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LECTION 3. COMMODITY FUTURES MARKETS: THEIR MECHANICS AND PRICE RELATIONSHIPS 1. Description of futures LECTION 3. COMMODITY FUTURES MARKETS: THEIR MECHANICS AND PRICE RELATIONSHIPS 1. Description of futures trading. 2. The technologies of futures trading. 3. Key points about trading pit. 4. Futures contracts in brief.

KEY WORDS: Organized Market Place – організоване ринкове місце cash sales – спотова торгівля KEY WORDS: Organized Market Place – організоване ринкове місце cash sales – спотова торгівля open outcry system – система відкритого голосового аукціону Open interest – відкриті позиції по ф’ючерсних та опціонних угодах hand signals – жести рук futures contract – ф’ючерс hedger– хеджер speculator - спекулянт

1. Description of futures trading. Organized Market Places ü Trading on futures markets involves 1. Description of futures trading. Organized Market Places ü Trading on futures markets involves buying and selling standardized contracts for the future delivery of the commodity. ü Trading in futures contracts takes place only on formally organized central market places. Typically, buyers and sellers do not intend to take or make delivery on the contract. ü Trading in futures contracts started in Chicago in the 1860's. ü An organized market provides a trading place, aids in disseminating market information, aids in trading mechanics, and helps regulate the business dealings of members hence, helps settle disputes.

2. The technologies of futures trading. Types of technologies Electronic trading Open outcry system 2. The technologies of futures trading. Types of technologies Electronic trading Open outcry system

Open outcry system ØIn futures markets, trading must take place at a designated place Open outcry system ØIn futures markets, trading must take place at a designated place and time by open outcry. ØCME Group first invited members to trade futures contracts on agricultural commodities via the Open outcry system. ØThis system of trading which is still used today is similar to hundreds of auctions going on at the same time. ØTraders stand in a trading pit and call out prices and quantities that indicate their willingness to buy or sell. They use hand signals to convey the same information. ØOpen outcry is an efficient means of "price discovery, " allowing buyers and sellers to arrive at the best prices given the supply and demand for a futures or options product.

Electronic trading v. The explosion of electronic trading has prompted speculation that the open Electronic trading v. The explosion of electronic trading has prompted speculation that the open outcry system is quickly becoming obsolete. v. New advances in screen based trading have forced both traders and exchanges to keep up with rapidly evolving technological developments. v. In 1992, CME Group introduced a global electronic trading system (GLOBEX®), that regulated after hours trading. Its successor, GLOBEX 2, was introduced in 1998 for virtually round the clock trading. v. E mini S&P 500 contracts were introduced in September 1997, a smaller version of the standard S&P 500 contract. The e mini was the first screen based contract to trade during regular trading hours on the floor of a United States exchange. v. Today, the CME allows market participants to buy and sell futures in a number of ways. Whether they're sitting at trading booths on CME trading floors, working from offices and homes across the country, or making trades during or after regular trading hours, more and more choices are available to investors. Even on the CME trading floors in downtown Chicago, some traders buy and sell contracts exclusively using computers, some prefer being face to face with other traders in the pits, and an increasing number trade both ways.

3. Key points about trading pit Hand signals As mad as it may seem 3. Key points about trading pit Hand signals As mad as it may seem to an outsider, the use of hand signals provides an efficient and effective way to communicate in the pits. This unusual sign language lets traders and other floor employees know how much is being bid and asked, how many contracts are at stake, the expiration months, the types of orders and the status of those orders. The signals are the favored form of floor communication, especially in the financial futures pits, for three main reasons: ü 1) Speed and efficiency. Hand signals enable fast communication over long distances (as much as 30 or 40 yards) between the pits and order desks and within the pits themselves. ü 2) Practicality. Hand signals are more practical than voice communication because of the number of persons on the floor and the almost deafening noise level. ü 3) Confidentiality. Hand signals make it easier for customers to remain anonymous, because large orders do not sit on a desk, subject to accidental disclosure.

An Introduction to Hand Signals Buy / Sell • When indicating you want an An Introduction to Hand Signals Buy / Sell • When indicating you want an offer to buy (signaling a bid), the palm of the hand always faces toward you. You can remember this by thinking that when you're buying, you're bringing something in toward you. • When making an offer to sell (offering), the palm always faces away from you. Think of selling as pushing something away from you.

Size and Quantity Hand Signals Size and Quantity Hand Signals

Expiration Month Futures Hand Signals Expiration Month Futures Hand Signals

Other Market Signals Conclusion We just reviewed some of the basic futures hand signals Other Market Signals Conclusion We just reviewed some of the basic futures hand signals that are used in the trading pits. As you can see, it is very complicated and will required quite a bit of practice to master these signals. It is absolutely critical that a new futures trader have these hand signals committed to memory; if they do not, the losses incurred from making an incorrect signal can be massive. Also remember, we have gone over the basics for the CME Group floor; futures hand signals may vary across different exchanges.

