Price Trends:
Normal, Inverted, Contango, and
Backwardated Markets
Now that you are familiar with reading futures quotes, you need to learn about some of the patterns they form. This isn't a technical analysis course, but rather a way of understanding what the markets are signaling when the prices steadily rise or fall as the contract maturity increases. This is important to understand since the different patterns indicate what the market participants are suggesting will happen with that commodity in the future. If you are familiar with bonds, this is similar to analyzing a yield curve. For example, if yields steadily fall, which is called an inverted yield curve, the markets are anticipating an upcoming recession. In a similar fashion, rising or falling patterns with commodity prices can give great insights into potential future pricing conditions.
We saw in the last course that "last trade" or "settlement" prices are generally listed online or in your newspaper by ascending contract maturities. What does it mean if the price steadily rises? What if it falls
| Thought Questions: |
Normal, Inverted, and Mixed Markets
Take a look at the column labeled "Last" for the wheat futures quotes in the following table. As a reminder, this column is showing the price at which that contract last traded.
Notice how those prices increase as the contract time is increased. In other words, as we move from May toward December, the prices of the contracts rise. For most commodities, this rising price pattern will often be the case, due to the cost of carry. Remember, in an earlier course, we said that cost of carry is another way of saying financing cost. As the time to maturity increases, one would certainly think that the contract prices should rise since the cost to carry it increases. Whenever you see this pattern of rising prices, that commodity is said to be in a normal market.| WHEAT (CBT) | ||||||||
| Contract | Last | Chg. | Open | High | Low | Settle | Lifetime High | Lifetime Low |
| May | 2784 | -36 | 2830 | 2840 | 2776 | 2822 | 3122 | 2522 |
| July | 2822 | -32 | 2860 | 2874 | 2816 | 2854 | 3154 | 2554 |
| September | 2880 | -24 | 2920 | 2932 | 2876 | 2904 | 3204 | 2604 |
| December | 2982 | -26 | 3020 | 3030 | 2980 | 3010 | 3310 | 2710 |
As luck would have it, our intuition about rising prices is not always correct. While it may seem logical that prices should rise as the maturity rises, there are some commodities where the reverse pattern will be true.
For instance, New York Harbor unleaded gasoline futures contracts at the New York Mercantile Exchange (NYMEX) are often cheaper as contract time is increased. This is called an inverted marketand is shown in the following table. Notice how when we move from May toward September, the price of the contract actually falls:| Unleaded Gasoline (NYM) | ||||||||
| Contract | Last | Chg. | Open | High | Low | Settle | Lifetime High | Lifetime Low |
| May | .8100 | -.0104 | .8105 | .8191 | .8000 | 0.8204 | .8220 | .7982 |
| June | .8030 | -.0074 | .8028 | .8085 | .7930 | 0.8104 | .8106 | .7912 |
| July | .7810 | -.0104 | .7809 | .7875 | .7800 | 0.7914 | .7830 | .7784 |
| Aug | .7635 | -.0049 | .7632 | .7670 | .7615 | 0.7684 | .7652 | .7595 |
| Sept | .7404 | 0 | .7400 | .7434 | .7390 | 0.7404 | .7455 | .7373 |
Then there are also some markets that are a mixture of normal and inverted markets, which exhibit rising or falling prices for a few months but then reverse direction at a later point in time. For example, the next table shows quotes on the oats futures at the CBOT. Notice how prices rise fall from May through December but then rise in March '03. This is called a mixed market:
| OATS (CBT) | ||||||||
| Contract | Last | Chg. | Open | High | Low | Settle | Lifetime High | Lifetime Low |
| May | 2010 | +40 | 1962 | 2030 | 1956 | 1970 | 2170 | 1770 |
| July | 1732 | +32 | 1696 | 1750 | 1692 | 1700 | 1900 | 1500 |
| September | 1440 | +10 | 1434 | 1440 | 1430 | 1430 | 1630 | 1230 |
| December | 1436 | +12 | 1430 | 1444 | 1430 | 1424 | 1624 | 1224 |
| Mar 03 | 1460 | +14 | 1460 | 1460 | 1460 | 1444 | 1644 | 1244 |
 | Key Points |
- If prices continually rise, it is a normal market
- If prices continually fall, it is an inverted market
- If prices rise and then fall (or fall and then rise), it is called a mixed market
Why would prices rise in one market, fall in another, and be mixed in yet another? The answer took a long time to solve and dates back to the 1930s to the writings of two famous economists, John Hicks and John Maynard Keynes.
The reason for this phenomenon lies in the net balance of the number of hedgers and speculators in that particular commodity. We said during the first course section that speculators provide an important economic function for the futures markets in that they are the ones bearing the risk. They are willing to take the opposing side of the hedgers and speculate on making money solely through price movements.
Hicks and Keynes thought that maybe some markets were dominated by long hedgers. These are markets where certain manufacturers wish to buy the underlying commodities in the future. In other words, they wish to lock in their future purchase price today. If these people wish to protect their purchase prices, they must persuade another person -- usually a speculator-- to take the short side of the futures contract. How do you persuade someone to hold a short futures contract? The long hedgers must bid it up above its expected spot price in the future. If they do, the price of the futures contract will fall as it nears expiration, leaving the speculator with a positive expected return.
For example, using our wheat quotes from above, let's assume that everybody expects wheat to be trading for, say 2975, in December. If the futures markets price wheat exactly at this price, then a speculator who sells the futures contract today will be agreeing to sell wheat for 2975 in December. If the contract is, in fact, trading for 2975 in December, the speculator must buy it back at that same price, which leaves no net gain.[1] In other words, the speculator is agreeing to buy and sell wheat for the same price of 2975, which leaves no profit. However, if the long hedgers bid the contract up to a higher amount, such as 2982, the speculators can sell the contract for 2982 and buy it back for 2975 (remember that the futures price will converge to the spot price at expiration), which leave them with an expected profit. Just because it is an expected gain does not mean that one will result. That is the incentive given by the long hedgers to the speculators to take the short side of the futures contract.
While this may sound confusing, it is a natural occurrence whenever one person is trying to encourage another to sell something. Take, for example, this excerpt from a Seinfeld episode:
George is invited over to his girlfriend's parent's house and brings a marble rye bread for them as a gift. George accidentally takes the bread he intended as a gift with him when he leaves. Jerry goes to the bakery to purchase a rye bread but discovers the last one has been sold. He offers the old lady that purchased the last one far more than she paid but she refuses.
