Futures For You

INSIDE THE FUTURES WORLD

Want to learn how the futures markets really work? Dan O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com), responds to your questions about today's futures markets.

To submit a question, post your question to our website at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Dan O'Neil

OUT OF THE PITS

I've heard about a couple of exchanges introducing "side-by-side" trading in some of their products. What is that?

"Side-by-side" trading is the simultaneous trading of a commodity or financial futures product electronically and in the trading pit during business hours. As more exchanges introduce electronic trading, many investors are wondering whether to shift their trading from the pits to the computerized systems. While the contract specifications for products traded in the electronic and open-outcry arenas are usually identical, there are key differences.

Open-outcry trading involves orders communicated to brokers in a pit via customer requests made to their brokerages via phone or computer. Customer bids and offers are matched between pit brokers, and trades are executed when prices are mutually acceptable. In electronic or screen-based trading, customers send buy/sell orders from their computers to an electronic marketplace offered by the exchange. The trading screen replaces the pit, and electronic market participants replace the pit brokers. One advantage of electronic trading is more price transparency, as the top current bids and offers are visible to all market participants. In addition, electronic trading tends to be faster and more accurate.

Thanks to these advantages, new participants have entered the futures markets. Trading in currency futures products at the Chicago Mercantile Exchange and interest rate futures at the Chicago Board of Trade has migrated to the electronic side, leaving behind little action in the pits. Electronic trading accounts for over 70% of the total volume at both marketplaces.

This kind of success has resulted in other exchanges experimenting with electronic trading during traditional open-outcry hours, hoping to integrate the method into their traditional pit-based business. Since August 1, traders at the CBOT have been able to access futures on the exchange's agricultural complex from both the exchange floor and the eCBOT electronic system. Between the two formats, these agricultural contracts can be traded daily from 6:30 pm Central Time to 6:00 am (electronic only) and 9:30 am to 1:15 pm (electronic and open auction). On September 5, the New York Mercantile Exchange (NYMEX) debuted side-by-side electronic and pit trading during regular trading hours in some of its most popular energy products, including crude oil, natural gas, heating oil, and gasoline futures, providing access to electronic trading in these in-demand markets around the clock. The NYMEX contracts are available for trading from 6:00 pm Eastern time Sundays through 5:15 pm Fridays, with a 45-minute break each day between 5:15 pm and 6:00 pm.

While these exchanges aim to increase the attractiveness of their benchmark products to electronic-intensive market participants like proprietary trading firms, the effects of these moves to side-by-side trading figure to trickle down to individual speculators and hedgers as well as increased liquidity, better access, and longer trading hours. If so, traders stand to see exciting developments in these markets in the near term.

DELIVERANCE

I'm a new trader in the futures markets, and I'm concerned about getting stuck with delivery of a commodity. How can I avoid winding up with thousands of pounds of soybeans on my lawn?

There are two types of futures contracts: those that provide for physical delivery of a particular commodity and those that call for a cash settlement. Even in the case of delivery-type futures contracts, few actually result in delivery. Most speculators realize their gains or losses by offsetting their futures contracts prior to the delivery date. Selling a contract previously purchased liquidates, or "offsets," a futures position, and any gain or loss is simply the difference between the buying price and the selling price. Even hedgers don't make or take delivery; most find it more convenient to offset their futures positions and (if they realize a gain) use the money to offset whatever adverse price change has occurred in the cash market.

When delivery does occur, it's often in the form of a negotiable instrument that shows the holder's ownership of the commodity. But it's not advisable for investors to wade into delivery, which involves unfamiliar processes -- as well as inspection, warehousing, and insurance, just to name a few. Many traders who enter this process find it can be a confusing and costly proposition.

Cash-settled futures contracts are precisely that -- contracts settled in cash rather than by delivery. Stock index futures contracts are settled in cash on the basis of the index number at the close of the final trading day; there is no provision for delivery of the stocks that make up the indexes. With a cash settlement contract, convergence between the futures contract and the underlying instrument is automatic.

If delivery on futures contracts is the exception, why do most contracts even have a delivery provision? It offers buyers and sellers the chance to arrange for delivery if they choose. The fact that buyers and sellers can take or make delivery helps assure futures prices reflect the cash market value of the underlying commodity when the contract expires, so futures and cash prices will eventually converge.

Originally published in the November 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.

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