Chicken farmer example
You are planning to start a chicken farm. After asking around, you find that Red Rooster Chicken is the one which you need to farm as this breed is a local favorite. After calculating the cost of procurement of chicks, and all other costs, you find out that the cost of farming, fully grown Red Rooster Chicken is $3 per chicken. And you know that the market price for Red Rooster Chicken is $5 per chicken. And you can produce only 1000 chicken at a time, which will take 3 months to mature, enough to be sold. After elaborate analysis, you calculate that you can sell the whole lot of Red Rooster Chicken for a profit of $2000. So you invest in the farm and procure chicks. And then you hear the news.
Another brand of chicken, Black Rooster Chicken has come to town, and people have started liking it. As the price for both the brands are the same, you start to panic. If the demand for Red Rooster dips in the next 3 months, the market price for Red Rooster may fall. So you start searching for buyers in advance.
As it turns out, there happens to be a buyer who believes that he can buy your whole lot of Red rooster Chicken when they mature, at $5 per chicken and supply to the next town super market for $8 ( which he of course doesn't tell you ). He believes that after $1 per chicken, cost of transportation and storage, he still can have a profit of $2000 for the whole lot. So both of you enter into a contract, which is a futures contract in its simplest form.
The contract stipulates that, no matter what the market price is, after 3 months, you should sell your whole lot of chicken (1000 Nos) for $5 per chicken, and no matter what the market price is, after 3 months, the buyer should buy your whole lot of chicken (1000 Nos) for $5 per chicken.
After 3 months the story can end in two different ways.
Climax No 1:
What you feared, happened. Market price for Red Rooster Chicken plummeted to $2 per chicken. But the buyer had to buy the whole lot of chicken for $5. You pocketed a profit of $2000 as you had hoped for. What happened to the buyer is another story.
Climax No 2:
The Black Rooster Chicken lasted only for a few weeks. And the Red Rooster Chicken gained in market price to $10, in 3 months time. But, you had to sell your whole lot for $5 per chicken as the contract stipulated. Had the buyer not entered into a contract with you, he would have had to buy the chicken from the local market for $10. And you pocketed a profit of $2000 only.
But you had always known that both scenarios would have worked out. You just wanted to remove the risk of a falling market price. You didn't hope for an exorbitant profit, if the market price gained to $10. This strategy of minimizing the risk is called hedging. You can also see that the buyer also hedged his risk of an unexpected gain in the market price.
1. Now you can understand that a futures contract always has a buyer and a seller on both sides of the contract.
2. The current market price of a commodity or any goods or any securities for which the contract is written between two parties is called the spot price. In the previous example, the spot price at the time of investment was $5, then in scenario 1, it decreased to $2, and in scenario 3, it increased to $10.
3. You entered the futures contract believing that the prices would. You would profit only if the price of the chicken falls below $5 after 3 months. If it goes up to $10 you still will have to sell at $5. People who agree to sell a commodity at the contract price, who take positions in a contract believing that the spot price will fall in the future are called the Shorters. The buyer has agreed to buy the chicken at $5 believing that the prices would go up. If it falls below $5 after 3 months, he still will have to buy at $5, thus incurring a loss. People who agree to buy a commodity at the contract price, who take positions in a contract believing that the spot price will go up in the future are called the Longers.
Example of a simple currency futures contract
Before going through the definition of futures, you have to understand two kinds of prices.
1. Spot price
It is the current price of the underlying stock on which the futures is based on. Every futures have their own underlying stocks. The relation between the futures and the underlying stocks will become apparent when you read on
2. Futures price
It is the price of the position you hold. How this price is arrived at will also be apparetn when you read on.
What are futures.
A futures is a contract between the market maker and the traders. The contract stipulates that the market maker will ensure that, the difference between the spot price of the under lying stock and the price of the futures held by traders will be settled on a daily basis between the buyer/seller and the market maker.
This is the most important thing to understand. There is no contract between a buyer and a seller. There isn't any physical delivery of the underlying stock between the seller and the buyer as seen in the chicken farmer example. When a buyer buys futures, it becomes a long position, and when a seller sells futures, it becomes a short position. Each positions are unique. You can sell your long position or buy your short position at anytime, given there is a buyer or a seller for your positions. Daily settlement of the difference between the spot price of the underlying stock and the futures price is undertaken by the Market make only.
To understand how the futures is settled, you have to read on.
Longers and Shorters
People who believe that the spot price would go up are called Longers, and their futures position is called a long position.
People who believe that the spot price would go down are called Shorters, and their futures position is called a Short position.
Bid price and Ask price and Spread
Bid price is the price at which a buyer puts up a buy order. Ask price is the price at which a seller puts up his sell order. The difference between the bid and the ask price is called the spread.
