The trading of futures contracts occurs at a futures exchange and every exchange has an associated clearing house
. Each contract has two parties at either end; the buyer and seller, as well as an acting intermediary which is the clearing house. Once a contract is forged, the clearing house (under obligation) buys the underlying asset from the seller and sells the same asset to the buyer before the settlement date. If either trader does not fulfil his obligation, only the clearing house is impaired.
The buyer of a contract is said to have a long position
whereas the contract seller holds a short position. If the underlying asset being traded decreases in value by the settlement date, the short position holder profits and vice versa. Since every profit is counteracted by a loss, the futures market does not have much of an impact on the commodities traded within.
Futures contracts do not actually cost anything in themselves.
They only represent an obligation to buy an underlying asset as specified in the contract. Besides marginal posts, payment does not have to be made until the actual delivery of the asset. Defaulting on a futures contract will have different penalties, depending on which exchange is used.
The Physical Process
1. The client sends an order to his broker.
2. The broker sends this order to the trading floor which represents that particular futures asset. The floor will belong to an exchange which the broker is a member of.
3. On the floor, open outcry and electronic trading are used to secure the order.
4. The clearing house of the exchange steps in between a buyer and seller, as shown above. Due to how this intermediary functions, traders close their positions independently of each other.
5. Traders post their performance and maintenance margins and wait until the final settlement date.
6. Assuming that the contract will move to completion and delivery, settlement occurs as the long position holder makes payment to the exchange / as the short position holder delivers the asset.
The method of delivery varies. Agricultural goods for instance, are transferred via warehouse receipts.
To protect the clearing house from loss, traders are required to post an initial performance bond (initial margin requirement)
, which is normally 5-15% of the futuresí value. A traderís account will be credited or debited accordingly every day because futures contracts are marked to market
. This means that the value of the security is changed according to market prices rather than the prices stated on a futures. If an account balance falls below its margin requirement, it will require a maintenance performance bond, or maintenance margin percentage
. This is normally 75% of the initial marginal value. Margin calls made are expected to be answered (paid) on the same day.
When a trader defaults on his maintenance margin, the clearing house will offset an appropriate amount of his contracts to return his account to the required level.
In some cases, margin requirements are reduced or waived for hedgers that own the traded commodity since such traders are covered. Such exemptions are decided by each futures exchange, as are the maintenance and performance margins they design.
The term variation margin
pops up in cases where the underlying asset is volatile in value. These are essentially maintenance margins paid to restore an accountís performance bond daily. In this case brokers can make margin calls daily or even intra-day.