Jerry was trying to get the lady to exchange the bread for money (a verbal contract). He wanted to be the buyer (the long position) so had to give her incentive to be the seller -- the short side of the contract. To provide this incentive, he keeps raising his bid price. At some point, at least theoretically, the lady should have realized she could purchase the bread at a later date for far less money and kept the rest as profit and agreed to sell. But theory doesn't work for Jerry like it does for the futures markets.
In a similar sense, long hedgers with futures contracts must do the same thing. They must be willing to bid the contract higher than the price that is expected at expiration so that the seller, the short contract, can expect a profit. In a market dominated by long hedgers, we would expect the prices to continuously rise as time to maturity is increased, which is exactly what we see with the wheat quotes in the earlier table.
The theory that says hedgers hold long contracts on a net balance (meaning there are more long hedgers than short hedgers) is called contangotheory. Similarly, futures contracts that exhibit rising prices as time is increased are said to be in a contango market.
| Key Points |
Contango Theory:
Hedgers hold long contracts on a net balance thus creating a normal market.
Contango Market:
Futures markets that exhibit rising prices as time to maturity increases.
While prices rise from month to month in a contango market, the price of the contract is expected to fall as expirations approaches. This may seem contradictory, but think about what is happening. The hedgers must bid the contracts higher than their expected prices at expiration so the short sellers can expect a profit. So while the futures contract prices rise from month to month, the individual contract prices are expected to fall as expiration gets closer. Their prices fall because the futures price will converge to the spot price. The next chart shows the mechanics of a contango market. The futures price is bid up higher than the current spot price and is also bid up higher than the expected spot price that will prevail in the future. Once that future spot price emerges, the futures price will fall to meet that price.
Please keep in mind that this is a theory that explains this price pattern. It does not necessarily mean that it must turn out this way. Nonetheless, we should expect to see an overall positive return for short sellers of futures contracts in a contangomarket.
We've just seen why some markets exhibit rising futures prices as the time to maturity increases. How can we explain patterns of falling prices such as with the quotes for unleaded gasoline?
There is a theory opposite that of the contango theory which states that some markets will be dominated by short hedgers -- those wishing to sell the asset in the future. These people are usually the producers of the commodity who wish to protect their selling price and therefore need a short hedge. In order to persuade a speculator to hold a long futures contract in this market, they must sell it below the expected future spot price so that the speculator can expect a positive return.
Again, this is probably confusing at first, so let's use another example you're more familiar with. Let's say you wish to trade in a car that has a market value of $10,000. That's the price it can be sold for quickly at a retail dealership. If that were the case, why would the dealer give you $10,000 for it? If he did, he would pay $10,000 for the car and then sell it for the same amount, which leaves him with no profit. In order to persuade the dealer to take your car (take the long position), you must be willing to take less than the market value for it (although the ridiculously low bids made by the dealer are another story!) You may, for example, take $8,500 for it meaning the car dealer is "long" at $8,500 and can sell it for the expected $10,000 market value, which leaves him an expected profit.
In the same sense, short hedgers must be willing to take less than the expected future spot price to get a speculator to hold the long side of the futures contract. The theory that supports this argument is called normal backwardationand, just for the record, I had nothing to do with the selection of that name! At any rate, normal backwardation theory states that hedgers are primarily short the futures contracts and speculators are long. The short hedgers compete in the market and push the price below the expected future spot price in order to get a speculator to purchase the contract.
| Key Points |
Normal Backwardation Theory
Hedgers hold short contracts on a net balance thus creating inverted markets.
Normal Backwardated Market
Futures markets that exhibit falling prices as time to maturity increases.
The next chart shows how the dominant short hedgers push the futures prices below the expected future spot price. This below-expected price allows the speculatorsto expect a positive gain. Again, please do not think that if you hold long futures contracts that you must have a gain. This theory suggests that the overall price is below what it is expected so that the long speculators have some incentive to hold the contract. Market conditions can change quickly, leaving the long positions with large losses. So the theory suggests that one can expect a positive gain over time and not that gains must occur on each contract.
Other markets, such our oats example, exhibit a mixed market whereby sometimes the prices rise (or fall) throughout a certain range and then reverse directions at a later time. The rational for the mixed markets is basically a mixture of the contango and normal backwardation theories. Depending on supply and demand conditions, sometimes the markets are dominated by long hedgers and other times by short hedgers. Harvests also affect the supply side and can cause prices to fall when crops are expected to come to market in large quantities.
So while contango markets rise in price with the more distant months, those prices are expected to fall as expiration nears to compensate the short speculators. The reverse is true for normal backwardated markets. Normal backwardated markets fall in price with the more distant months; however, those prices are expected to rise as expiration nears to compensate the long speculators. The following figure shows how contango markets are expected to fall and normal backwardated markets are expected to rise as expiration nears:
More on Price Discovery
We have just seen how futures prices can provide a means for investors to "see into the future" and gauge where prices are expected to trade. We referred to this earlier as price discovery. We now need to take a little closer look at different market types and why price discovery may work well in some markets while not so well in others.
While there are many types of futures contracts, they can basically be categorized as either a "storable" commodity or a "non-storable" one. Most grains such as wheat, oats, and rice for example are storable and can be preserved for long periods of time. Others, such as milk or eggs cannot be stored for any long length of time. These are the "non-storable" goods.
It is the non-storable commodities that provide the most efficient means of price discovery. That is, the futures price is a pure reflection of what market participants expect the future price of that commodity to be. If the supply of milk, for example, were expected to rise in the next three months, you would see the futures prices rise to that expected level as well. In a storable goods market, this may not be the case. The reason you may not see futures prices of non-storable goods rise under the same conditions is that market participants can pull that supply out of the market today and store it for delivery in the future. This is similar to our "cash-and-carry" arbitrage we talked about in an earlier course. For example, if wheat is expected to rise 20% in the next three months, you still may not see that much of a difference between the spot price and the futures price. That's because, as the price of the futures contracts rise, arbitrageurs will buy wheat today, store it, and deliver it in the future. These actions will put buying pressure on the spot price and selling pressure on the futures price. You will see a rise in the spot price rather than a rise in the futures price. The end result being that the spot price and futures price will be separated by the cost of carry.