If you wish to buy 1000 nos of $100 shares of XYZ corp, you will have to put up $100000. Now if your exchange gives you a margin of 1:100 for the futures of the same XYZ corp, then you can buy futures. You know that the lot size for the futures of XYZ corp, is 1000 nos per lot. You can buy 1 lot ie 1000 nos of $100 futures of XYZ corp for $1000 only. This is what is meant by a margin of 1:100. You need to put up 1/100th of the value of the futures. And you can have the same profit if price of the underlying stock goes up. This is because the futures price more or less follows the spot price. Why so? Follow on.
You visit your broker's office. You see that the stock of XYZ corp is trading at $100. Since you are very clever, and since you have read this blog, you decide to buy 1 lot of XYZ corp futures. You know that 1 lot has 1000 nos of XYZ corp futures. And you see that the Last traded price is $102. But since you have read in this blog, that the price of the futures is determined only by the buyer and the seller, you decide to put a buy order for 1 lot of XYZ corp at $20. The broker looks at you as if you don't know anything. Then a message in the screen reports that $20 is no allowed, the maximum deviation from the last traded price, is 20%. So you modify your buy order to $80. Now you find out that the nearest seller is at $106.
Now you understand an important principle of the futures trading. At any time, a trader will assume that the probability of the price of the underlying stock, at the expiry date of the futures is around the current price of that stock, most of the time.
Traders always believe that the stock price will ( in the worst case) hover around the current spot price.. This is because, the expiry date for a stock futures contract is normally a short period, most of the time, 1 month. So if the trend of the stock is upward, a Longer(buyer) will naturally assume the spot price to go up, and in the worst case to stay the same, And a Shorter will believe that the price of the stock will decrease towards the expiry date or in the worst case will remain the same.
Normally people do not think that anything exceptionally good or bad will happen to the underlying stock. This shortsightedness is what allows the futures price to follow the underlying stock.
Now when you put the buy order at $80, the Shorters will think that if they sold you at $80, and in the worst case, if the spot price remains the same, then he will lose $20. So he will always try to sell you at a price above $100, which is the spot price of the underlying stock.
Since you finally understood this principle, you increase your buy order to $100. You are sure a seller would agree to sell you at this price. But no one is willing to sell you at this price. This is because the general market is in an uptrend. So the Shorters would like to sell you at a price above $100, just in case, the stock moves up. Now you understand that why the Last traded price was at $102. So you increase the price to $101. Suddenly a seller matches your bid price and the trade happens at $101. And the last traded price resets to $101.
Daily settlement and Margin calls
This is a bit complicated. You may have to read this section many times to understand the process.
If you have gone through the chicken farmer example, you must have seen that both farmer and the buyer, have to honor the contract at the expiry date of the contract. And mainly these kind of contracts are tailor made for hedging purposes.
But stock market futures contracts are made mostly for speculative purposes, though some traders may use it for hedging. Most of the traders are attracted to futures because of the leverage these kind of instruments give.
Leverage is the ability of a trader to buy and sell an instrument with an amount which is smaller than the actual value of the trade. With a little money you can trade large amount of instruments and can make potentially huge profits (or losses).
Since huge leverages are used, if a stock is going down the drain, a person who has taken a trade against the trend of the underlying stock might lose large amount of money, if he holds a futures contract till its expiry. By the time, the contracts expire, the trader who has taken a position against the trend, will find his account burned.
As you have read in the beginning, all the settlements on a daily basis is done by the market maker. Which means, the market maker has to credit money to a trader who has mad a profit, and debit money from a trader, who has made a loss. When a Longer guy takes a long position on an underlying stock which is plummeting, then he will have to give huge amount of money to the Market maker. There is a possibility of someone absconding without paying his liabilities, or huge litigation costs for the brokers or the exchange.
In order to make settlements on a daily basis, and for protecting the recovery of losses, the exchanges have put in place two mechanisms; Margin Money and Daily Settlement.
As you have read, the market maker debits money from the losers account and also credits the profits in the gainers account. So the distribute profit and losses. They also take commission from both the buyer and the seller for each trade. They also need to minimize risk of non payment of liabilities. In order to make payments for profits and retrieve the losses, the market makers pools money from the traders. Every trader has to pay some margin money to the market maker, if he wishes to buy or sell futures. This money is a fraction of the actual value of futures traded. The margin money is set by the market maker almost daily and depends upon the following.
1. What is the volatility of the underlying stock. If the stock plummets, then the market maker's only option to retrieve money from a buyer is to debit money from the margin money he has put up.
2. What is the liquidity of the futures. If the number of buyer and trader for a futures is low, then if a fall out happens, a buyer cannot exit his trade, or if the stock sky rockets, then the seller also might not be able to cover his position.
