Futures contract is an agreement to buy or sell an asset at a:
> specific grade,
> quantity or contract size,
> price,
> on a future date,
> delivery type,
> standardized delivery point,
> between parties (firms or individuals)
Futures contract main purpose is price risk management, and not delivery of actual or physical commodity. Market participants often used futures to hedge and trade speculation for profit.
Assets class are natural commodity or man-made financial instruments.
Commodity types and examples of underlying assets:
> Agriculture; Sugar, Corn, Wheat, Coffee, Cocoa, Soybean, Palm oil, Rice
> Metals: Gold, Silver, Copper, Platinum, Palladium, Stainless steel
> Energy: Crude oil, Gasoline, Heating oil, Natural Gas, Fuel oil
> Livestock: Live cattle, Feeder cattle, Lean hogs, Eggs, Milk
Financial instruments and examples of underlying asset:
> Stock index: Dow Jones, S&P 500, Nasdaq 100, Russell 2000
> Bonds: 2-year, 5-year, 10-year, 30-year US Treasury Bonds
> Currency/FX: Euro, Pound, Franc, Yen, Krone, Krona, Peso
> Cryptocurrency: Bitcoin
Futures contracts are not limited to assets listed here.
Futures Trading Participants
Commercials are producers and users of commodity often taking delivery.
Speculators trade brings liquidity to the market often avoids delivery.
Large traders are speculators with large trade size set by regulators.
Exchange is a central marketplace for trading with established rules where buyers and sellers meet to trade, providing facilities to transaction execution.
Futures Commission Merchant (FCM) is a term for commodity broker.
Speculation profits from trading in the right price movement; buy low, sell high, above buy price with more than sufficient gains to cover trading cost. Speculators often do not plan to take delivery and avoid settlement so they liquidate market positions before the last trading day contract expiration.
Hedge is a way to reduce risk of investment from adverse price change.
Normally taking an opposite position from the investment to limit risk.
Commercial business may buy futures to lock in price for cost control.
Diversification in variety of investment is a form of hedging.
It can reduce gains from investment but control against risk exposure.
Hedge can be imperfect with risk. Firms commonly hedge using derivatives.
Futures contract is a Form of Derivatives
Derivatives
Derivatives are financial instruments valued based on underlying asset. 4 forms of derivatives contracts are Forward, Futures, Options, Swaps:
- Forwards:- customized contracts according to 2 parties requirements in trading an underlying asset at a specified price and date often over the counter (OTC) without a structured exchange organization.
- Futures:- contracts in standard specification for 2 parties to buy and sell an underlying asset at a predetermined price and future date, in a structured exchange.
- Options:- contract that gives a right, but not obligation to buy or sell an underlying asset where the option can expire unsettled.
2 types of options may be exchange traded or OTC instruments are:
> Call option is a right to buy.
> Put option is a right to sell. - Swap:- derivative contract between 2 parties exchange financial instruments, that can be any security or cash flows, based on notional principal amount. Swaps are custom created and OTC instruments.
Over the counter (OTC) derivatives is a greater portion of the derivatives market with a greater possibility of counterparty risk.
Counterparty risk is the possibility of parties may default on obligation.
Derivatives traded on regulated exchange are standardized and regulated.
Futures market is a centralized market place with buyers and sellers.
Cash market physical or underlying market) are specific market locations where exchange of physical product for payment takes place.
Futures contract is designed with specifications to match cash market commodities and industry standards.
Futures tend to mean the overall market. There are many types of contracts.
FCM / brokerage often allow traders/customers to leverage.
Leverage
Leverage is borrowed capital to enter a market position.
Leverage can also refer to amount of debt to finance asset.
Firm can use debt financing to invest instead of issuing stock.
Highly leveraged means the account has more debt than equity.
Leverage is borrowed capital to enter a market position.
Leverage can also refer to amount of debt to finance asset.
Firm can use debt financing to invest instead of issuing stock.
Highly leveraged means the account has more debt than equity.
Leverage gives the ability control large sum asset with limited margin, which can magnify returns with a downside risk making it double-edge sword that if unfavourable means magnify loss.
Leverage ratio of 5:1 is $100,000/$20,000 or 20% means trading futures contract worth $100,000 using $20,000.
Margin
Margin is a practise of paying a portion of asset/investment’s price.
Initial margin is deposit required to open an account or enter a trade.
Maintenance margin is sum of money required to hold a trade position.
Margin call is the sum of position and account goes below maintenance margin where trader must deposit money to meet brokerage’s required margin level. If deposit not received in time, brokerage will liquidate the positions, and customer is responsible for loss, trade cost and interest, if any.
Margin account is a brokerage account which the broker lends the customer cash to purchase shares or other financial products like futures or forex. The loan in account is collateralized by the securities purchased and cash, which incurs interest and margin fee. Customer will have a leverage holding.
Risk also stems from uncertainty of future value of the asset.
History
Futures market for trading rice at the Dojima Rice Exchange in Japan 1730.
Traders of futures contract do not own the goods but the obligation to buy/supply the goods. This enables short selling an asset yet to exist.
Market position
Short futures position is an initial sell position that represents an obligation to make delivery of the underlying asset. To close-out or offset or liquidate short selling position is buying the identical contract before expiry.
Long position is an initial buy executed and represents an obligation to settle payment and accept delivery of the contracted asset. Offset by sell.
Open interest (OI) is the number of contracts that have traded but have not been closed out through offset or delivery. Often use to indicate contract’s liquidity or pricing efficiency. OI is for futures market not share market.
Volume is the number of futures contract that are trade in a given period.
Factories secure supply of metals from miners to manufacture appliances such as in The London Metals and Market Exchange that began in 1877.
The Chicago Board of Trade (CBOT) in the United States started in 1848 trading corn futures contract, then wheat and soybeans.
Trading Price
Bid is an expressed price to buy.
Ask or offer is an expressed price to sell.
Tight bid/offer price spread occurs when bids and offers are close together. This reflects on the market’s efficiency and liquidity. Spot price refers to current price which instrument can be bought/sold immediately.
