In this article we are going to review how futures contracts are priced in the marketplace. We’re going to take a look at the price of futures contracts and how Futures are traded on the exchange. It is important to note that the exchanges set all of the standardized terms for every contract and all contracts are for a stated number of units. For example, 5,000 bushels of wheat, 1,000 barrels of oil or 100 Troy oz of gold, all of the contracts are for a standard number of units and all contracts are priced on a per-unit basis. The minimum price variation or the minimum price change, is the smallest amount by which the price of the contract can change from the previous transaction. This increment is known as a tick. In order to understand some of the pricing dynamics regarding the trading of Futures contracts review the following examples:
Corn – For a corn contract the minimum price variation or tick is 1/4 of one cent, that’s one quarter of $0.01 per bushel, times 5,000 bushels, making the value of one tick on a corn contract worth $12.50. If a corn contract increased by one tick from the previous transaction the value that contract increased by $12.50
Gold – For a gold contract each contract covers 100 troy ounces. Some of you may be asking what a troy ounce is? A troy ounce is slightly less than 1.1 Oz, it’s a little bit of a different measure of an ounce, and that is how the contract units were established by the exchange. It is not important that you know exactly what a troy ounce is, but you will see that terminology on the exam and don’t let it throw you. So every gold contract covers 100 troy ounces of gold and the minimum price variation or tick for a gold contract is $0.10. To determine the value of the tick for each contract, use the following formula: 10 cents per ounce x 100 oz, the value of a tick for gold contract is $10.
Daily price limit
When talking about price variations, the tick is the smallest increment by which a contract may change, the daily price limit is the maximum by which a contract can change in any given day. To ensure that there are no panics in the commodities markets, the exchanges have established daily price limits for most of the contracts. The daily price limit again is the maximum amount of which the contract can change in any given trading day and the price the exchange uses to determine the amount of the change or the daily price limit is the previous day’s settlement price. The settlement price is determined by the Clearing House based on a formula and the settlement price is not necessarily the last trade executed or the last trade reported to the tape. The settlement price is established by a formula that the Clearing House uses to determine an actual settlement price. The settlement price can change or be slightly different than the last trade executed, which is the last trade to actually take place or the last trade reported which was the last trade reported to the tape. If a contract trades by or changes by the maximum amount allowed, the daily price limit, the contract will be in what is known as a state of limit up or limit down. During a state of limit up buying the contract could be very very difficult for someone who is looking to either establish or offset a position. When this condition exists the contract is said to be in a state of lock limit up. From an exchange operational point of view the CBOT will increase or expand the daily price limit to 150% of the daily price limit if 3 contracts close in a state of limit up or limit down. During a time of significant volatility when the exchange expands the daily price limit, the CBOT will automatically increase the margin required to open a new position in that futures contract. Additionally, the CBOT will increase the minimum maintenance required to hold that contract position. The new requirement will remain in effect until the state of limit up / down is no longer in effect for 3 consecutive days. These are the actions that will be taken by the CBOT. Now, you want to be aware of the fact that the CME will not automatically increase the margin requirement when the CME expands the daily price limit. When the exchange increases the margin requirement, should an established position fall below the new increased minimum margin requirement, a call will be issued and the contract holder must deposit enough margin to meet the new increased initial margin requirement.
Now let’s take a look at the example of what can happen when a contract goes into a state of limit up or limit down.
If corn has a settlement price of $5.10 per bushel and it has a daily price limit of $0.10 that means that corn in trade either $0.10 up or $0.10 down. In this case the established trading range is anywhere between $5 and $5.20 per bushel. This trading range represents the range of prices based on fundamental supply and demand. Anything outside of these prices would represent either a panic or manipulative activity. If corn settled at $5.10 per bushel yesterday and it trades up to $5.20 today, the contract would be in a state of lock limit up. When corn is $5.20 bid and is offered at $5.21, the only way someone could buy to establish or buy to offset a short position would be if another investor was willing to sell the contract at $5.20 and they happened to be lucky enough to be there to buy it at that time. So a state of lock Limit Up occurs when a contract is bid at limit price or higher. On the other side of the equation, we can have what is known as a state of lock limit down or a state of limit down. If corn settled at $5.10 per bushel yesterday and the commodity has fallen precipitously during the course of the day it would reach a state of limit down at a price of $5.00. If corn was offered at $5.00 per bushel and bid $4.99, an investor could not sell that corn contract at $4.99 as it is outside of the daily price limit. The only way an investor could sell that corn contract would be if another investor was willing to buy it from them at $5.00. So here you have a state of limit down. For your exam you want to be aware of the fact that during a state of lock limit up or lock limit down, it is virtually impossible or close to Impossible to enter or offset a position. Additionally, you want to make sure that you know that the daily price limit is based on the previous day’s settlement price. A little bit of an odd test point here, is what would be the settlement price for a futures contract, if no trades took place during the trading day? if no transactions took place during a trading day, the answer is the midpoint between the bid and offer would be the settlement price
We hope that this article has helped you better understand futures contracts are priced and traded on the exchanges.
Pass your exam guaranteed or your money back with our GreenLight Pass guarantee
Good luck on your exam!
The Securities Institute of America
For more than 25 years we’ve helped students pass over 250,000 exams and we’ve done so with industry leading pass rates!