If the commodity is not storable, or at least not easily stored, then arbitrageurs will not be able to complete the cash-and-carry arbitrage steps. They cannot buy that future supply today because it does not exist, which also means they certainly cannot store it. The result is that the futures price must fully reflect that change in expectations.
You may hear news sources say something like, "The futures markets are pricing an anticipated quarter-point rate hike from the Feds." This simply means they are looking at the Federal Funds futures contracts and observing the difference between that price and the current rate. The Federal Funds futures are a good predictor of future rates -- they behave like a "non-storable" commodity since you cannot meet future bank reserves by purchasing them today. For storable commodities, such as wheat, the futures may not serve as a good predictor of the expected price due to the fact that arbitrageurscan buy it today and store it for future delivery.
So be careful when using futures quotes as a predictor for future prices. Only when the commodities are non-storable will the futures markets serve as a valuable predictor of future prices.
[1] The speculator is technically not required to buy it back. However, if he does not, he must deliver the asset at expiration. Because speculators are not interested in making delivery, we are assuming they must buy back the contract.
The Trading Process on Single-Stock Futures
We've covered a lot on futures and most of that material was probably new to you, so I'm sure you won't object if we do a review before moving forward! This is a good time for us to go back and review-- especially the key concepts such as marking to market, maintenance, and variation margin.
To make this a little more fun and not strictly a review course, we're going to assume that you want to trade a single-stock futures contract. We'll take you through the entire process from opening an account to placing your first trade. After that, we'll monitor your position to see how it will be affected as the underlying stock moves and make sure you know how you'd be affected by maintenance and variation margin.
Let's start by opening an account...
Opening an Account
The process for opening a futures account is not much different from opening an account with a stockbroker. In fact, if you plan to trade single-stock futures, you will be able to open the account and execute trades through most retail brokerage firms. This means you will be able to talk to your same broker and keep the futures contracts under the same account number as your current stocks, bonds, and mutual funds. However, if you wish to trade commodity futures, you must do so through a futures broker, which is technically called a Futures Commission Merchant, or FCM.
The reason you will be able to mix stocks with single-stock futures is because single-stock futures are not easily classified into a futures or stock products. (Remember the Shad-Johnson Accord from the second week)? The CFMA said these hybrid products should be treated as both and therefore regulated by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Therefore, any firm trading single-stock futures must be registered as a broker dealer with the SEC and as a futures commission merchant with the CFTC. Keep in mind that this applies only to single-stock futures. Once again, if you wish to trade commodity futures, you must do so through an FCM.
Please keep in mind that just because your brokerage firm is allowed to trade single-stock futures does not mean they must. Individual firms can certainly elect to not trade specific assets and most do to a degree. However, we feel the single-stock futures will make such a celebrated debut that most will offer them for fear of missing out on the action.
Let's assume you find a broker with whom you feel comfortable and wish to open an account. First, the broker will require you to fill out an account application, which will be very similar in length and questions to the one you filled out for a stock or option trading account. They are generally three to five pages long with basic information including past investment experience. In addition, there will be a confidential net worth statement, which is required by law under the "know your customer" rule. The brokers need to know that you have a positive net worth before investing in futures. You will also need to sign a supplemental risk disclosure document, which states you have read and understand the risks involved in futures trading.
Using the Web
To see some of the information that will see on a risk disclosure document, you may wish to visit the following link:
http://www.cftc.gov/opa/brochures/opafutures.htm
Most FCMs or brokers will e-mail or fax an application to you. Most will even have a form you can download from their Web site. While they can accept electronically transmitted forms, they cannot accept an e-mailed or faxed signature. However, the better firms usually provide their Federal Express account number so you can overnight the application back to them at no cost to you. If they don't offer an overnight number, it never hurts to ask.
Placing an Order
Once you open your account, you're ready to take advantage of single-stock futures. Please be aware that most firms will require cash deposited to your account before a trade is placed and many will require that to be cleared cash. This just means that your check may need to sit in the account for a few days while it clears your bank before you can trade. Another alternative is to deposit a cashier's check or money order. I think it's safe to say that none of them will accept cash.
Let's say it is January, and Microsoft is trading for $60. You think the stock price will rise over the next three months and wish to buy a futures contract to potentially profit from your outlook.
You simply call your broker and give him the instructions to buy one Microsoft March futures contract. Because you are entering the contract, you are "opening." When it comes time to exit the contract, you would place an order to sell the same contract and thus be "closing" the contract. Remember from an earlier course that although you will be opening and closing contracts, you do not need to specify the terms "opening" or "closing" when placing the order. But most brokers may use the terms just to confirm what you are doing so there are no mistakes. For example, he may say, "Is this an opening contract?" or something to that effect. Incidentally, because many new traders find this terminology confusing, some brokers will use the terms "new" and "offsetting" to designate opening and closing transactions respectively.
The broker will give you the contract symbol, which, according to the Securities Industry Association (SIA), will likely be a five-letter code representing the underlying stock followed by a standardized letter representing the month. The following table gives the standard codes for the months for all futures contracts. These tables are readily available through the exchange Web site, and your broker can certainly give you the information, too:
| Month Code | Month |
| F | January |
| G | February |
| H | March |
| J | April |
| K | May |
| M | June |
| N | July |
| Q | August |
| U | September |
| V | October |
| X | November |
| Z | December |
A proposed symbol structure by the SIA for single-stock futures will look something like the following diagram:
The proposed symbols will not be nice, simple three- or four-letter codes that you're used to seeing with stocks. That's because there has not been any formal arrangement between futures and equities regarding symbols, for the simple fact there was never a need. In fact, there are currently some symbols that are the same for futures and stocks and must be separated by an exchange code at the end. With the development of single-stock futures, there could certainly be room for complications if these measures were not taken. Unfortunately, awkward symbols will be the result. Again, there's no need to worry about it as your broker will certainly look up the symbol for you.
Let's assume the broker gets a quote and tells you that the March contract on Microsoft is bid $60.50 and asking $61.
| Thought Questions: |
Because each futures contract represents 100 shares of stock, that contract has a value of $6,100. Of course, you will only be required to post the initial margin, which is expected to be 20% of this value, or $1,220. We're also going to assume that maintenance level will be 20% below this amount, or $976.