Open price is futures contract price at market open
High price is futures contract highest traded price for the period.
Low price is futures contract lowest traded price for the period.
Close price is the last trading price for the period.
Closing price for a trading day is designated by exchange and applied to futures contract settlement.
Tick is a minimum point price movement.
The value of one tick is stated in the contract specification.
1 tick value is usually smaller than 1 price point value.
E.g., MES contract 1 tick = 0.25 price point = value $1.25
MES contract 1 price point = 4 ticks = value $5
MES is the ticker symbol for Micro ES futures contract.
Bear or bearish reflects lower or declining market prices.
Bull or bullish reflects higher or increasing prices.
Market price is discovered in a futures market from the interaction between supply sellers’ offers and demand buyers’ bids and used in spot market.
Spot (current) market or for cash forward type contracts, are traded for immediate delivery; exchange cash for underlying asset at a future date.
Futures market is actively traded such as airlines buying futures contract of oil when prices are favourable and ensures into the future travel peak. They hedge against higher price for control cost and secure supply as required. If oil prices increase next month then the airline has successfully hedged its risk and seller is obligated to deliver oil at the contract price and expiration of the futures contract. The seller shorting the futures contract was also hedging its position against market price decline which would reduce the seller’s earnings.
Manufacturers buy crude palm oil from producers in Malaysia and Indonesia through regulated exchange such as Bursa Malaysia is another example.
United States exchanges are the most widely traded futures market with two heavily traded futures being U.S. bond and wheat. CME Group comprise of 4 exchanges; CME, CBOT, NYMEX, COMEX, is the world’s leading and most diverse derivatives marketplace.
Contract months are represented in alphabet code:
> January : F
> February : G
March : H
April : J
> May : K
> June : M
July : N
August : Q
> September : U
> October : V
November : X
December : Z
Contract month code is stated after a ticker symbol code, followed by year.
The expression ‘March US Treasury Bond futures contract’ expires in March
On expiry, open position will proceed to settlement.
Settlement by physical delivery or cash settled stated in contract spec.
Settlement usually incurs additional cost like material handling, physical storage, insurance and full payment of contract value.
Traders can avoid settlement by liquidating position before expiration.
Roll forward by closing shorter term / spot contract and open position in a new longer term contract for the same underlying asset.
CME observes 11 US recognized holidays where trading hours may vary often affecting opening and closing times and close early on a holiday eve.
CME Group Holiday Calendar 2021
Dr. Martin Luther King, Jr. : 15–19 January 2021
President’s Day : 12–16 February 2021
> Good Friday : 1–5 April 2021
> Memorial Day : 28 May — 1 June 2021
Independence Day : 2–5 July 2021
Labor Day : 3–7 September 2021
> Thanksgiving : 24–26 November 2021
> Christmas : 23–27 December 2021
New Year’s : 30 December 2021–3 January 2022
Trading hours are set by exchange depending on type of market.
CME trading hours are in U.S. Central Time unless stated otherwise.
In general, these are 3 major times with details at CMEGroup.com.
CME and CBT products submitted via CME ClearPort Clearing, the hours are:
Sunday 5:00 p.m. — Friday 5:45 p.m. CT with no reporting Monday — Thursday 5:45 p.m. — 6:00 p.m. CT
CME OTC FX products submitted via CME ClearPort Clearing, the hours are:
Sunday 6:00 p.m. — Friday 5:45 p.m. CT with no reporting Monday — Thursday 5:45 p.m. — 6:00 p.m. CT
NYMEX and COMEX submitted via CME ClearPort Clearing, the hours are:
Sunday 5:00 p.m. — Friday 4:00 p.m. CT with no reporting Monday — Thursday 4:00 p.m. — 5:00 p.m. CT
Another is the Intercontinental Exchange (NYSE: ICE) ta Fortune 500 company began in 2000 with clearing houses in US, United Kingdom, European Union, Canada and Singapore.
Shanghai Futures Exchange (SHFE) has 196 members, is regulated by China Securities Regulatory Commission (CSRC), lists 20 futures contracts and 5 commodity options. Other futures exchanges are available.
Singapore International Monetary Exchange (SIMEX) was founded as the first financial futures exchange in Asia in 1984 which later pioneered the first international exchange link with the Chicago Merchantile Exchange (CME) trading the Eurodollar contract on a 24 hour trading system. Also introduce Japanese Yen/US dollar futures. Merging with Stock Exchange of Singapore and Securities Clearing and Computer Services into Singapore Exchange (SGX) in December 1999.
Futures contract are detailed in contract specification and respective exchange’s rulebook.
U.S. futures markets are regulated by the Commodity Futures Trading Commission (CFTC) created by US Congress in 1974 to ensure the integrity of futures market pricing, prevent fraud and abusive trading practises.
The following examines the Risk disclosure (25 pages simplified) from NFA.
Risk Disclosure Statement for Futures Securities Futures Contracts Interpretation
National Futures Association (NFA) in the United States of America is designated by the CFTC as a registered futures association to safeguard the integrity of the derivatives market, protect investors and ensure members meet regulatory responsibilities.
The disclosure statement discusses the characteristics and risk of standardized security futures traded on regulated U.S. exchanges registered under the Securities Exchange Act of 1934.
The original 25 pages document may be updated from time to time.
1.1. Risk of Security Futures Transactions
Traders can lose money, substantial amount quickly in trading futures. Substantial means more money than your deposit.
1.2. General Risks
Trading security futures contract can lose potentially unlimited.
Be cautious of claims that you can make large profit.
Loss incurred is immediately. Under margin positions are liquidated at loss.
Market conditions can be difficult or impossible to liquidate position.
Conditions such as Computer system fail, Irregular activity, Low volume; can force liquidation at a price with large loss.
Page 2 of NFA’s Risk Disclosure Statement for Security Futures Contract:
Certain market condition can limit you from trading an opposite position in another contract month, market or underlying security to manage trader’s risk. Section 4.
Certain market conditions may not get traders customary trading price.