3. Various other things.
Consider the following example
A longer has taken a long position by buying into a contract at a price of $102. He pays the margin money set by the Market maker, which is $10000. He has taken 10 lots of 100 nos each. The underlying stock price at that time is $100. All of a sudden, some bad news circulates about the company, and the stock starts to move down. After a few days, the futures price also moves down to $80. Now the longer panics and tries to exit. He puts up a sell order for $80. But the nearest buyer is at $77. So he modifies the sell order to $77 and the trade happens. But now the now the longer owes the Market Maker $25*1000, ie $25000. The longer is unable to pay such a huge sum to the market maker.
So instead of allowing the longer and the shorter to hold the contract until it expires, without making any payments, the market maker decides to settle the contract on a daily basis. The basic idea is to settle whatever the difference between the spot price and the contract price on a daily basis when the market closes.
Continuing with the example, suppose there is only 30 days for the futures to expire, The contract price on the day 1, is $102. Suppose the closing price of the futures (The last traded price at the end of the day) is $100. And the closing price of the underlying stock price is $98. Then,the maker maker takes, the difference of the contract price and the closing price of the futures . In this case it is $102-$100= $2. If buyer had exited the trade at the end of the day at the closing price of the futures, that is, at $100, he would have incurred a loss of $2*1000=$2000. So the market maker debits the loss ( which he might have incurred had he exited ), from the buyer's account,
This is done by a simple method. The exchange sells the long position of the longer at the closing price of $100 and buys the short position of the shorter at the same closing price. So when the market closes, the contract is settled, and the buyer and the seller no longer holds any contract. The loss incurred by the buyer,$2000 is debited from his margin money and credited to the seller. But on the next day morning, a new contract is created between the buyer and the seller for $100.
So in effect, the contract is reset to $100 and the difference is settled with both the buyer and seller. This goes on till the expiry, if the buyer and the seller chooses not to liquidate their position. There must be other buyers and sellers in the market, who have traded futures at different prices, but their futures are also settled and reset at the closing price of the futures.
Remember, The futures prices are reset at the previous closing price of the futures and not the previous closing price of the underlying stock. But the futures price is settled at the price of the underlying stock at the time of the expiry. Please read on to know how this is done.
Continuing with the previous example. What happens when the price of the futures falls to a closing price $80 in a days time, and the buyer couldn't exit his long position at $77 only. In that case, even if the market maker resets the prices, the buyer has payed only a margin of $10000. The market maker has to debit $102-$80=$22, loss per futures, ie $22*1000=$22000, from the buyers account, in order to reset the prices.
So the market maker makes a margin call. The market maker demands $12000 or more from the buyer, if he wishes to trade again in the futures market at all. If he doesn't pay up the margin money called, then the market maker retrieves the money by either selling his other assets or through litigation. He will also be banned from the futures market.
If the price starts plummeting at a very high rate, then the market maker might sell the long positions, without asking the buyers, and then make the margin call. This is applicable to the sellers as well, if the prices sky rocket.
Settlement at the time of expiry
If you have read the daily settlement section, you must have understood that, the prices are reset every morning to the previous day closing prices. So you can only imagine that, the price of the futures you have held till expiry, will also be reset to the previous day closing price, at the day of expiry .
Continuing with the earlier example, you had bought the futures at $102. After resetting daily, the price of the futures at the day of expiry is $105, say. And you still are not willing to sell it. At the end of the day of the expiry, the underlying stock closes at $106.
Now the market maker has to honor the contract. So it will assign a value of $106 for your futures, which you had bought at $102 at day 1, and credit the margin money and the profit back to your account. As you had paid a margin money of $10000, and your profit is $4*1000, Your account will be credited $14000 minus the transaction costs like brokerage, tax etc. Suppose you had sold the futures ie taken a short position at day 1, at a price of $102. Then also the market maker assigns $106 for your short position and debits the loss of $4*1000 from your account and credits the margin money of $10000. So you will be credited $6000 in you account.
Can you buy and sell between the Day 1 and the expiry date
Of course you can. You can buy on Day 3, the long position which the buyer bought at $102. You can buy it at any price the buyer agrees to sell it to you. As usual the price of the long position on Day 3 will also be hovering around the underlying stock price. Say the stock price at Day 3, at the time of trading is $90. The last traded price of futures is say $88. And you put a buy order at $87.Suddenly, the buyer who bought a long position at Day 1 is ready to sell to you at $87. The trade happens. The buyer who sold to you loses $102-$87=$15 per futures in his account ie $15000. Now on Day 6 you can sell it at $95, if there is another buyer available, who is willing to buy your long position a that price. You will make a profit of $8000.
The mechanism of daily trades are elucidated graphically in coming sessions. So please read on.
Snapshot 2 is the snapshot of the market when the buy orders and sell orders have been put up by the traders. You can see that, none of the buy orders and sell orders have matched. So no trade has been executed yet.
In snapshot 3, the arrows represent order matching. Either the buyer or the seller or both relented and the trade is executed
Flow chart on the order process