Trading mechanism of future contract

1. Introduction to Futures contracts
Futures contracts are exchange traded contracts to
sell or buy Standardized Financial or Physical
commodities. today ,most common assets which
are traded in the future markets are commodities
,agricultural products, equities stock and so on it is
observed that the commodity futures market has
witnessed a remarkable growth in India since
2003.during 2003 [NCDEX] Mumbai,[MCX] Mumbai
were commenced The market has grown 61times
in2007-08 now all futures exchanges are facilitating
online screen based trading using a networked
computer system.

2. Meaning & Definition of Futures
A futures contract is an agreement between two
parties to buy or sell particular asset on a
specified future date.
“ Futures are exchange traded contracts to sell or
buy financial instruments or physical
commodities for future delivery at an agreed
price” --- BSE .
“Futures contracts are organised or Standardised
contracts,which are traded on the exchanges”.

3. TRADING MECHANISMS OF FUTURES
CONTRACT
STEP1:The order flow : In futures contracts an order
to buy or sell one futures contract ,Buyers begin
by contracting their exchange member ,who
inturn directs customers order to a floor broker
on the exchange floor who executes the trade. All
orders are executed on the floor of exchange
according to the rules .an Important aspect of
these rules is that they require all bids and offers
to be exposed to other traders in the pit in order
to assure execution of orders at open and
competitive prices.[open outcry system]

4. The Results of one contract trade: the clearing
house will have on its books two contractual
obligation – one long and one short .the
names of initiating buyer and sellers will
appear only on the book of exchange
members ,as obligations of the exchange
members.

5. STEP2: SETTLING A FUTURES POSITION:
Once having established a futures
position ,traders have an obligation under the
terms of the futures contract either to take
delivery or to make delivery of the underlying
commodity. However ,making or taking
physical delivery of future contracts can be
settled by three ways. 1] Physical delivery 2]
offsetting 3] by cash delivery.

6. PHYSICAL DELIVERY
• Liquidating a futures position by making or
taking physical delivery is usually the most
cumbersome way to fulfill contractual
obligations it requires actually purchasing or
selling a commodity, something traders would
normally not want to do unless they had a
particular need for commodity in large
quantity. A commercial firm ,which deals in
commodities ,might very well wish to settle by
physical delivery.

7. EXAMPLE: Let us take a particular futures contracts;
Coffee traded on NCDEX .A trader who is short one
coffee futures contract is required to make physical
delivery of 50 bags of coorg of arabiaca quality.
The operational procedure for making physical delivery
on futures differ by the type of futures contract .at the
beginning of delivery month on the exchange
designated notice, lets say for Feb 5th contract
,exchange rules requires that all traders having open
positions in feb 5th contract notify their respective
members that they intend to make or take delivery
during february when & what quantities such
deliveries are desired. the exchange members inturn
must notify clearing house of their customers
intentions.

8. • After the nomination process is complete the
clearing house matches longs and shorts
.delivery notices are then sent.
• Physical delivery imposes obvious costs on
traders ; warehouse expenses, insurance
costs, possibly shipping costs and brokerage
fees.
• The amount of commodity that meets
exchange specified quality standards and is
available for delivery at exchange specified
locations .the concept of deliverable stock is
relevant.

9. OFFSETTING:
The most common way of liquidating an open futures
position is to effect an offsetting transaction – in
effect to reverse the initial transaction which
establishes futures position .in this offsetting
settlement the initial buyer [long] liquidates his
position by selling or going short an identical futures
contract same commodity and same delivery month .
Similarly the initial seller short liquidates his position
by buying going long an identical contract. after these
traders are executed and reported to the clearing
house ,both traders obligations are extinguished in
the books of the clearing house and in those of the
exchange members.

10. • In comparison comparison to making or taking
physical delivery ,settlement by offset is
relatively simple .it requires only a liquid
futures market to facilitate offsetting trades,
and entails only the brokerage costs.

11. CASH DELIVERY:
• This procedure is a substitute for physical delivery
and completely eliminates having to make or take
physical delivery. it is available only for futures
contract that specifically designate cash delivery
as the settlement procedure. physical delivery is
not permitted in these contracts. The Mechanics
of cash delivery are simple: the price of the
relevant futures contract, at the close of trading
day in that contract is set equal to the cash price
of underlying asset at that time.

12. • Exchange has adopted cash delivery as an
alternative to physical delivery for two
reasons:
• 1] The nature of the underlying commodity
may not permit feasible physical delivery. Ex:
stock index futures would require physical
delivery of hundreds or thousands of shares of
stock in finely calculated proportions. requires
a cumbersome & costly delivery procedure.

13. • 2] cash delivery avoids the problem that it
may be difficult for traders to acquire the
physical commodity at the time of delivery
because of temporary shortage of supply .cash
delivery also makes it difficult to manipulate
or influence futures prices by causing artificial
shortage of the underlying commodity.
• The popularity of cash delivery has grown
substantially in recent years and has enabled
exchanges to offer futures contract s that
would not have been feasible without such a
delivery mechanism.