Illiquid or insufficient trade volume, market is closed, report delayed, trading halted or delayed in some or all of the securities of the index.
Holding position until expire last trading day end requires to settle with physical delivery, with additional costs. Section 5.
System failure can result in loss.
Security futures contracts involve risk despite strategy.
Know securities and the futures markets.
Page 3 of 25:
Day trading strategies pose special risks.
Day trading is buying and selling the same contract in a day.
Risk includes substantial commissions, exposure to leverage and competition from professional traders. Section 7.
Contingent order: “stop-loss” or “stop-limit” do not limit to intended loss. Market conditions may make it impossible to execute the order or stop price.
Read and understand customer account agreement with your brokerage firm before entering into any transactions.
Regulatory protections depend on the contract traded through securities or a futures account. Firms are required to disclose the differences between securities account and futures accounts. Customer can elect account type.
Page 4: Section 2 — Description of a Security Futures Contract.
2.1. What is a Security Futures Contract?
Security futures contract is a legal agreement by 2 parties to trade buy or sell an ‘asset’ in the future at a specific quantity at a certain price.
‘Asset’ is an underlying securities that may be shares of a security or component security index.
Future is at the expiration date of the contract.
Price that contract trades (contract price) is determined by relative buying and selling interest on a regulated exchange.
Long a contract is to buy a security futures contract with obligation to purchase an underlying security.
Short or short-sell is entering a contract to sell an underlying asset. To settle a short position requires a buy order.
Entry into a security futures contract requires fund deposit with brokerage firm usually 20 percent of contract’s market value. Futures contract are settled daily at close of trading day at daily settlement price. Section 3
Open position can be a long or short position that can be closed or liquidated by an offsetting transaction prior to contract expiration, at an equal and opposite transaction to the open position. This prevents settlement obligation of physical delivery and additional cost.
Long position liquidates by selling identical contract and quantity.
Short position settles by buying identical contract and quantity.
Some security futures contracts are settled by physical delivery of the underlying security, at expiration, paying the final settlement price set by regulated exchange or clearing organization, and take/send delivery of the underlying security/share.
Other security futures contracts are settled through cash settlement, according to the final settlement price by the exchange or clearing organization, without physical delivery. Section 5.
Page 5 of 25
2.2. Purpose of Security Futures
Speculation, Hedge, and Risk management.
Not provide capital growth or income.
Speculation
Speculators are firms or individuals seeking to profit from futures price increase or decrease. Buy low, sell high, return more than cost of trade.
Example (E.g.,):
Trader A buy a contract at $50 with 100 shares per contract
Trader B sells a contract at $50 with 100 shares per contract
> Price of XYZ at liquidation : $55
> Trader A profit/loss : $500
> Trader B profit/loss : -$500
> Price of XYZ at liquidation : $50
> Trader A profit/loss : $0
> Trader B profit/loss : $0
> Price of XYZ at liquidation : $45
> Trader A profit/loss : -$500
> Trader B profit/loss : $500
Spread trade hopes to profit from an expected change in price relationships.
Spreader buy contract expiring in 1 contract month and sell another contract on the same underlying security in different month.
E.g., buy June, sell September of XYZ single stock futures = calendar spread.
Spread buy and sell on same contract month in 2 different but economically correlated security futures contracts
E.g., speculator believe ABC has stronger growth than XYZ, buy June ABC futures contract and sell June XYZ futures contract of 100 shares each.
Trader A scenario:
Opening position: Buy ABC at 50 at 100 shares per futures contract
> if Price at liquidation: $53
> Gain $300
Opening position: Sell XYZ at 45 at 100 shares per futures contract
> if Price at liquidation: $46
> Loss $100
= Trader A’s net gain: $300 - $100 = +$200
Trader B scenario:
Opening position: Buy ABC at 50 at 100 shares per futures contract
> if Price at liquidation: $53
> Gain $300
Opening position: Sell XYZ at 45 at 100 shares per futures contract
> if Price at liquidation: $50
> Loss $500
= Trader B’s net loss: $300 - $500 = -$200
Arbitrage similar to spread except that the long and short positions occur on 2 different markets. Arbitrage position in a security futures contract on another exchange taking an option contract or underlying security.
Page 6:
Hedging
Hedge is to buy or sell a security future to reduce or offset the risk of a position in the underlying security (or close economic equivalent).
Hedger gives up potential profit from favourable price change in the position being hedged in order to minimize the risk of loss from adverse price change.
E.g., Trader has 1,000 shares of ABC that has increased.
Sell now at $50 per share is profit but trader wants to collect dividend.
Trader can sell ten 100-share ABC futures contracts then buy back later when trader sells the stock, assuming the stock price and futures price change by same amount, the gain or loss in stock will be offset by the loss or gain in futures contracts.
Price later September: $40
Value of 1,000 ABC shares: $40,000
Gain or Loss on Futures: $10,000
Effective Selling Price: $50,000
Price later September: $50
Value of 1,000 ABC shares: $50,000
Gain or Loss on Futures: 0
Effective Selling Price: $50,000
Price later September: $60
Value of 1,000 ABC shares: $60,000
Gain or Loss on Futures: -$10,000
Effective Selling Price: $50,000
Hedging to lock a price now in anticipation of purchase at later date.
E.g., Mutual fund plans to buy stocks in glove company using proceeds of bonds that matures in August. Mutual fund can buy security futures contracts on a narrow-based index of stocks from that industry. Come August, buy stocks and liquidate security futures of index position.
If the relationship between the security futures contract and the stocks in the index is constant, the profit or loos from the futures contract will offset the price change in the stocks, and lock in the value of stocks selling then.
Hedging can mitigate risk but do not eliminate all the risk.
E.g., Relationship between the price of futures contract and price of the underlying security tend to remain constant but it can vary. Expiration or liquidation of futures contract may not coincide with the exact time of hedging buy or sell of the underlying stock.
Page 7 of 25:
Risk Management
Institutions can manage portfolio risks without changing portfolio by taking a futures contract position opposite to some/all of its securities. The risk greater than traditional hedge because it does not substitute for an anticipated purchase or sale.
