TRADING MECHANISM OF FUTURES CONTRACTS.pptx

Trading mechanism of future contract

1. Introduction to Futures contracts Futures contracts are exchange traded contracts to sell or buy Standardized Financial or Physical commodities . today ,most common assets which are traded in the future markets are commodities ,agricultural products, equities stock and so on it is observed that the commodity futures market has witnessed a remarkable growth in I ndia since 2003.during 2003 [NCDEX] Mumbai,[MCX] Mumbai were commenced The market has grown 61times in2007-08 now all futures exchanges are facilitating online screen based trading using a networked computer system .

2. Meaning & Definition of Futures A futures contract is an agreement between two parties to buy or sell particular asset on a specified future date. “ Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price” --- BSE . “Futures contracts are organised or Standardised contracts,which are traded on the exchanges”.

3. TRADING MECHANISMS OF FUTURES CONTRACT STEP1 :The order flow : In futures contracts an order to buy or sell one futures contract ,Buyers begin by contracting their exchange member ,who inturn directs customers order to a floor broker on the exchange floor who executes the trade. All orders are executed on the floor of exchange according to the rules .an I mportant aspect of these rules is that they require all bids and offers to be exposed to other traders in the pit in order to assure execution of orders at open and competitive prices.[open outcry system]

4. The Results of one contract trade: the clearing house will have on its books two contractual obligation – one long and one short .the names of initiating buyer and sellers will appear only on the book of exchange members ,as obligations of the exchange members.

5. STEP2: SETTLING A FUTURES POSITION: Once having established a futures position ,traders have an obligation under the terms of the futures contract either to take delivery or to make delivery of the underlying commodity. However ,making or taking physical delivery of future contracts can be settled by three ways. 1] Physical delivery 2] offsetting 3] by cash delivery.

6. PHYSICAL DELIVERY Liquidating a futures position by making or taking physical delivery is usually the most cumbersome way to fulfill contractual obligations it requires actually purchasing or selling a commodity, something traders would normally not want to do unless they had a particular need for commodity in large quantity. A commercial firm ,which deals in commodities ,might very well wish to settle by physical delivery.

7. EXAMPLE: Let us take a particular futures contracts; Coffee traded on NCDEX .A trader who is short one coffee futures contract is required to make physical delivery of 50 bags of coorg of arabiaca quality. The operational procedure for making physical delivery on futures differ by the type of futures contract .at the beginning of delivery month on the exchange designated notice, lets say for Feb 5 th contract ,exchange rules requires that all traders having open positions in feb 5 th contract notify their respective members that they intend to make or take delivery during february when & what quantities such deliveries are desired. the exchange members inturn must notify clearing house of their customers intentions.

8. After the nomination process is complete the clearing house matches longs and shorts .delivery notices are then sent. Physical delivery imposes obvious costs on traders ; warehouse expenses, insurance costs, possibly shipping costs and brokerage fees. The amount of commodity that meets exchange specified quality standards and is available for delivery at exchange specified locations .the concept of deliverable stock is relevant.

9. OFFSETTING : The most common way of liquidating an open futures position is to effect an offsetting transaction – in effect to reverse the initial transaction which establishes futures position .in this offsetting settlement the initial buyer [long] liquidates his position by selling or going short an identical futures contract same commodity and same delivery month . Similarly the initial seller short liquidates his position by buying going long an identical contract. after these traders are executed and reported to the clearing house ,both traders obligations are extinguished in the books of the clearing house and in those of the exchange members.

10. In comparison comparison to making or taking physical delivery ,settlement by offset is relatively simple .it requires only a liquid futures market to facilitate offsetting trades, and entails only the brokerage costs.

11. CASH DELIVERY : This procedure is a substitute for physical delivery and completely eliminates having to make or take physical delivery. it is available only for futures contract that specifically designate cash delivery as the settlement procedure. physical delivery is not permitted in these contracts. The Mechanics of cash delivery are simple: the price of the relevant futures contract, at the close of trading day in that contract is set equal to the cash price of underlying asset at that time.

12. Exchange has adopted cash delivery as an alternative to physical delivery for two reasons: 1] T he nature of the underlying commodity may not permit feasible physical delivery. Ex: stock index futures would require physical delivery of hundreds or thousands of shares of stock in finely calculated proportions. requires a cumbersome & costly delivery procedure.

13. 2] cash delivery avoids the problem that it may be difficult for traders to acquire the physical commodity at the time of delivery because of temporary shortage of supply .cash delivery also makes it difficult to manipulate or influence futures prices by causing artificial shortage of the underlying commodity. The popularity of cash delivery has grown substantially in recent years and has enabled exchanges to offer futures contract s that would not have been feasible without such a delivery mechanism.