price can be done by buying October Live Cattle futures contracts. This is called a long hedge.
Who are hedgers?
Well, you know about lumber producers and meat packers. Others are commercial firms or individuals whose businesses concern the same or similar commodities that are traded on the futures markets. They’re both U.S. and international firms, including banks, corporations, pension funds, exporters and importers who need to protect against foreign currency fluctuation, food processors and a great variety of other businesses.
Reading Quotes
Futures — Prices are published for every trading session.
Futures prices are reported daily in major newspapers such as The Wall Street Journal. Following is a brief explanation to help you decipher these listings. Section 2 of The Wall Street Journal contains futures price and volume quotes from the previous trading session. Contracts are grouped into like commodities such as Food and Fiber, Metals and Petroleum, Financial and Livestock and Meat.
Futures Stats
Over 395 million futures contracts were traded on U.S. futures exchanges in 1995. In parentheses, and adjacent to the name of the contract, is the abbreviation of the exchange on which the contract is traded. Each of the contracts shown in The Wall Street Journal listing on the previous page are traded at the CME (Chicago Mercantile Exchange). Let’s use the Live Cattle listing as an example. Just to the right of the exchange abbreviation (CME) is the contract size and the cost per unit. With Live Cattle, a contract represents 40,000 pounds of cattle. The prices quoted are listed as cents per pound (i.e., 67.85 cents per pound).
Each contract maturity or delivery month is listed downward along the left margin. Just next to the settle is the net Change in the closing price from the prior day’s trading session. In this case, the net change is + .40.
The next two columns indicate the Lifetime High and Lifetime Low for the contract. The last item is Open Interest, which indicates the number of open positions in that contract. Remember, when two people trade one contract (one trader buying from a trader selling), that represents one open interest.
At the bottom of each contract heading (under the quotes for that particular commodity) is another line that provides information detailing:
— The estimated volume of contracts trading that day.
— The volume traded in the previous session.
— Total open interest for all contracts in this particular commodity.
— The net change in open interest from the previous trading day.
*Courtesy of CME Group