2.3. Where Security Futures Trade
Security futures contract must trade on a regulated U.S. exchange subject to regulation by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
Security futures contracts traded on one regulated exchange may not fungible / exchangeable with security futures contract on another regulated exchange for various reasons:
> Contract terms (E.g., size, settlement method) differs,
> Different clearing organization,
> Regulated exchange may not permit it.
Listing standards are required by law.
Changes in underlying security may result in contract not to meet standards.
Exchange has rules to trading that no longer meet listing standards.
“Regulated exchanges that trade security futures contracts are required by law to establish certain listing standards. Changes in the underlying security of a security futures contract may, in some cases, cause such contract to no longer meet the regulated exchange’s listing standards. Each regulated exchange will have rules governing the continued trading of security futures contracts that no longer meet the exchange’s listing standards. These rules may, for example, permit only liquidating trades in security futures contracts that no longer satisfy the listing standards.”
Page 8:
2.4. How Security Futures differ from the Underlying Security
(Contract different from Asset/Security)
Company shares represent a fractional ownership interest in the issuer of that security. Ownership of securities confers various rights (E.g., vote, dividend, reports) that are not in security futures contracts.
Section 8.1 on corporate events on security futures contract.
Security futures contracts are marked-to-market daily, usually after close of trading (Section 3) which credits any gains or debits any loss based at end of day / daily settlement price.
Shareholder only gets credit/debit when position is closed out.
Long security futures contract holders are required to deposit additional funds as the contract price decrease against position. Short position price increase requires deposit into account according to mark-to-market.
Security futures contracts expire by date.
Open position not liquidated requires contract settlement through physical delivery or cash settlement. Cash settled contract result no economic interest in securities underlying the security futures contract.
Page 8–9 of 25:
2.5. Comparison to Options
Options contract Buyer have the Right but not Obligation to buy/sell the security (listed in options) prior to expiration date.
Options contract Seller have Obligation to buy/sell the security prior to expiration date.
Security futures contract long/short have right and obligation to buy/sell the security at a future date. Trader can liquidate futures contract position with an offsetting contract.
Options contract buyer can lose the entire paid buying price (premium) if not options contract liquidated in secondary market or exercise at/prior to expiration because it is a wasting asset. Lost limited to premium.
Options contract seller can receive premium (short sell price) and assumes the risk required to buy/sell the underlying security on/prior expiration, in which losses may exceed premium received.
Options contract sellers are required to deposit margin to reflect the risk of its obligation.
Security futures contract trader enters agreement to buy/sell specific quantity of underlying security. Based on price movement of underlying security, holding a position in futures contract can gain/loss more than initial margin deposit.
Risks of security futures contract are similar to risk of selling an option.
Security futures contract trader have daily margin obligation mark-to-market, may be called to meet margin requirement or receive credit of funds on its open position in security futures contract.
E.g., Trader A and B anticipate XYZ stock price increase from $50 a share.
Trader A buy XYZ 50 call options (100 shares at premium of $5 per share). Option premium is $500 ($5 per share x 100 shares)
Trader B buy XYZ security futures contract (100 shares of XYZ), value at $5000 ($50 share value x 100 shares). Margin required $1000 (20% contract value)
Price of XYZ at expiration: 65
Trader A profit/loss (options): 1000
Trader B profit/loss (futures): 1500
Price of XYZ at expiration: 60
Trader A profit/loss (options): 500
Trader B profit/loss (futures): 1000
Price of XYZ at expiration: 55
Trader A profit/loss (options): 0
Trader B profit/loss (futures): 500
Price of XYZ at expiration: 50
Trader A profit/loss (options): -500
Trader B profit/loss (futures): 0
Price of XYZ at expiration: 45
Trader A profit/loss (options): -500
Trader B profit/loss (futures): -500
Price of XYZ at expiration: 40
Trader A profit/loss (options): -500
Trader B profit/loss (futures): -1000
Price of XYZ at expiration: 35
Trader A profit/loss (options): -500
Trader B profit/loss (futures): -1500
Trader A risk $500 of option premium
Trader A breaks even at $55 per share, gain at higher prices.
Trader B may lose more than initial margin deposit.
Margin on futures contract is not cost but a performance bond.
Gain/Loss depends on settlement price.
Price $35 means Trader A lose $500 and B lose $1500 (5000 -(35 x 100))
Page 10:
2.6. Components of a Security Futures Contract
Ask broker for a copy of Contract Specification according to exchange.
2.6.1. Size of a security futures contract x Price = Value of contract.
E.g., Futures contract for single stock may be 100 shares of stock.
Narrow-based security indices: Price of component securities x Multiplier set by exchange in contract terms = Value of contract.
2.6.2. Expire at set times.
E.g., Third Friday of expiration month.
Liquidate open position before expiration or settle in cash/ delivery cost.
2.6.3. Contract specifications of security futures contract differ in each regulated exchange even though same underlying security.
Price vary because of different contract specifications by each exchange.
2.6.4. Prices of security futures contracts are usually quoted the same way prices are quoted in the underlying instrument.
E.g., contract quoted in dollars and cents per share.
Contracts for indices quoted by index number, usually 2 decimal places.
2.6.5. Tick is minimum price fluctuation of security futures contract.
E.g., Tick size of 1 cent for contract will price #23.22 not $23.215
Page 11 of 25:
2.7. Trading Halts
Regulated exchanges are required to halt trading by law in some instances. Trading halt can be in security futures contract or underlying security. The value of traders’ position in futures contracts can be affected.
Examples of trading halt are:
- pending news
- regulatory concerns
- market volatility
- underlying security index halted requires security futures contract halt if securities account for 50% of the market capitalization of the index.
- futures halt when S&P 500 Index declines 7%, 13% and 20% in 1-day
- regulated exchange discretion to halt trading in other circumstances — such as to maintain a fair and orderly market.
Traders cannot liquidate position during trading halt.
2.8. Trading Hours
Open and close for trading times differ between regulated exchanges. May also differ from market trading for underlying securities.
