Getting In and Out
of Futures Contracts
By Peter Lang and Chris Schafer
Futures Contracts
• A contractual agreement, to buy or sell a
particular commodity or financial
instrument at a pre-determined price in the
future
– Commodity: wheat, oats, sugar, crude oil,
heating oil, natural gas etc
– Financial: treasury notes, bonds, etc
Futures Positions
•
•
Long Position: the holder agrees to buy
the contract's underlying asset at a
specified price, with the payment and
delivery to occur on the expiration date
Short Position: holder agrees to sell an
asset at a specific price, with delivery
and payment occurring at expiration.
Futures Positions
• If both the long and short parties hold their
contracts to the expiration date, their
profits or losses would be determined by
the price of the asset on the spot market
– If spot price increases long party would profit
– If spot price decreases short party would profit
• Futures contracts are a “zero sum game”
– When one side profits the other looses money
Investment Reasons
• Speculation
– Investors speculate on the price changes of
the underlying assets in futures contracts
– It is an alternative to buying or short selling
the commodity itself
Investment Reasons
• Hedging
– Investors are able to hedge against adverse
price movements with futures contracts
– True hedging is done to reduce price risk, not
to make a profit
– If an investor loses money from their
investment in the underlying commodity, then
they make up for it with profits from their
futures contracts and vice-versa
Futures Exchanges
• Futures contracts are traded on
exchanges.
• Exchanges are set up as membership
organizations with a fixed number of seats
with a seat being a precondition for direct
trading on the exchange.
Futures Exchanges
• There are two main types of members on
most exchanges
– Commission Brokers: Buy and sell futures
contracts for their customers. Responsible for
most of the trading on the exchanges
– Locals: Trade on the exchange from their own
account. Normally involved in speculation or
arbitrage situations
Futures Exchanges
• Each exchange is responsible for
standardizing the commodities for which it
offers futures contracts on
• The underlying assets must have a
standardized grade or type as well as a
standardized amount
Futures Exchanges
Chicago Board of Trade
(CBOT)
Chicago Mercantile Exchange
(CME)
Commodity Exchange
(COMEX) (NY)
Kansas City Board of Trade
(KCBT)
Mid-American Commodity Exchange
(MidAm)
Minneapolis Grain Exchange
(MGE)
New York Mercantile Exchange
(NYMEX)
Philadelphia Exchange
(PHLX)
Getting In to a Futures Contract
• Choose a commodity
• Decide on your position
• Find the exchange your chosen
commodity is traded on
• Deal with the Clearinghouse
Clearinghouse
• To give futures marketability, exchanges
use clearinghouses
– Act as an intermediary
• Most exchanges have their own
clearinghouse
– Makes futures contracts more attractive to
invest in
Clearinghouse Purposes
• Make it easier to get in and out of
contracts
• Guarantee that both parties will live up to
their end of the contract
• Collects and manages funds posted by
parties
• Helps with delivery process at expiration
Clearinghouse Position
$
A
$
CH
April Oil
B
April Oil
Initial Margin
•
Is the amount that must be deposited by the investor on
the day the futures position is established.
– Can be in the for of cash or cash equivalents
•
The trader does this by setting up a margin account with
the broker and depositing the required amount with
them
•
The amount of the margin is determined by the
exchanges margin requirement
– Usually between 3%-5%
•
•
Is a percentage of the total contract value
Reduce the chance of default.
Marking to Market
• When there is a decrease in the account
value, the futures trader’s broker has to
transfer money through the clearing firm
equal to the loss on the position to the
broker and clearinghouse with the gain.
Maintenance Margin
• Is the amount of additional funds that
futures traders must deposit to keep the
equity in their account equal to a certain
percentage of the initial margin value.
• This insures that the balance in the
trader’s account does not drop too low
– This is required by brokerage firms
Margin Call
• If one did not deposit the required margin
when their equity fell below the required
amount, they would then receive a margin
call, and would be required to add
additional funds to their account
• If one failed to post the additional funds
their position in the contract would be
closed
Margins
• Investors often deposit more funds than
required by margin requirements
– Reduces the responsibility involved with
constantly managing a futures position
• Can be done by depositing more cash or
investing in other future funds
Getting Out of Futures Contracts
• Settlement
– Delivery of physical asset of contract or cash
in the case of stock index futures
– Each exchange has their rules and
procedures governing the deliveries of
contracts and delivery dates
– Very few futures contracts ever reach delivery
Getting Out of Futures Contracts
• Cover Position
– Same number of contracts on the same
commodity but with the opposite position of
the original futures contracts
– Clearinghouse takes care of the hassle for the
investors
Questions?
Review
• Question 1
Which position benefits if the spot price
increases?
Long Position or Short Position?
Review
• Answer
Long Position
Review
• Question 2
What is one function of the clearinghouse?
Review
• Answer
Gives futures contracts marketability
Acts as an intermediary
Makes it easier to get in and out of futures
contracts
Guarantees both parties will live up to their
side of the contract
Review
• Question 3
What percentage is normally required for
an initial margin?
Review
• Answer
3% - 5%
Review
• Question 4
What is the amount of additional funds that
futures traders must deposit to keep the
equity in their account equal to a certain
percentage of the initial margin value
known as?
Review
• Answer
Maintenance Margin
Review
• Question 5
What are the two main reasons investors
trade in futures contracts?
Review
• Answer
Speculation
Hedging
Review
• Question 6
Who is responsible for standardizing the
commodities traded on each exchange?
Review
• Answer
The exchange that the commodity is
traded on
Review
• Question 7
What position are you taking when you
want to get out of a futures contract?
Review
• Answer
Cover position