Trading Derivative Instruments I
This lesson will cover the following
- Spot market
- Futures market and futures as instruments
- Rollover day
Spot and futures markets
In the previous sections weve talked about trading in the financial markets and generally described what forces move prices up and down. We also spoke about the foreign exchange market, its major participants and the system as a whole, explaining the chain from retail users at the bottom to liquidity providers at the top. But we havent really mentioned until now that according to their point of settlement, markets can be spot markets and futures markets.
The spot market, or also knows as the “cash market” and “physical market”, is a financial market on which commodities or financial instruments are sold for cash and delivered immediately. The spot market can be an organized market, an exchange, or over-the-counter.
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The physical market is the opposite of the futures market where the settlement and the delivery are due at a later date. Contracts bought and sold on the cash market become effective instantly and the delivery should be made within two business days after the trade order was placed.
Participants in the spot market use it in order to physically purchase or sell goods, which means that a large part of the players here are actually farmers or producers who need to restock their inventories and so on. Investors who would like to acquire shares of a company also purchase them through the spot markets. For example, if you would like to buy Company XYZ stocks and own them immediately, you would go to the New York Stock Exchange or some other exchange, if the company has met the requirements to be listed there. If not, the corporations shares would be traded over-the-counter and you can still buy buy them for cash. If youd like to purchase gold in the spot market, you could go to a coin dealer and exchange cash for gold.
In Forex, the spot market has an imposed two-day delivery period, which originates from the time it would take to move money from one bank to another. Most often speculative Forex trading is executed as spot transactions on online trading platforms provided by different brokers, something of which weve spoken earlier in the chapter.
The futures market, on the other hand, is a centralized financial exchange where standardized futures contracts are being traded, according to which a certain amount of a commodity or other instrument must be delivered at a specific time in the future.
Futures are categorized as “derivatives”, instruments which are based on an underlying asset and whose price movement depends, but not solely, on the pricing of the underlying stock, commodity, currency pair, index etc.
When we speak about such contracts, the key word is standardized. Futures are contracts between two counterparts to buy or sell a standardized quantity of a specific asset of standardized quality at a particular price, set today. The delivery and payment occur at a specific future date, also called the delivery date.
There is one more key difference between operations in the futures market and participating in the cash market – by holding a futures contract you are not necessarily obligated to physically receive or deliver large stockpiles of commodities, such as gold, oil, copper, corn etc. Traders enter the futures market primarily to speculate whether prices will go up or down, or to hedge a risk, rather than physically exchange raw materials, which is the main use of the spot market.
That said, we can conclude that a futures contract is more like a financial position and unlike the actual farmers, producers etc. who trade in the spot market, most of the players in the futures market are speculators, whose sole goal is to profit through price fluctuations.
Futures have become a major part of the financial markets exactly because neither the buyer, nor the seller are obligated to receive or deliver the amount of commodities or securities traded. But this arouses the following question: since the two counterparts have struck a deal with a maturity date, what happens on the maturity date and if we dont want to receive or send a physical shipment, how do we avoid it ?
As futures contracts come closer to maturity, their prices narrow the gap to the spot price of the underlying asset and become equal on the expiration day, a situation also known as a convergence. It is very important that traders close their open positions to avoid taking delivery of the traded asset. In most cases, expiration day comes on the third Friday of each quarter, as in December, March, June and September. A week earlier, the second Thursday of each quarter is known as “rollover” day.
On the rollover day, the trading volume of an expiring futures contract begins to be transferred to the new contract month, which means that all market players who wish to continue holding positions of this asset must trade out from the expiring contract and enter the next one, the so-called “front month” contract. But have in mind, this operation is not executed automatically by the broker, which means that traders must know when that date comes and then sell, or cover, the expiring contract and open a position in the front month.
The significance of this period lies in the fact that as of the rollover day, volume in the expiring contract begins to slowly dissipate until the expiration day comes, or as we said next Friday, which means that liquidity during that last week becomes a major problem. Also, each front month carries with it a “premium” or “discount” to the spot price of the underlying asset so the price of the new month will differ from the expiring contract.
Apart from the already noted characteristics of the futures contracts, there are a few others, which further distinguish them from the forward contracts, of which we will speak a bit later.
As we said, futures are contracts, according to which a certain amount of an asset must be traded on a specific date at a price agreed upon today. They are standardized and traded on exchanges and as such, the interest of each counterpart must be protected. This happens through the so-called initial margin and maintenance margin, which an investor is required to deposit and sustain, unlike when trading forwards.
The initial margin is a deposit of good faith, which a trader must make in his account in order to enter the market. It is used to debit any day-to-day losses. This leads us to another feature of futures contracts. They are settled on a daily basis, which means that at the end of each trading session, your account is debited or credited with your day-to-day losses or gains. Unlike futures, forward contracts are settled only on the date of maturity, which means that daily price movements of the underlying asset have no current reflection on your account.
When you place an order on a futures contract, the exchange will require a minimum amount of money that you must have deposited, the initial margin, which is most often between 5% and 10% of the contract. When you exit your position, you will be refunded the initial margin plus or minus the gains or losses you accumulated while holding the contract.
After a trader makes his initial deposit and enters a position, he must then sustain a so-called “maintenance margin”, which is the lowest amount of money he can have in his account before needing to add new funds. If your maintenance margin drops to a certain level after a bad losing streak, brokers will require from you to deposit new funds in your account and bring the margin back up to the minimum maintenance level (maintenance margin). This is the so-called “margin call”. It is a safety mechanism, which clearing houses use to remove the risk of one of the counterparts not meeting its obligations, thus creating a risk-free environment for all parties.