Trading before open or after close may be less liquid than regular market hours.
Page 12: Section 3 — Clearing Organizations and Mark-to-Market Requirements
Regulated U.S. exchange trading security futures contracts are required to have a relationship with Clearing organization that serves as the guarantor of each security futures contract traded on that exchange.
Clearing organization functions:
- matching trades,
- effecting settlement and payments,
- guaranteeing performance, and
- facilitating deliveries.
If an account with brokerage firm is not a member of the clearing organization, then the brokerage firm will carry the security futures position with another brokerage firm that is a member of the clearing organization.
Trade records that do not match must be resolve before/on the open of next trading morning. Clearing organization assumes legal and financial obligations of reported transactions that have been verified.
Clearing organization role is the “buyer to every seller and the seller to every buyer.” Counterparty to every transaction enables traders to liquidate position without regard to the other party decides to do.
Clearing organization effects daily settlement paying/receiving the difference between current price and previous day’s settlement price to/from clearing members, depending on conventions and market conditions. Clearing organization assumes legal and financial obligations for each security futures contract which ensures payments are made promptly to protect its obligations.
Daily settlement mark-to-market reflects on trader’s account daily. If daily settlement price rises, buyers gain and sellers loss. If daily settlement price decline, buyers lose and sellers gain, on security futures contracts. (Settle daily)
Page 13: E.g., Buy price $120
Daily settlement value: $125
Buyer’s account: $500 gain (Credit)
Seller’s account: $500 loss (Debit)
Daily settlement value: $117
Buyer’s account: $300 loss (Debit)
Seller’s account: $300 gain (Credit)
Open trade equity = cumulative gain/loss on trader/customer’s open security futures positions; often listed as a separate component of account equity in a/c statement.
Role of clearing organization in effective delivery (Section 5)
Page 14: Section 4 — Margin and Leverage
Margin = cash deposit down payment by trader/customer to trade a security.
Margin deposit also referred to as a “performance bond”.
Security futures contract is an obligation and not asset.
Security futures contract has no value as collateral for a loan because the potential for a loss as a result of daily marked-to-market.
Margin are set by exchange subject to minimum set by law.
Basic margin required is 20% of current value of security futures contract.
Margin call = request for additional margin to be deposit into account.
Brokerage firms require higher than exchange requirements.
Brokerage’s “House” margin requirement can be increase without notice.
Required margin can be made for next day or same day.
Brokerage may have special request for deposit certified, wire transfer, or cashier’s check/cheque. Read and understand brokerage’s customer agreement before entering transactions in security futures contracts.
Loss in account of security futures contract can also be incurred through daily settlement process, reducing funds on deposit (equity) below maintenance margin or house margin requirement, requires additional deposit.
Additional margin not deposited according to brokerage’s policies means, brokerage can liquidate customers/traders’ position to cover margin deficiency. Customer/trader remains responsible for shortfall in account after liquidation. Customers are not entitled to choose which futures contract to liquidate to meet margin call or obtain extension time.
Brokerage reserve the right to liquidate customers/traders’ security futures contract positions or assets to meet margin call any time without contacting customer.
Brokerage may also enter into equivalent but opposite positions for your account to manage risk created by a margin call.
Even if brokerage notified customer of margin call and set date for deposit, brokerage can still take action as necessary to protect its financial interest, including liquidating positions before set date.
Page 15:
E.g., trader buy 3 July EJG futures @ 71.50 each contract 100 shares.
Nominal value of position is $21,450 (71.50 x 3 contracts x 100 shares)
If margin rate is 20% of nominal value, margin required = $4,290
Next day settlement price 69.25
Mark-to-market loss is $675 (71.50–69.25 x 3 contracts x 100 shares)
Trader’s equity = $3,615 ($4,290 — $675) decrease from $4,290
Nominal value now is $20,775 (69.25 x 3 contracts x 100 shares)
Maintenance margin rate 20% requires $4,155
Trader’s equity $3,615 — $4,155 = $540 additional margin required.
Alternative next day settlement price is 75.00
Mark-to-market gain is $1,050 (75–71.50 x 3 contracts x 100 shares)
Trader’s equity = $5,340 ($4,290 + $1,050) increase
Nominal value now is $22,500 (75 x 3 contracts x 100 shares)
Maintenance margin rate if at 20% requires $4,500
Trader/customer’s equity $5,340 — $4,500 = $840 in excess equity.
Short position higher settlement price will incur margin call and deposit.
Leverage = margin required is a fraction of nominal value of contract.
Higher leverage = margin requirement is smaller in relation to contract.
Leverage allows exposure to underlying asset for a fraction of investment needed to buy the quantity outright. Security futures contract trading provides the same monetary profit and loss outcomes as ownership (or shorting) the underlying security.
Page 16:
E.g., Security futures contract price of $50.
Nominal value is $5,000 (if contract is for 100 shares).
Margin requirement may be as low as 20% (which is $1,000)
Contract price rise from $50 to $52 increase nominal value is $200.
$200 represents profit to buyer of the security futures contract.
$200 is 20% return on $1,000 margin.
If price fall to $48, buyer lose $200 or 20% to $1,000 margin.
Leverage can benefit or harm traders/investors.
4% decrease in futures contract value resulted in loss of 20% of margin.
20% decrease will wipe out 100% of margin on security futures contract.
Page 17: Section 5 — Settlement
Open futures contract position that is not liquidated before the last trading day expiration will be obligated to settle by:
1. Cash settlement = pay or accept cash payment
2. Physical delivery = deliver or accept delivery of underlying security in exchange for final payment of the final settlement price.
Mode of settlement is determined by contract terms.
Expiration listed on contract specification.
On expiration day, security futures contracts cease to exist.
Typically, the last trading day will be 3rd Friday of contract month.
Expiration day will be the following Saturday.
This follows expiration conventions for stock options and broad-based stock indexes. Actual expiration day is set by exchange and deviate from norm.
5.1. Cash settlement
Cash settlement do not have physical delivery of security at expiration.
