Futures contracts which are in many ways similar to forward contracts except that they are exchange traded and have standardized contracts. This has some important implications including the requirement for an investor using futures to deposit margin.
A futures contract is dealt on a recognized exchange and there are a number of ways in which futures and forwards differ:
An exchange will set the expiration dates; these are often set at three month intervals, e.g. March, June, September and December. Many contracts are only available for a maximum period of one year, although some are for longer. The exchange also sets which specific day of the month is the expiry day.
In the U.S., trading of futures in an exchange takes place in the trading pit by a system of open outcry or by electronic trading. The hours of trading, the contract size and the minimum price movement are also set by the exchange.
As in the case of forward transactions, a party to a futures transaction takes either a long or short position. If a party wishes to close or terminate a position prior to expiry he can enter the market and do an offsetting order (this feature means that futures contract are fungible), for example the holder of a long position can go into the market and take a short position in exactly the same contract. Because the clearinghouse acts as the counterparty for the settlement of each transaction, the two transactions can be offset.
Margin requirements make the futures market safer since they provide an assurance that traders will be able to meet their financial obligations. This is different to a margin in the securities market which refers to a loan being made.
Before a trader enters into a futures transaction he must deposit funds with a broker. These funds are called the initial margin and the dollar amount per contract is usually set by the clearinghouse. This is a deposit against future liabilities and once a transaction is settled it is returned, with interest that has accrued, to the trader.
Each day the contract is marked-to-market. If a trader starts to lose money on a transaction and the value of his equity with the broker falls to the maintenance margin level (often around 75% of the initial margin) he will receive a margin call, and will need to deposit sufficient funds (the variation margin) to bring the account back to the initial margin level. This is the process of daily settlement or marking to market. Alternatively, if a trader is making profits they can withdraw funds as long as the account’s equity value stays above the initial margin.
The clearinghouse collects margin payments from clearing members only, so if a broker is not a member it will clear all trades with a clearing member.
Terminating a futures position
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