Your broker will tell you these levels and then ask you how you wish to enter the order. You will need to tell him the following information:
- Action (buy or sell)
- Quantity (number of contracts)
- Contract (name of contract, i.e. Microsoft, Intel, S&P 500)
- Month (expiration month)
- Price (market or limit -- see below)
- Time (how long do you want the order to stay open? -- see below)
- Exchange (to which exchange do you want your order to go?)
Your broker will be able to help you with most of the information. However, when it comes time to decide on price and time, you must supply that information, so it is important to understand the following types of orders. While the following is a fairly extensive list, it is not exhaustive. But it does contain most of the orders used in nearly all of the cases you will ever need to use. Also, just because these orders exist does not mean that your broker must offer them. Be sure to check with them regarding which types they accept.
To place the order, we need to tell the broker to buy one Microsoft March contract. In most futures markets, the number of contracts will be straightforward with the exception of grains and soybeans. In those commodities, because the contract size is 5,000 bushels, it is convention to just strike three zeros off the contract size to determine the number of contracts. For example, if you tell your broker to buy five corn contracts, you are really just purchasing one contract, which controls 5,000 bushels. This really shows that it is important to confirm the order with your broker. You can see where trading lingo and other oddities within each marker can really cause confusion. The point of all this is that you can't be too careful -- especially when you are starting out. Don't let the broker rush you. If you have a question, ask.
We're going to place our hypothetical Microsoft trade "at market" to be sure we get filled. If you are familiar with what this means and are comfortable with the various types of orders, you can skip to the next section "Confirming Your Order" and continue with the example. However, if you are not familiar with them, or just wish to take a quick review, most of the types of orders you will encounter are listed below:
Types of Orders
Most of the orders you're used to seeing with stocks, such as market, limit, stop orders, and others will apply to futures as well. In addition, there are some types of orders that are unique to futures. We'll go through each to make sure you understand the basic ideas behind them.
Orders that Control Price: Market, Limit,Opening Only, Market on Open, Or-Better, Disregard Tape
The most commonly used orders for buying and selling contracts are market and limit orders. Depending on your situation, one order will be preferable to another so it is important to understand the differences and risks with each type.
Market Orders
Let's start with the most important feature of a market order, which is that market orders guarantee the execution but not the price.
In fact, a market order is the only way to make certain you will get the trade executed.[1] However, in order to guarantee the fill, you must be willing to accept the best available price at the time your order hits the floor. So while you may see a contract quoting a certain price when you send your order, that is not necessarily the price at which you will be filled. In most cases, though, it will be very close if not exact. Also, be sure to look at the current asking price if buying (or the current bid price if selling) rather than the price of the last trade. That last trade could have taken place a long time ago and not be close to the true price of the contract.
There are also times when fast markets occur, which means the quotes are not keeping up with the true order flow. In these cases, you may certainly be filled at an unfavorable price and you have no recourse with your broker. Be careful using market orders under "fast market" conditions.
Two Special Cases of Market Orders: Opening Only, Market on Open
There are two special cases of market orders you should be aware of. They are "opening only" orders and "market on open." Both of these are types of market orders, as they are guaranteed to fill; however, they specify when the order is to be filled.
Opening-Only Orders
An opening-only order can only be filled during the opening range of prices. If the order is a market order, it must be filled. If it is marked as a limit, stop (or stop limit) then it may or may not be filled. Many traders feel this range of prices is a truer representation of value than intra-day prices so elect this type of order.
Market on Open (MOO)
This type of order is used to execute trades at the opening. Traders often use this designation to take advantage of a build-up of sell or buy orders through the night. For instance, if you wish to sell your contract and good news is released near the close of trading you may wish to enter a MOO order for the following day. That way, you will likely get a higher price from the influx of buy orders that arrive through the night.
Limit Orders
While market orders have the advantage of a guaranteed fill, they come with the disadvantage of not necessarily knowing the price that you will pay or receive. Limit orders were developed to prevent this risk.
With a limit order, you tell your broker that you are willing to buy or sell but only at a certain price, which is called the limit price. If you say to buy the March Microsoft futures contract at a limit of $60, this means your order will only be filled if it can be filled for $60 or less. If you wish to sell at a limit of $60, that means your order will only be filled if it can be filled for $60 or more. Because you are specifying a specific price, the risk of the limit order is that your order will never get filled. Limit orders guarantee the price but not the execution.
Also, a limit order may be filled in part, unlike a market order. For example, if you place an order to buy 10 contracts at a limit of $60, it's possible that you get filled on only five contracts or some other number less than 10. With a limit order, what you are really telling your broker is that you are willing to buy up to[2] 10 contracts. If you are only willing to buy all 10 or nothing at all, you will need to use an "all-or-none restriction discussed later.
When placing an order, you need to figure out which is more important -- making sure it is filled (market order) or making sure you get a certain price (limit order). There is no way to guarantee the execution and price -- you get one or the other.
Or-Better Orders
There is a type of limit orderwhich sort of blends a market and limit order called an "or better qualifier. With an "or-better" order, you place buy orders above the current asking price and sell orders below the current bid price. Why would anyone be willing to pay a higher price or receive a lower price? The reason is that it allows some room for the contract's price to move while your order is being routed to the floor.
Some brokers will tell you that "or better" is always implied with any order and that you do not need to specify that terminology. They may say, "We always try to get you the better price so you don't need to state that." This is not true; there is a very good reason why you need to understand the distinction, which we'll explain with an example.
Assume that Microsoft contract is asking $60.75 and it is moving rapidly higher and you want to buy it right now. If you are online and place an order to buy at $61 or better, there's a very good chance you'll get filled and may even get it at a better price (hence the name "or better"). However, the computer doesn't know this. It just sees that you entered an order to buy for a price higher than the current market price. Are you trying to get the execution now (or better) or are you trying to buy it if the contract moves up to that price (such as with a stop order that we'll talk about shortly)? Since the computer doesn't know what you're trying to do, you must check off a box that says "or better" so that it knows you're really trying to get an immediate execution. If your broker insists that there's no reason to designate the order, ask why their trading tickets have the "or better" designation. If it were always implied, why would they bother to print it?
Some people think that using "or better" orders are a recipe for disaster, as the floor will probably fill you at the higher $61 price in this example. This is not true, as the traders are bound by time-and-sales, which reflect the current prices at the time your order was received. With "or better" orders, your order is still not guaranteed to fill but the odds are much higher compared to a straight limit order. Assuming you're willing to pay the higher price, I would almost always use "or better" orders if the underlying stock is moving quickly.