Cash settlement must be paid or receive cash payment based on the difference between final settlement price and the previous day’s settlement price.
Normal circumstances, final settlement price for cash-settled contract will reflect the opening price for the underlying security. Once payment is made, buyer and seller of the security futures contract has no obligation to the contract.
5.2. Settlement by physical delivery
Physical delivery settlement is carried out by clearing brokers or their agents with National Securities Clearing Corporation (NSCC), an SEC-regulated security clearing agency.
Settlements are made in much the same way as they are bought and sold of the underlying security.
After last trading day, the regulated exchange’s clearing organization will report a purchase and sale of the underlying stock at the previous day’s settlement price (referred as “invoice price”) to NSCC.
If NSCC do not reject the transaction by time specified in its rules, settlement is affected accordingly which is 2 business days or shorter timeframe based on exchange’s rules and NSCC’s Rules and Procedures.
Short positions are required to make delivery of the underlying securities by tendering them to brokerage firm. If trader do not own the securities will be obligated to buy them. Some brokerage may not buy for trader. Trader has to buy from different firm.
Page 18: Section 6 — Customer Account Protections
Positions in security futures contracts may be held in a securities account or a futures account, which brokerage may or may not permit trader to pick. The protections for the funds deposited/earned depends on the positions are carried in a securities account or futures account. Positions in a securities account may not receive protections available for futures account, vice versa. Ask broker which of these protections apply to fund.
https://www.finra.org/sites/default/files/InvestorDocument/p005935.pdf
Regulatory protections do not insure traders against loss as a result of price changes of a security futures contract. Trader is responsible for any market losses in account.
Brokerage firm must inform customers/traders if security futures positions will be held in a securities account or futures account. If brokerage gives customers a choice then brokerage must tell customers what customer have to do to make the choice and which account type to use, if you fail to do so.
6.1. Protections for Securities Accounts
Positions in a securities account are covered by SEC rules.
SEC rules prohibit broker-dealer from using customer funds and securities to finance its business. Broker-dealer is required to set aside funds equal to the net of all its excess payables to customers over receivables from customers. Broker-dealer must segregate all customer fully paid and excess margin securities carried by the broker-dealer for customers.
Securities Investor Protection Corporation (SIPC) also covers positions held in securities accounts. SIPC created in 1970 as a non-profit, non-government, membership corporation, funded by member broker-dealers. Its main role is to return funds and securities to customers if the broker-dealer holding these assets becomes insolvent.
SIPC applies to current (and some cases former) SIPC members.
Most broker-dealers registered with the SEC and SIPC members.
Few that are not must disclose to customers.
SIPC member must display official sign showing membership.
Check at www.sipc.org, call SIPC members department at (202) 371–8300 or
Write to SIPC Membership Department, Securities Investor Protection Corporation, 1667 K Street NW, Suite 1000, Washington, DC 20006–1620.
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SIPC coverage is limited to $500,000 per customer, includes up to $250,000 for cash. E.g., if customer has 1,000 shares of XYZ value at $200,000 and $10,000 cash in account, both security and cash balance would be protected.
E.g.2., if stock holding is $500,000 and cash $250,000, only $500,000 total assets will be protected.
SIPC covers customers who have securities or cash deposit with a SIPC member for the purpose of securities transactions. SIPC do not protect funds placed with broker-dealer just to earn interest. Insiders of the broker-dealer; such as owners, officers, and partners are not customers for the purposes of SIPC coverage.
6.2. Protections for Futures Accounts
Positions in futures account must be segregated from brokerage firm’s funds. Cannot be borrowed or use for brokerage’s own purposes. If funds are deposited with another entity (bank, clearing broker, or clearing organization) then that entity must acknowledge that the funds belong to customers and cannot be used to satisfy the firm’s debts. Different customers funds cannot be used to fund another customer’s margin or guarantee transactions.
Brokerage firm must add its own funds to its customers’ segregated funds to cover customer debits and deficits. Brokerage must calculate segregation requirements daily.
Customer may not recover full amount of funds if brokerage firm becomes insolvent and insufficient funds to cover its obligations to all of its customers.
Customers with segregated funds receive priority in bankruptcy proceedings.
All customers with segregated funds have same priority in bankruptcy and, there is no ceiling amount of funds that must be segregated for or can be recovered by a particular customer.
Brokerage firm is required to separately maintain funds invested in security futures contracts traded on a foreign exchange. These funds may not receive the same protections once they are transferred to a foreign entity (foreign broker, exchange or clearing organization) to satisfy margin requirements for respective products.
Ask broker about bankruptcy protections in the country the foreign exchange (or entity holding funds) is located.
Page 20: Section 7 — Special Risks for Day Traders
Day trading security futures contracts requires in-depth knowledge of the securities and futures market and of trading techniques and strategies.
> Compete against professional traders can risk losses.
Day trading security futures contracts can result in substantial commission charges, even if the per trade cost is low.
> More trades incur higher total commission.
> Commissions add to losses and reduce profits.
E.g., Round-turn trade cost $16 x 29 round-turns per day = requires $111,360 annual profit to cover commission expenses.
Day trading can be extremely risky.
> Not for people with limited resources, limited investment or trading experience, and low risk tolerance. Trader should be prepared to lose all the funds use for day trading. Do not fund day trading with indispensable money.
Page 21 of 25: Section 8 — Other
8.1. Corporate Events
(Section 2.4) Equity security represents fractional ownership interest in the issuer of that security.
Security futures contract is a contract for future delivery of underlying security and not ownership. No dividend and other corporate events, depending on clearing organization rules.
Common types of adjustments to consider:
Stock splits enable owners to own more share of the stock.
Reverse stock splits reduce quantity of share of owners.
Security futures contract depends on terms of the contract.
Special dividend is cash dividend payment outside normal customary practice. Terms of security futures contract may be adjusted for special dividends, if any, will be based upon the rules of the exchange and clearing organization. In general, no adjustments for ordinary dividends as its customary and already accounted for in the pricing of security futures.
