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The mechanics of futures trading

Kshama Fernandes

Leo Melamed, the founder of the concept of financial futures, in his book Escape to the Futures describes his first glimpse of the world of futures trading: "In total bewilderment, I peered through the glass doors at a scene I had never before imagined. I was Alice stepping through the Looking Glass into a world of not just one Mad Hatter, but hundreds. The shouting among the traders, the movement of their bodies and hands, captivated me like nothing before."

He was of course referring to the 'Eggs and onions futures' trading floor at the Chicago Mercantile Exchange, or CME, in the early sixties. Today, much of the futures trading takes place on electronic exchanges. The excitement, the tempo and the fervour, however, remain undiminished. The leverage and ease of trading futures has added to the growth of the market. The two largest organised financial exchanges in the world, the CME and the Chicago Board of Trade, or CBOT, are futures exchanges. Here, we take a look at how futures trading works.

A futures contract is an agreement to buy or sell an asset for a certain price at a certain time in the future. Once initiated, the contract takes a life of its own and trades in the market just like any other security or commodity. When an exchange develops a new contract, it specifies the asset, the contract size (how much of asset to be delivered under one contract), the place and the time of delivery.

Financial assets underlying futures contracts are generally more well-defined and unambiguous than assets underlying commodities contracts. For instance, the 100-ounce gold futures contract trading on the CBOT has the following asset underlying it: Refined gold in the form of one 100-ounce bar or three 1-kilo bars assaying not less than 995 fineness. The total pack cannot vary from a 100-troy-ounce weight by more than 5 per cent, whereas the currency futures contracts trading on the International Monetary Market, or IMM, merely mention the currency underlying the contract. (There is no need to specify the grade of a Japanese yen or a Canadian dollar!)

The National Stock Exchange's, or NSE's, index futures contracts (one month, two months and three months) will be based on the S&P CNX Nifty, which means that the asset underlying the contract is the portfolio of 50 stocks comprising the index. Unlike commodity futures, where actual delivery takes place at the end of the term specified in the contract, index futures contracts are cash settled. The delivery is actually a cash settlement of the difference between the original transaction price and the final price at the termination of the contract.

The contract size specifies the amount of assets to be delivered under one contract. The size of the contract is an important aspect that could influence the success of the contract in the market. If the size of the contract happens to be too big, investors who would like to hedge away small exposures or take small speculative positions will be unable to use the contract.

On the other hand, if the contract size is too small, trading may turn out to be expensive as the user would incur transaction costs with each contract traded. The S&P index futures contract trading on the CME trades in multiples of 250, i.e. the value of the S&P 500 futures, contract can be calculated by multiplying the futures index price by $ 250. The S&P CNX Nifty futures will be traded on NSE in multiples of 100, i.e. if the current value of the futures index is Rs 1400, the value of one contract would be Rs 1400*100 = Rs 140,000.

The futures price is based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the underlying portfolio minus the present value of dividends obtained from the stocks in the portfolio.

A long-position holder, one who has bought a contract, profits from a rising futures price and contract value, because he could then sell at a higher price to offset or liquidate the position.

A short-position holder, one who has sold a contract, profits from a price decline, because he could then buy in at a lower price to offset or liquidate the position. The gains or losses of a person buying/selling the contract would depend upon the spot index movements from the time he bought or sold the contract till the time he decides to close his position.

For the purpose of ensuring smooth settlement, all index futures contracts are subject to margins by the clearing corporation. Initial margin is the amount that must be deposited with the clearing corporation when the contract is first entered into. This serves as a safeguard against potential losses on outstanding positions and, hence, the amount of exposure that a member can take is based on initial margin deposited by him.

On NSE's index futures market, the computation of initial margin will be done using the concept of 'value-at-risk' and will be large enough to cover a one-day loss that can be encountered on 99 per cent of the days.

The other margin collected by the clearing corporation is the 'mark-to-market' settlement margin. All open futures positions are re-valued or marked-to-market every day and the margin account is adjusted to reflect the investor's gain or loss. This daily settlement process provides for collection of losses as soon as they have occurred. In short, this ensures that the actual daily losses incurred on all open positions are paid up by the losing member and credited to the account of the gaining member on a T+1 (one day after the trade) basis.

For example, if you had gone long on the futures contract at a price of Rs 1,400 and the price rose to Rs 1,410, you would have Rs 1,000 in cash added to your account (Rs10 * 100). If, instead, the price had fallen to Rs 1,380, Rs 2,000 would be deducted from your account. To ensure that the balance in the margin account never becomes negative, a maintenance margin is set, which is a figure somewhat lower than the initial margin. If the balance in your margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level immediately.

The importance of this margining system can seldom be overstressed. It is this margining system followed in the futures markets that ensures that market participants do not sustain losses due to default, and forms the foundation on which rests the future of sound futures markets all over the world.

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

Derivatives Center

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