4. Futures contracts in brief • There are certain fundamental conditions which must be 4. Futures contracts in brief • There are certain fundamental conditions which must be met before standardized futures contracts can be established for specific commodities and futures trading can be successfully instituted. These include: • Competitive market conditions must exist in production as well as distribution. This implies production by numerous individuals spread over a wide area, as well as many buyers, so that no individual can control prices by withholding supplies or refusing to buy except at his own price. • The commodity must be subject to specific grading. • The commodity must be in the raw or semi processed state. A completely manufactured item is subject to production increases or decreases at the will of the manufacturer. • Wide spread trade participation is necessary to supply the hedging contracts and the large volume of trading needed for a liquid market. • The commodity must be storable, under proper conditions, through at least the major portion of the marketing year. • While these conditions may be modified to some extent for some successful exchanges, elements of all appear to be essential.

ØThe seller of a ØThe seller of a "futures contract" takes a SHORT position. Ø The buyer of a "futures contract" takes a LONG position. ØBoth parties of a "futures contract" must fulfill the contract on the settlement date.

Pricing on futures contract • The situation where the price of a commodity for Pricing on futures contract • The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as CONTANGO. • The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as BACKWARDATION. • This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around theoretical price.

EXAMPLES OF CONTANGO AND BACKWARDATION ON FUTURES MARKETS EXAMPLES OF CONTANGO AND BACKWARDATION ON FUTURES MARKETS

F>St (normal contango) S (spot) F (futures) Se (S expected) F<St (normal backwardation) F F>St (normal contango) S (spot) F (futures) Se (S expected) F

Se Se Se Se

HOW TO READ FUTURES PRICES Corn (CME Group) 5, 000 bu. ; cents per HOW TO READ FUTURES PRICES Corn (CME Group) 5, 000 bu. ; cents per bu. Open High Low Settle Change Lifetime High Lifetime Low Open Interest May (this year) 252. 00 252. 75 250. 75 278. 00 . 25 285. 00 228. 00 4233 July 258. 00 258. 75 256. 50 258. 00 . 25 285. 50 232. 50 141648 Sept 262. 75 263. 50 261. 50 262. 00 . . . 270. 50 238. 00 33922 Dec 266. 25 267. 50 264. 75 266. 75 . . . 268. 00 235. 50 141307 March (next year) 272. 50 273. 50 271. 00 272. 75 . . . 274. 00 249. 50 14723 May 276. 25 277. 00 275. 00 276. 75 . . . 277. 75 259. 50 1352 July 278. 25 279. 25 277. 25 278. 75 . . . 280. 00 254. 00 7351 Dec 253. 75 252. 75 253. 50 . . . 258. 50 239. 00 4373 Est. vol 38, 000; vol Wed 38, 592; open int 348, 967 + 987

v. The line of the table reads as follows: v. The line of the table reads as follows: "Corn (CME Group) 5, 000 bu; cents per bu. " and means that the table applies to the CME Group corn contract and the contract size is 5, 000 bushels. The prices shown in the table are in units of cents per bushel, so 252. 75 cents means $2. 52 and three quarters of a cent per bushel. v. The open or opening price is the price or range of prices for the day's first trades, registered during the period designated as the opening of the market or the opening call. v. The word high refers to the highest price at which a commodity futures contract traded during the day. v. Low refers to the lowest price at which a commodity futures contract traded during the day. v. Some publications show a close or closing price in their tables. The closing price is the price or range of prices at which the commodity futures contract traded during the brief period designated as the market close or on the closing call—that is, the last minute of the trading day. v. Because the last few minutes of trading are often the busiest part of the day, with many trades occurring simultaneously, the exchange computes a settlement price from the range of closing prices. The settlement price, which is abbreviated as settle in most pricing tables, is used by the clearing house to calculate the market value of outstanding positions held by its members. It is also frequently used synonymously with closing price; although they may, in fact, differ. v. The change refers to the change in settlement prices from the previous day's close to the current day's close. v. The lifetime high and low refer to the highest and lowest prices recorded for each contract maturity from the first day it traded to the present. v. Open interest refers to the number of outstanding contracts for each maturity month. Some newspapers do not include this information. v. At the end of the table another line of information appears: Est. vol 38, 000; vol Wed 38, 592; open int 348, 967 + 987. Est. vol indicates that the estimated volume of trading for that day was 38, 000 contracts. Vol Wed means that the trading volume for the previous day was 38, 592 contracts. Open Int refers to the total open interest for all contract months combined at the end of the day's trading session. The 348, 967 open contracts represent an increase of 987 contracts from the open interest of the previous day at the close.