Merger and acquisitions may cause underlying security to change over the contract duration. Security futures contracts may also be adjusted to reflect other corporate events affecting the underlying security.
8.2. Position Limits and Large Trader Reporting
Position limit restrict quantity of security futures contracts that any one person/group may hold/control.
Position accountability limit permits the accumulation of position in excess of the limit without prior exemption.
Position limits and position accountability limits are beyond the thresholds of most retail investors/traders.
Security futures contract is subject to position limits and the level for such limits depends on the trading activity and market capitalization of the underlying security of the security futures contract.
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Position limits also apply only to an expiring security futures contract during its last 3 trading days. Regulated exchange must establish a default position limit on a security futures contract that is no greater than 25,000 of 100-share contracts (or the equivalent if contract size different) either net or on the same side of the market, unless the underlying security exceeds 20 million shares of estimate deliverable supply, in which case the limit may be set a level no greater than 12.5 percent of the estimated deliverable supply of the underlying security, either net or on the same side of the market.
Security futures contract on a security with a 6-month total trading volume of more than 2.5 billion shares and more than 40 million shares of estimated deliverable supply, a regulated exchange may adopt a position accountability rule in lieu of a position limit, either net or on the same side of the market. Under position accountability rules, a trader holding a position in a security futures contract that exceeds 25,000 of 100-share contracts (or equivalent for different contract size) or such lower level specified under the rules of the exchange, must agree to provide information regarding the position and consent to halt increasing mist that position if requested by the exchange.
Brokerage firms must report large open positions held by 1 person (or several persons acting together) to the CFTC and to exchange holding the positions.
CFTC requires reporting of 1,000 contracts of security futures positions on individual equity securities and 200 contracts for positions on a narrow-based index.
Exchanges may require reporting of large open positions at levels less than CFTC.
Brokerage firms must submit identifying information on the account holding the reportable position (on form “identification of Special Accounts Form” or “Form 102”) to the CFTC and exchange no later than the following business day when reportable position is first established.
8.3. Transactions on Foreign Exchanges
U.S. customers may no trade security futures on foreign exchanges until authorized by U.S. regulatory authorities.
U.S. regulatory authorities do not regulate the activities of foreign exchanges and may not enforce the rules to foreign exchanges or country.
8.4. Tax Consequences
For most taxpayers, security futures contracts are not treated like other futures contracts.
Security futures transaction tax depends on the status of the taxpayer and type of position (long or short, covered or uncovered) because of the importance of tax considerations, readers should consult their tax advisors as to the tax consequences of these transactions.
Page 23: Section 9 — Glossary of Terms
For understand but not inclusive and not intended to suggest legal meaning.
Arbitrage — take an economically opposite position in a security futures contract on another exchange, in an options contract, or in the underlying security.
Broad-based security index — security index not within statutory definition of a narrow-based security index. A future on a broad-based security index is not a security future. This risk disclosure statement applies solely to security futures and not broad-based security index. Futures on a broad-based security index are under exclusive jurisdiction of the CFTC.
Cash settlement — a method of settling certain futures contracts by having the buyer (long) pay the seller (short) the cash value of the contract according to the procedure set by the exchange.
Clearing broker — a member of the clearing organization for the contract being traded. All trades and daily profits/losses must go through a clearing broker.
Clearing organization — a regulated entity responsible for settling trades, collecting losses and distributing profits, and handling deliveries.
Contract — 1) unit of trading for a particular futures contract (e.g., 1 contract may be 100 shares of the underlying security)
2) the type of future being traded (e.g., futures on ABC stock)
Contract month / Delivery month — the last month of futures contract with delivery or cash-settled.
Day trading strategy — trading regular transmission of intra-day orders of buy and sell of same security/securities.
EDGAR — the SEC’s Electronic Data Gathering, Analysis, and Retrieval system maintains electronic copies of corporate information filed with the agency. EDGAR submissions may be accessed through SEC’s website: www.sec.gov
Futures contract — 1) agreement to buy/sell a commodity for delivery in the future; 2) at a price determined at initiation of the contract; 3) that obligates each party to the contract to fulfil it at the specified price’ 4) that is used to assume or shift risk; and 5) that may be satisfied by delivery or offset
Hedging — buy/sell a security future to reduce/offset the risk of a position in the underlying security/group of securities (or a close economic equivalent)
Illiquid market — market/contract with few buyers and/or sellers.
Little trading activity and those trades that occur may be done at LARGE price increments.
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Liquidation — offset transaction.
Sell a contract previously purchased liquidates a future position in the same way selling 100 shares of a particular stock liquidates an earlier purchase of the same stock. Futures contract initially sold is liquidated by an offsetting purchase.
Liquid market — market/contract with numerous buyers and sellers trading at small price increments.
Long — 1) buy side of an open futures contract
2) a person who has bought futures contracts that are still open
Margin — money deposited by trader/customer to ensure performance of the person’s obligation under a futures contract. Margin on security futures contracts is a performance bond rather than a down payment for the underlying securities.
Mark-to-market — to debit or credit accounts daily to reflect that day’s profits and losses.
Narrow-based security index — in general, and subject to certain exclusions, an index that has any one of the following 4 characteristics:
1) Index that has nine or fewer component securities;
2) Any one of its component securities comprises more than 30% of its weight 3) Five highest weighted component securities together comprise more than 60% of its weighting; or
4) Lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with 15 or more component securities, $30 million). A security index that is not narrow-based is a “broad based security index”
Nominal value — face value of the futures contract, obtained by multiplying the contract Price by the Number of shares or Units per contract.
If XYZ stock index futures are trading at $50.25 and contract is for 100 shares of XYZ stock, the nominal value of the futures contract would be $5,025.00
Offsetting — liquidating open positions by either selling fungible contracts in the same contract month as an open long position or buying fungible contracts in the same contract month as an open short position.
Open interest — the total number of open long (or short) contracts in a particular contract month.
Open position — a future contract position that has neither been offset nor closed by cash settlement or physical delivery.
