The Role of the exchange in futures Trading

The Role of the exchange in futures Trading

Price discovery

As sellers offer to sell and buyers offer to buy in the pit, they provide immediate information regarding the price of the futures contract.

The price is usually given as “Bid -Ask”.

E.g.: - Price for corn might be $2.40 bid, $2.42 ask, meaning a buyer is willing to pay $2.40 a bushel, but the seller wants $2.42 a bushel.

Risk Transfer

In a futures transaction, risk is inherent part of doing business. The exchange provides a setting where risk can be transferred from the hedgers to the speculators.

Liquidity

If risk is to be transferred efficiently, there must be a large group of individuals ready to buy or sell. When a hedger wants to sell futures contracts to protect his business position, he needs to know whether he can effect the transaction quickly. The futures exchange brings together a large number of speculators, thus making quick transaction possible.

Standardization

The exchange writes the specifications for each contract, setting standards of grading, measurement methods of transfer, and times of delivery. By standardizing the contracts in this manner, the exchange opens the futures market to almost anyone willing to hedge risk. In the pits, then, the auction process is facilitated because only the price must be negotiated.

Functions of futures markets

The futures market serves the needs of individuals and groups who may be active traders or passive traders, risk averse or profit makers. The above broadly classifies the functions of the futures markets: -

1) Price Discovery

2) Speculation

3) Hedging

1) Price discovery

“Futures prices might be treated as a consensus forecast by the market regarding trading future price for certain commodities”. This classifies that futures market help market watchers to “discover” prices for the future.

The price of certain commodity depends on the following factors:-

a) The need for information about future spot prices

Individuals and groups in society need information not only for generating wealth but also for planning of future investment and consumption.

E.g.- A furniture manufacturer, making plywood furniture for printing his catalogue for next years needs to estimate price in advance. This task is different as the cost of plywood varies greatly, depending largely on the health of the construction industry. But the problem can be solved by using prices from the plywood futures market.

b) Accuracy

The accuracy of the futures market is not too good but it is certainly better than the alternative.

2) Speculation

Speculation is a spill over of futures trading that can provide comparatively less risk adverse investors with the ability to enhance their percentage returns. Speculators are categorized by the length of time they plan to hold a position.

The traditional classification includes: -

Scalpers

They have the shortest holding horizons, typically closing a position within a few minutes of initiation. They attempt to profit on short-term pressures to buy and sell by “reading” other traders and transacting in the futures pits. Thus, scalpers have to be exchange members. They offer a valuable market service because their frequent trading enhances market liquidity.

Day Traders:-

They hold a futures position for a few hours, but never longer than one trading session. Thus, they open and close to futures position within the same trading day.

3) Hedging

While engaging in a futures contract in order to reduce risk in the spot position, hedging is undertaken. Therefore the future trader is said to establish a hedge.

The 3 basic types of hedge are:

a) Long hedge/ Anticipatory hedge

An investor protects against adverse price movements of an asset that will be purchased in future, i.e. the spot asset is not currently owned, but is scheduled to be purchased or otherwise held at a later date.

b) Short hedge

An investor already owns a spot asset and engages in a trade or sell it’s associated futures contract.

c) Cross hedge

In actual hedging positions, the hedgers needs do not perfectly match with the institutional futures. They may differ in

-Time span covered

-The amount of commodity

-The particular characteristics of the particular goods

Thus, when a trader writes a futures contract on another underlying asset, he is said to establish a cross hedge.

The regulators and regulations

The first level of regulation is the exchange.

The exchange does not take positions in the market. Instead, it has the responsibility to ensure that the market is fair and orderly.

It does this by setting and enforcing rules regarding margin deposits, trading procedures, delivery procedures and membership qualifications.

Each exchange consists of a clearinghouse.

The clearinghouse ensures all trades are matched and recorded and all margins are collected and maintained.

It also is in charge of ensuring deliveries take place in an orderly and fair manner.