The Fundamentals of How a Futures Markets Work - Understanding ...

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The Fundamentals of How a Futures Markets Work. (Adapted from Material Presented by the Mid-America Commodity Excchange). Many people wonder how ...

The Fundamentals of How a Futures Markets Work (Adapted from Material Presented by the Mid-America Commodity Excchange)

Many people wonder how business can actually take place in an environment as chaotic in appearance as the trading pits. But through the noise and commotion of the floor, the time-tested system of open outcry insures that orders are executed fairly and efficiently. What Goes on in the Trading Pit, And How Do Speculators Fit In? Speculators play an important role in the futures markets. They assume risk -- risk that already exists for producers and users of commodities or financial instruments. They can be categorized in any number of ways. One type is the position trader -- a trader who initiates a futures or options position, and then holds it over a period of days, weeks, or months in order to profit from long term swings. A day trader, on the other hand, holds market positions only during the course of a trading session. Scalpers are professional traders who trade many times throughout the day, hoping to make a small profit on a large volume of trades. The presence of speculators in the market is essential for producers and users of dairy products to be able to use the futures markets for hedging purposes. Many investors are attracted to the futures market because of leverage which allows control of the full value of a contract for relatively little capital. For example, if you purchase a BFP contract from the CME (200,000 lbs) at $12.00/cwt ($12.00 x 2,000 cwt, or $24,000 for the contract), the required margin might be $1,200 (approximately 5% of the contract value). This capital requirement is not a down payment, but serves as a security deposit to insure contract performance. If the market moves against the position of an investor, there may be a requirement that additional margin be deposited. If the market moves in favor of his position, his account will be credited Many contracts are priced in tick, the smallest amount that the price of the contract can change. For example, in US currency, the smallest unit of exchange is the penny. Similarly, tick size refers to the minimum price increment for a futures contract. The Mechanics of Purchasing a Futures Contracts How are futures contracts purchased or sold? Before we talk about the mechanics of these transactions, it may be useful to outline the types of transctions (orders) that can occur. Market Orders The most common type of order for the purchase is the market order. In a market order, the customer states the number of contracts of a given delivery month he wishes to buy or sell. He does not specify the price -- he simply wants it executed as soon as possible at the best possible price. When a market order is filled, it's usually close to the price that was trading at the time the order was placed. However, in a fast market, the price could be different from when the order was

entered. Limit Orders A limit order has a price limit at which it must be executed. It can be executed only at that price or better. The advantage of a limit order is that the customer knows the worst price he will receive if his order is executed. The disadvantage is that his order might not be filled. Stop Order Stop Orders normally are used to liquidate earlier transactions. As such they are orders that are primarily used by speculators. When a stop order is placed, the customer authorizes his position to be liquidated when some predefined trigger price is reached. Once the market reaches this trigger price, the stop-loss order becomes a market order. This order could be filled at a lower price, rather than the price designated in the order. Stop orders also can be used to enter the market. Suppose a trader expected a bull market only if it passed a specific price level. In this case, he could use a buy-stop order when and if the market reached this point. One variation of a stop order is a stop-limit order. With a stop-limit order, the trade must be executed at the exact price (or better) or held until the stated price is reached again. If the market fails to return to the stop-limit level, the order is not executed. These are just some of the more common orders used; many others exist. Keep in mind that it is at the discretion of the individual brokerage firm and exchange as to which kinds of order are accepted. How do you place an order?

Customer Futures Market The customer, who can be a hedger or a speculator, wants to buy or sell for the purposes of investment or risk management. To place an order, the customer must enlist the services of a broker.



Customer

Broker

Futures Market The broker can be full-service or discount. A full-service broker provides trading advice, whereas the discounter makes trades based solely on the decision of the customer. Customer

Broker

Futures Market

Phone Clerk The phone clerk receives the order from the broker, time stamps it, and hands it to a runner.

Customer

Broker

Futures Market Runner

Phone Clerk The runner takes the order from the phone clerk and delivers it to the floor broker.

Customer

Broker

Futures Market Runner Floor Broker

Phone Clerk

The floor broker, through open outcry, negotiates a buying or selling price with other floor traders. When a price is arrived at, then the order is filled, and the runner returns the executed order to the phone clerk, who then contacts the broker.

Customer

Broker

Futures Market Phone Clerk

Runner Floor Broker

Phone Clerk

Runner

The broker confirms the transaction with the customer.

Broker Customer

Broker

Futures Market Runner

Phone Clerk

Runner

Phone Clerk

Floor Broker

Order complete! Customer

Broker