DRT Orders (Disregard Tape)
A DRT order is a discretionary order that allows the brokers to use their judgment in obtaining a better price. This does not mean they will be able to get you a better price; in fact, you may even get a worse price. However, in most cases, if you consistently use these orders, you should obtain slightly better fills over the long run. This is due to the fact that the brokers on the floor have much more knowledge than we do as to what is happening down there. A DRT designation gives them discretion to use their expertise in trying to obtain a better price.
DRT orders are more commonly known as a "not held or "market not held" order when dealing with stocks. All of these orders accomplish the same thing and basically say that you will not hold the broker to the time and sales reports (the tape) if you should get an unfavorable price.
For example, if you place an order to sell your contract at market DRT, you may see prices over the next several minutes of $62 or higher trading. However, you may get a confirmation back with a fill at $61.90. You cannot come back and tell your broker you saw higher prices and are therefore due a better price. They will come back and tell you that the ticket was market DRT, which gives full discretion to the floor broker and there is nothing that can be done.
Orders that Control Risk: Stop, Stop Limit, Market-If-Touched, Market-on-Close
Stop and stop limit orders are intended to be risk-management tools. They are usually used as a means to sell an exit an existing position if unfavorable price movements occur. In other words, they are used to sell long positions and buy back short positions. While stop and stop limit orders can really help you, they can also cause great losses is you're not sure how they work.
If you are planning to use stop orders on your futures trades, make sure you understand this section.
There are two basic types of stop orders: stop orders and stop limit orders. There are very important differences between the two so we'll look at them individually.
Stop Order
A stop order is a conditional order to buy or sell at market. You specify a price at which point the trade is "triggered" and becomes a market order to either buy or sell.
For example, say you paid $60 for the futures contract and it is now trading for $70. You feel it could climb much higher, so you'd like to keep holding it, but at the same time, you don't want to see it fall back to $60. This is the ideal situation for a stop order. You could place an order to sell your contract at a stop price of $68, for example. When you specify a stop price, that is the "trigger price" and is not necessarily the price you will get for your contract. So if the contract trades at $68 or lower, your order is triggered and becomes a market order, which will be filled at the next best available price.
It is very important to note that the contract needs to trade at or lower than your stop price in order to become triggered. This is where a lot of traders get themselves in trouble. Using the above example, say you placed a stop at $68 and the contract settles that day at $68.50. The stop order is not triggered, so at this point you still have the contract. However, the first trade the following morning is $62 on bad news. Because the last trade is below the stop price of $68, you will be filled at market -- around $62 -- which is very different from the stop price of $68. Remember, the stop price is only a trigger point and is the price where the order is activated. It is not necessarily the price you will receive! In cases where the futures contract falls slowly, though, stop orders work very well and the price you receive can be close to your stop price.
Stop orders used to be called "stop loss" orders until the Securities and Exchange Commission ruled to change the name because it is misleading. It sounds like the order will prevent losses, which is definitely not true.
Stop Limit Orders
In this last example we assumed you placed a stop orderof $68 in anticipation of getting that amount if the contract should fall. Under normal circumstances, if the contract falls slowly, this method can work great. It's only when you see the large gaps down where the prices can be very different.
What if the there is a large gap down but you would rather hold onto your contract if you couldn't be assured of getting the $68 stop price? This is the ideal situation for stop limit orders.
With a stop limit order, you specify two prices. One is the trigger point and the other is the sell limit price. If you can't sell for $68 and you'd rather hold the contract, you could instead place a stop limit order and tell your broker to sell at a stop price of $68 with a stop limit of $67.50, for example. If the stock trades at $68 or below (the stop price) the order will be activated as with a regular stop order. However, instead of becoming a market order, a stop limit order becomes a limit order to sell. This order is saying to activate it at $68 (the stop price) but do not sell for anything less than $67.50 (the limit price). The limit price can be equal to or less than the stop price.
In this example, when the futures contract opened at $62, the trader with the stop limit order would also have his order activated. However, he will still hold the contract because it could not be sold for $67.50 or higher. If the stock does rise to that price during the day (or later if using a good-til-cancelled order), the contract will be sold. Remember, it is a live order once it has been triggered. If you do not want to sell the contract, you need to cancel the order.
Notice again that the stop limit order did not prevent a loss either when the futures price gapped down below the stop limit price. With the stop limit order, you still own the contract. The stop order just gives a realized loss since it is sold while the stop limit order gives an unrealized loss.
Buy Stops
Buy stops work the same as sell stops but in the other direction. Usually they are used by short sellers -- those who borrow shares to sell hoping to buy them back cheaper at a later time. In order to prevent the futures price from getting away from them to the upside, these traders often place buy stops.
For example, say you are short the Microsoft contract at $60. The risk to this trader is that Microsoft moves higher. In order to make sure the stock doesn't get away from you, you could place a buy stop at $62. This is saying to buy the shares at market if the futures trade at $62 or higher. Again, this is not necessarily the price you will pay, as the $62, in this example, is only the trigger point.
If the trader does not want to pay more than a certain price, he can elect to place a buy stop limit. As an example, you could place an order to buy the futures at a stop price of $61, with a stop limit of $61.50. If the futures trade at $61 or higher, the order will be activated but will only fill if the contracts can be purchased for $61.50 or lower.
Traders also use buy stops to buy contracts on momentum. For example, say Microsoft stock has been sitting flat for a very long time at $60. The rumor is that a new product is expected to be released that could send the shares much higher. Rather than buy it now and possibly wait a long time for that day to come, traders may put in a buy stop order at $63 (and possibly add a stop limit), for example. Now, the only time the trader will be filled is if the futures contract is trading at $63 or higher. In effect, the trader is buying the stock only if it appears the market is starting to rally the stock. Again, this is a nice management tool to assure that you purchase the contracts on anticipated news without having to watch the markets all day long.
Market-If-Touched (MIT)
Market-if-touched orders, also called board orders, are unique to futures trading. You will not be able to use them for stock or optionstrading, although that may change in the near future. A market-if-touched (MIT) order is like a reverse stop order. It allows a trader to buy or sell if the price moves in a favorable direction, rather than an unfavorable one. For instance, if you buy the Microsoft contract for $60, you may wish to sell if it hits $65. Normally, you would have to use a sell limit order and place an order to sell your contract at a limit of $65. The problem with this type of order is that you must receive at least $65 in order to get filled. An MIT order at $65, however, will trigger if the contract touches (trades at) $65 or higher. Once it does, the order becomes a live market order and sells your contract at the best prevailing price at the time your order is filled, which may be below $65. If the market reverses directions quickly, you may not be able to get filled with a sell limit of $65 but would get out with an MIT order.