Performance bond — another way to describe margin payments for futures contracts, which are good faith deposits to ensure performance of a person’s obligations under a futures contract rather than down payments for the underlying securities.
Physical delivery — the tender and receipt of the actual security underlying the security futures contract in exchange for payment of the final settlement price.
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Position — a person’s net long or short open contracts.
Regulated exchange — a registered national securities exchange, a national securities association registered under Section 15A(a) of the Securities Exchange Act of 1934, a designated contract market, a registered derivatives transaction execution facility, or an alternative trading system registered as a broker or dealer.
Security futures contract — a legally binding agreement between 2 parties to buy/sell in the future a specific quantity of shares of a security (such as common stock, an exchange-traded fund, or ADR) or a narrow-based security index, at a specified price.
Settlement price — 1) the daily price that the clearing organization uses to mark open positions to market for determining profit and loss and margin calls,
2) the price at with open cash settlement contracts are settled on the last trading day and open physical delivery contracts are invoiced for delivery.
Short — 1) the selling side of an open futures contract,
2) a person who has sold futures contracts that are still open.
Speculating — buy/sell futures contracts with the hope of profiting from anticipated price movements.
Spread — 1) holding a long position in 1 futures contract and a short position in a related futures contract or contract month in order to profit from an anticipated change in the price relationship between the two,
2) the price difference between two contracts or contract months.
Stop limit order — an order that becomes a Limit order when the market trades at a specified price. The order can only be filled at the stop limit price or better.
Stop loss order / Stop order — an order that becomes a Market order when the market trades at a specified price. The order will be filled at whatever price the market is trading at.
Tick — the smallest price change allowed in a contract.
Trader — a professional speculator who trades for his/her own account.
Underlying security — the instrument on which the security futures contract is based. This instrument can be an individual equity security (including common stock and certain exchange traded funds and American Depositary Receipts) or a narrow-based index.
Volume — the number of contracts bought or sold during a specified period of time. This figure includes liquidating transactions.
Revised Dec.2002, Dec.2007, Oct.2010, Apr.2015, Oct.2018, August 2020.
End of NFA Disclosure Statement.
Other risks may include trading risk, market risk, currency risk, brokerage risk.
Trading risks is the ability of a trader in making correct trading decisions and actions. Decisions on trend, price analysis, strategy and execution of trades without error. Selecting the right contract, month, quantity, price, order type, advanced settings are execution order. Some even made the news; “Stocks rattled by $617bn ‘fat finger’ trading error …”
Trade execution orders
Check with broker/dealer about trade orders allowed.
The following is demonstrate the sophistication of trading execution order.
Buy or Sell
Entry or Exit : Sell Short (Sell to open). Buy to Cover (Buy to exit short)
All or None : means fill all quantity or none and no partial quantity fills
New, Replace or Cancel
Specify ticker symbol
Specify futures contract month & year
Quantity of unit to trade
Price unless market order
Order type:
Trade order types:
Market order :- Buy Market will enter trade at seller’s ask price
Sell Market enters trade at active buyer’s bid price.
Limit order :- Execute at price or better. E.g. 1 unit using 3800 price:
Buy 3800 Limit — execute when price trade at 3800 or lower e.g. 3799.75
Sell 3800 Limit — execute when price trade at 3800 or higher e.g. 3800.25
Price touch 3800 may or may not be filled. Price breach 3800 to be sure.
Stop order :- Execute as market order if price touch stated price.
Buy 3800 Stop order — price touch 3800 order execute as market’s ask price
Sell 3800 at Stop — price touch 3800 order execute as market’s bid price
Stop Limit order :- Execute as limit order when price trades at stated price
GTC :- (Good till Cancel) attach to trade order where order remains until order is filled or cancelled. Otherwise order is void at active day’s close.
GTD :- (Good till Date) attach to trade order that remains until date.
IOC :- (Immediate or Cancel) attach to trade order for immediate fill or cancel. Partial fills of quantity may occur. Check with broker.
FOK :- (Fill or Kill) attach to trade order to be match in entirety or cancelled. Check order book and position to determine order status.
OCO :- (Order Cancels Order) group 2 orders if 1 fills cancels other order
Bracket order enables trader to enter buy or sell for entry or exit position
OSO :- (Order Sends Order) group orders if main fills secondary follows
Trader can set secondary order to buy additional units or stop loss order.
Other order types may be available depending on brokerage firm, such as stage orders, trailing stops, market if touched (MIT), etc.
Slippage occurs which is trading order price is deviates from intended price. The size of slippage is often more severe in illiquid market.
Market related risks consists of three aspects; Systemic Risk, Secondary Risk and Idiosyncratic Risk.
- Systemic Risk, also known as Market Risk, is the risk of the market trend moving against trader.
- Secondary Risk, or Industrial Risk, is the risk of specific industry trend moving against trader. E.g., crude oil
Secondary risk is address through diversification by in multiple markets in different industry. - Idiosyncratic Risk, or Company Risk, is price of a company or asset moving against trader.
When trading one commodity or company only exposes trader to all three market related risks.
Currency risk appears to foreign trader that has to convert currency to participate in a market.
E.g., Trading the US market from Singapore. Exposing to exchange rate between US dollar and Singapore dollar.
Traders can hedge this risk by purchasing a currency futures or currency swap to lock in a specific rate.
Derivatives has no intrinsic value as its value comes from the underlying asset, which makes derivatives sensitive to market sentiment, supply and demand factors. Supply and demand can cause derivative’s price and liquidity to rise and fall, regardless of the price of the underlying asset.
Brokerage risk is trader’s broker-dealer closes down taking your money with them.
Check brokerage firm’s reputation, financial strength, regulatory listing and FDIC protected.
Visit the NFA BASIC database to check:
- Registration
- Disciplinary or regulatory history
- Financial information
- Registration FAQs at CFTC.gov
Conclusion
Derivatives Futures Contract Trading has risk of losing money quickly, more than trader’s deposit. Read, be informed, aware and consider consequences of the terms, conditions, decisions and actions before you make a commitment.
This post is intended for educational knowledge.