Notice how this order differs from the sell-stop where you may place an order to sell at a stop price of $58, for example, which is an unfavorable move. Both the MIT and stop orders get you out of the contract. However, the MIT does so on a favorable move while the stop order executes on an unfavorable one. The MIT order is used to lock in gains while a stop order is used to minimize losses.
MIT orders can be used to close short futures contracts as well. In this case, you simply place the order to buy the contract at a lower price.
Market on Close (MOC)
There is a really nice tool that's not widely used by most traders. It's called a market-on-close order or MOC. With an MOC order, you try to buy or sell your contracts at a limit price during the trading day. If it is not filled, it converts to a market order within the final seconds of trading (60 seconds for financial futures). A market on close order must be filled within the prices that occurred during these time frames.
For example, say you bought two contracts at $60 and they are now selling for $70. The market looks really strong and there is a possibility they could trade much higher. However, you don't want to lose your profit. You could place an order to sell your two contracts at a limit of $72 MOC. Now, if it trades at $72 or higher, you will be filled. But if it doesn't trade that high, you will be sold very close to the closing price of the day. Keep in mind this could be much less than you anticipated! But MOC orders can be a great tool, as they allow you to try for better prices during the day but are assured to execute your order by the end of the day regardless. Please keep in mind that many brokers will refuse this order if it is not placed at some specified period (usually at least 15 minutes) before the close of trading.
Time Limits:
Day, Good Until Cancelled, Immediate-or-Cancel, Fill-or-Kill
If you use any order other than a market order, you must also specify a time period that the order is to remain open. Remember, a market order is guaranteed to fill so can only be marked as a day order (even though it will usually be filled within seconds). Technically there are four different time designations:
- Day
- Good-until-cancelled (GTC)
- Immediate-or-cancel (IOC)
- Fill-or-kill (FOK)
By far, most trades are entered as either day or good-until-cancelled, but we will go over each so you understand them all.
If you enter an order other than "market" it is not guaranteed to fill, so your broker will need to know if you want the order cancelled at the end of the day (day order) or cancelled after an indefinite time period with a good-'til-cancelled order, also called GTC. However, individual firms are free to set stricter requirements and may not allow a GTC order to stand open until the contract expires, so you should check with your broker regarding their policy. In fact, at the time of this writing, the New York Board of Trade only allows day orders due to the September 11 attacks, which damaged its trading floors -- they are now not able to hold tickets overnight. This is just to point out that GTC orders may vary from firm to firm and may not even be allowed at times. If you do not specify a time limit, the order will usually default to a day order.
Your broker may also have variations on GTC orders such as: are good this week (GTW), good this month (GTM) and good through date (GTD), which designate an order good through a specific date.
Instead of a day or GTC order, you can, instead, elect your timeframe to be immediate-or-cancel or fill-or-kill also known as IOC and FOK orders respectively. Both orders are asking for an immediate execution or cancellation of the order. The difference is that immediate-or-cancel orders allow for partial fills while fill-or-kill orders must be filled in their entirety.
Orders that Control Execution Size: All-or-None, Minimum Lots
If you place a limit order, for example, to buy 30 contracts at a limit of $5, it is possible to get filled on only a portion, say 20 contracts. With a limit order, you are telling your broker to buy up to the amount designated (30 contracts in this example).
All-or-None
If, however, you want to insure that you get all 30 contracts or nothing at all, you need to use an "all-or-none restriction, also designated AON. If you use this restriction, you are telling the floor to fill the entire order, or nothing at all.
There is a big danger in using all-or-none orders, though. Any order marked all-or-none goes to the back of the line (for listed stocks), or is held in the back pocket of an options or futures trader. This means that it is possible you'll never get an execution, even though many traded at your price or better, and you cannot hold the exchange to time and sales. The trader can always come back and say that all contracts could never be filled at once and you will have no recourse against your broker or the exchange. In addition, quotes to fill AON orders do not need to be within the current bid-ask range.
Minimums and Minimum Lots
If you don't like the idea of all-or-none restrictions, you can opt for a minimum. For example, say you are selling 50 contracts but want at least 30 or nothing at all. You can place the order to sell 50 with a minimum of 30.
Additionally, if you only want your trade filled in minimums of five contracts thereafter, you can tell your broker "minimum lots of five. So the order would look like "sell 50 contracts, minimum 30, and minimum lots of five". Now the order must be filled with at least 30 initially and in lots of five thereafter such as 35, 40 etc., up to 50.
Minimums and minimum lots are a nice alternative to all-or-none orders.
Canceling Your Order: Straight Cancellation, One Cancels Other
If you have placed an order, other than a market order, and wish to cancel it, you can do so by simply placing a straight cancellation order. Remember that market orders are guaranteed to fill and this is why you cannot request a cancellation of a market order. The second it hits the floor it's filled.
Once the floor receives your cancellation request, they will check to see if your order may have already been filled. If not, they will honor the request and cancel the order. However, you must understand that a cancellation order is technically a "request" to cancel and does not guarantee a cancellation. Just because you do not see a confirmation on your account does not necessarily mean that the order has not been filled. In many cases, the execution could have taken place minutes ago but just took a while for the floor to get the confirmation back to the broker.
OCO Orders (One Cancels Other, or Order Cancels Order)
An OCO order is used to change orders so that you don't risk getting two of them filled. Let's say you placed an order for the Microsoft futures contract at $60, the market is now rallying and you do not have a confirmation back yet. If you decide to pay a higher price, you can call your broker and tell him to buy the contract at a higher price, say $60.50 OCO.
This means your order will be presented at the new price of $60.50 and, if filled, will automatically cancel the first order to buy at $60. If the order has already been filled at $60, the new order at $60.50 is cancelled.
While this may not be a complete list of all of the orders, it will be nearly all you'll ever need to know. Keep in mind that as financial innovations reshape the markets, new types of orders will inevitably be introduced. Your broker will also be able to help you. If you let him know what you're trying to do, there is likely an order or designation that will accomplish your goal. By asking questions and learning, you will eventually understand all the orders that work best for you.
Confirming Your Order
Your broker will be able to execute and confirm your order with the same ease and speed you're probably familiar with in the stock market. It will usually take a matter of seconds to confirm your market order.
Let's say you are filled at the asking price of $61. What did you just do? This means you have agreed to buy 100 shares of Microsoft for a price of $61 per share at expiration of the futures contract. Again, this is a total contract value of $6,100, so you will be required to put up the initial margin amount of 20%, or $1,220. As a reminder, we're assuming the maintenance level is $976. Your broker will debit the account for $1,220 for your initial margin requirement, and he may or may not pay interest on that balance.
At the end of that day and every trading day thereafter, your account will be marked to market and debited if the contract value falls and credited if it rises. Remember too that futures contracts and stocks are traded on separate exchanges, so they do not necessarily move hand-in-hand. But as we learned in an earlier course, arbitrage keeps the prices separated by roughly the cost of carry. The result is that your long position should rise when the underlying stock rises and fall when the underlying falls.
Marking to Market
We talked about marking to market in an earlier course, so this is a great time to review and make sure you understand how it works. Let's say that the Microsoft futures contract has the following settlement prices over the next 10 days:
62.30
59.60
59.15
58.25
59.62
60.88
58.75
61.09
62.30
64.05
The next table shows how your account would look at the end of each trading day:
| Long Futures Position at $61 | |||||
| Day | Settlement Price | Net change | Gain/ | Account Balance | Remarks |
| | | | | Initial deposit (margin): +$1,220 | Contract purchased. Deposit 20% of $6,100 contract value |
| 1 | 62.30 | +1.30 | +$130 | $1,350 | Equity increased by $130 |
| 2 | 59.60 | -2.70 | -$270 | $1,080 | Equity decreased but still above maintenance margin of $976 |
| 3 | 59.15 | -0.45 | -$45 | $1,035 | Equity decreased again but still above maintenance margin of $976 |
| 4 | 58.25 | -0.90 | -$90 | $945 = maintenance call | Equity falls below maintenance marginof $976. Send broker check (variation margin) for $275 to bring equity back to initial $1,220 |
| 5 | 59.62 | +1.37 | +$137 | $1,357 | Equity increased |
| 6 | 60.88 | +1.26 | +$126 | $1,483 | Equity increased |
| 7 | 58.75 | -2.13 | -$213 | $1,270 | Equity decreased |
| 8 | 61.09 | +2.34 | +$234 | $1,504 | Equity increased |
| 9 | 62.30 | +1.21 | +$121 | $1,625 | Equity increased |
| 10 | 64.05 | +1.75 | +175 | $1,800 | "Sell to close" futures contract for $64.05 -- contract closed out |
Let's start at the top of the chart. We show in the top row that $1,220 is deposited, which we know is the initial margin requirement. We'll also assume this is the only position in the account in order to more easily understand how the mechanics of marking to market work. This means you deposit $1,220 and your total equity is $1,220 at that time.
Day 1
At the end of that day (the same day you purchased), the contract settles at $62.30, which is a net change of +$1.30 from your purchase price of $60. Because you purchased one contract (100 shares), you will be credited $1.30 * 100 shares = $130 and your equity will rise by that same amount. Why are you credited? Remember that long positions profit from an increase in prices. Because it is an increase from your purchase price to the settlement price, you receive a credit. The person who is short the contract would be debited the same amount. This credit is yours to withdraw immediately or just leave in the account. Most investors would leave it in the account in case a lower settlement price occurs. Your equity has now increased to a total of $1,350 ($1,220 initial + $130 credit). Notice how we based this marking to market on your purchase price and the settlement price. This is the only time that will occur. All others will be based on settlement to settlement prices -- you will understand why shortly.
Days 2 and 3
Now assume that on the next day, day 2, the contract settles at $59.60. This is a fall of $2.70 from the previous close of $62.30. Your account is now debited $2.70 * 100 = $270, which makes your new equity $1,350 - $270 = 1,080.
The third day is similar. The contract falls from $59.60 to $59.15, or 45 cents. This creates another debit of 0.45 * 100 = $45. Your equity is now $1,035.
Day 4: Maintenance Call
On the fourth day, we assume the price falls again to 58.25 from 59.15, down 90 cents. You are debited 0.90 * 100 = $90, leaving you a total equity of $945. We assumed that the maintenance margin was $976 and, with this recent decline, you are now below that level. This means your account is in maintenance and you will receive a maintenance call from your broker asking for more money, which is called variation margin. In this example, you will have to bring the account all the way back up to the initial margin level of $1,220, which means you must send a check for $275.
Day 5
On the fifth day, we have an increase in the value of the futures contract from $58.25 to $59.62, or $1.37. You will now be credited $137, which brings your equity to $1,337. (Don't forget that you had to bring your account up to $1,220 with variation margin. This means your equity is now $1,220 + $137 = $1,357).
This process continues through the tenth day when the contract is finally closed out for $64.05.
What's interesting to note is that although your account is debited and credited daily, the only thing that matters to your total equity is where the contract finishes. This should make intuitive sense from our earlier discussions of forward contracts. You may recall that forward contracts accrue all gains or losses at the end rather than daily. However, a futures contract and a forward contract under the same terms will finish with exactly the same gains and losses. The reason futures brokers will mark your account to market daily is to discover early those who cannot afford to take the loss.
To better understand why it doesn't matter to total equity where the underlying stock moves prior to expiration, let's look at an example. Say the contract settles up one additional dollar on day eight at $62.09 rather than $61.09 as shown. The means the net change would be $3.34 instead of $2.34. If so, would we have an additional $100 in the account and have equity of $1,900 rather than $1,800 at the end? The answer is no and the reason is that additional gain will be exactly mirrored in the opposite direction on the following day. On day nine, the net change would only be up 0.21 instead of $1.21. That's because the contract would rise from $62.09 to $62.30 for a 21-cent gain. On day ten, the net change would still be the same $1.75 rise. The result is that day eight would increase by $1 and day nine would fall by $1 for no net change. The only thing that matters to total equity is where the contract starts and where it finishes.
This leads to an even quicker way to calculate gains and losses for futures. In the example, we know the contract was purchased for $61 and ended up at $64.05. This means a gain of $64.05 - $61 = $3.05 was realized for a total gain of $305. In addition, a check for $275 was sent, so the total equity must be increased by $305 + $275 = $580. If we add $580 to the starting value of $1,220 we get $1,800, which is the same result obtained by going through all the debits and credits.
In order to find our gains or losses on a futures contract, we only need to know the opening price and the closing price. Notice that this is also the same for stocks, so there really is no difference between buying the futures contract and buying the stock in terms of gains and losses due to price movements. An investor buying 100 shares of stock at $61 and selling for $64.05 would realize the same $305 gain. The difference between one trader buying futures and another buying stock is that the futures trader is debited and credited daily whereas the stock trader only has "paper" gains or losses.
Using the above table, we can see that a trader buying stock for $61 would have an unrealized loss of $275 with the stock at $58.25 during day four. The futures trader must send a check for this amount but the stock trader does not. The reason the stock trader does not need to send money is because the stock is paid for in full and cannot fall below zero. The futures trader, however, is leveraged by placing a "good faith" deposit (initial margin) of only $1,220 in anticipation of paying $6,100 at expiration. If the futures trader deposited the full contract value of $6,100 at the beginning, there would be no difference at expiration between the futures trader and the stock trader.[3]
This leads to an important insight about investing in futures. Once you realize there is really no difference in the gains or losses that will be incurred but rather in the way they are incurred, the idea of investing in futures should be more appealing. The big difference is the fact that you can lose more than your initial deposit with futures contracts; however, you will not lose more in terms of total dollars when compared to an outright stock purchase.
The Short Position
We just saw what would happen to your account if you were long the above futures contract. The short position, as we've said before, will be faced with the opposite set of debits and credits. This is because futures are a zero-sum game and all the losses must total all of the gains in the market. To make sure you understand the short position, let's run through the same example but from the short positions side. In effect, we are looking at the person who is on the other side of your trade. In reality, you will never know who that person is. But you can be sure that you are joined together with another investor and all gains and losses will be equal.
Since we know that futures are a zero-sum game, if we do our calculations correctly, we should find out the short contract ends up with a loss of $305, which is exactly the gain of the long position we calculated previously. The next table summarizes the same transactions for the short position:
| Short Futures Position at $61 | |||||
| Day | Settlement Price | Net change | Gain/ | Account Balance | Remarks |
| | | | | Initial deposit (margin): +$1,220 | Contract sold at $61. Deposit 20% of $6,100 contract value |
| 1 | 62.30 | +1.30 | -$130 | $1,090 | Equity decreased by $130 but still above maintenance margin of $976 |
| 2 | 59.60 | -2.70 | +$270 | $1,360 | Equity increased |
| 3 | 59.15 | -0.45 | +$45 | $1,405 | Equity increased |
| 4 | 58.25 | -0.90 | +$90 | $1495 | Equity increased |
| 5 | 59.62 | +1.37 | -$137 | $1,358 | Equity decreased |
| 6 | 60.88 | +1.26 | -$126 | $1,232 | Equity decreased |
| 7 | 58.75 | -2.13 | +$213 | $1,445 | Equity increased |
| 8 | 61.09 | +2.34 | -$234 | $1,211 | Equity decreased |
| 9 | 62.30 | +1.21 | -$121 | $1,090 | Equity decreased |
| 10 | 64.05 | +1.75 | -175 | $915 | "Buy to close" futures contract for $64.05 -- contract closed out. |
The short trader must also post the initial margin requirement of $1,220. Shorting a futures contract is not like shorting stock, as the trader does not receive a credit. However, the short stock trader still has to post Reg T and pay 50% above the initial credit amount for security whereas the futures trader only pays 20%. It is still far cheaper and easier to short futures than stock.
Because the stock closes up $1.30 after the first day, the short trader is down by $130 for a position value of $1,090. There is no need to send a check, because he is still above maintenance margin of $976. Days two through nine are straightforward -- the trader gains when the stock falls and loses when it rises. After the tenth day, the account is down to $915, which would require variation margin to be sent in. However, because we are assuming it is closed out on this day, there is no need to send a check. This trader started with $1,220 equity and ended up with $915, which is a loss of $305 and exactly what we predicted. Once again we can take the shortcut method and realize that the contract was shorted at $61 and repurchased for $64.05, which is a loss of $3.05 or $305 when taking into account the 100-share size of the contract.
In the introductory courses, we said that futures trading can be risky, depending on how they are used. Now you should have a better understanding of what we meant. In this example, if you have the $6,100 and want to invest in Microsoft, there is really no difference whether you buy the stock or the futures. With the futures though, you get access to your gains immediately without having to close the position. This is something the stock trader cannot do.
However, if you do not have the money and wish speculate in the futures market, you can do so by placing a small amount down, such as the $1,220 in the example. But if you trade futures in this manner, great damage can be done. If you start receiving maintenance calls from your broker and do not have the money, they may close out your contract or even journal money from another account you may have with them. If they close the contract out for a loss, you are still responsible for that loss. These rights are given to them in the account agreement form you must sign in order to open the account. In this example, when the stock (futures) is $58.25 during day four, you may be forced to close out the contract if you cannot send a check immediately (you'll still be liable for the $275 though). Notice that with the stock or futures at $64.05 that a gain would have resulted (for the long position) had you been allowed to hang on to the contract. This is the dangerous aspect of futures. Most of the commodity contract values are very large, and many people do not have the kind of money readily available to pay for one contract outright. Because of this, many are forced to close contracts early even though conditions may turn in their favor in the end. Keep this in mind when you start trading single-stock futures or commodity contracts. Use contract values that are manageable and allow you to send in variation marginif that should happen. If you don't, one slight unexpected move can cause you to be out for a permanent loss. A better way to play the futures is to ask yourself if you can, or are comfortable, controlling a contract of that size, rather than determining if you can afford the initial margin amount.
[1] The only exception is with stocks since a short sale must be executed on an uptick and there is no guarantee that will occur. Futures, remember, do not need an uptick to go short, so market orders guarantee an immediate fill on a long or short futures position.
[2] This is not necessary with the equity options markets, as all option quotes must be good for at least 20 contracts. However, this is not the case for futures contracts and a particular quote may only be good for one contract.
[3] Of course, dividends, voting privileges, or other rights conveyed with stock ownership will not carry over to the futures trader. However, we are talking about differences due solely to price movements in the stock.
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