This is true for most people trading futures, but there are those who genuinely want the bananas. At the end of the day, somebody’s holding that banana contract at expiration.
I think in the case of the Macadamia nuts, there was a promise to buy the nuts at a certain price, and there was no one who bought the paper, and they were already shipped. I guess the trader was technically the owner, and I gather it wasn’t worth the cost of selling them and shipping them somewhere else. For all I know he may not have wanted to affect market prices by selling them at a discount. This is probably more common with agricultural products that will lose value over time.
Sometimes the trader just forgets to close out the contract (a big “oops”). I think that was the case with the gold delivery I mentioned above; either that or it was just a miscommunication of some sort.
I remember another story about a commodities trader who almost forgot to close out his contracts for a delivery of crude oil. We were joking that it shouldn’t be a problem, considering the CEO had lots of room in his back yard…
OK, so what does ‘closing out’ actually involve? Do you call the person with the other part of the contract and say “hey Bob, I don’t really want the oil and macadamias, so let’s just do the cash thing” or is there some terminology or automated mechanism for a cash-only transfer rather than the goods??
If you’re short, you buy a contract in the open market on the exchange. If you’re long, you sell your contract. Contracts are fungible - every contract is exactly like the others. You generally don’t know or care who’s on the other side. You might have opened your position when you bought a contract from a speculative trader in Chicago and closed it when you sold it to Cargill. See here. When it comes time to actually exchange cash for physical, the exchange facilitates the transfer of money and goods.
Note that all contracts have the exchange as a counterparty, so you really can’t call the person on the “other part” of the contract.
The cash vs. physical thing is largely specified on the standardized contract. Physical delivery is usual, but not universal commodities and bonds, while cash settlement is the standard for interest rates.
ICE Brent futures seem to have an option to do either.
Woah! Stop the thread! This is information that hasn’t been mentioned by anyone else, and completely alters my comprehension of the thing. So all you do is buy and sell with the exchange? It’s not like a game of Pit where you’re looking for someone else to sell to?
In the Wikipedia article about clearing houses linked to above, it explains it:
“Once a trade has been executed by two counterparties either on an exchange, or in the OTC markets, the trade can be handed over to a clearing house which then steps between the two original traders’ clearing firms and assumes the legal counterparty risk for the trade.”
Etc.
First, read this.
The exchange (at least the CME Group family) will serve only as a counter party of last resort - which has never happened in 100 years. The CME Group has it’s own clearing operation, but there are other clearing firms that are members of the CME. If an individual somehow manages to get his account into a debit, and is unable to post more margin/collateral, his clearing firm will eat the loss. Only if the entire clearing firm wiped out, will the exchange step in.
Yeah, that’s kind of why futures exchanges exist in the first place. Me and you could come to an agreement that I’ll sell you a barrel of WTI crude for $90 on Dec 25th, but you don’t know who I am and whether I’m trustworthy and I don’t know who you are and whether you’re trustworthy, so we’d both accept a lot of risk that I won’t show up with my barrel when the time comes, or you won’t show up with the money.
Doing the transaction on the exchange, though, you end up long a contract for crude, I end up with short a contract for the same crude, and the exchange (or its associated clearing house) steps in and says, “I’m going to guarantee that both of these transactions takes place, because I know both of you well enough that this is going to happen (and I’ve forced you both to post collateral)”. And from that point on it doesn’t matter who I am and who you are because all dealings are with the exchange.
I work in an energy trading function, and I think it should be clarified that not all trading of commodities for future delivery is done on an exchange. In fact I think it’s far more straightforward to start out with over-the-counter forward trading, rather than jumping straight into exchange-based trading, with all the complications such as clearing-houses and margining.
Where I work, traders pick up the phone to a counterparty and say something like, “Hi Martin, Paul here, how are the kids, what price can you get me for 100,000 therms of gas per day for delivery in December? Okay, I’ll buy at that price.”
Now, a confirmation will issue from the seller to the buyer a couple of days later, outlining the details of the trade and the terms or master agreement under which it has been transacted. But it is the phone conversation that is binding - the transaction is the execution, and the “confirmation” is just a record of the trade.
Following that transaction, the company has a long position of 100,000 therms/day of gas which will be delivered at the National Balancing Point in the UK every day in December. We then have the choice of taking delivery, and using the gas, or entering into another contract with another counterparty and selling the gas (at a profit or a loss, depending on whether the December price has gone up or down).
But even if we do sell, the contracts have not been cancelled. Although the net position is now zero, we have two open positions with two counterparties, and continue to bear the counterparty risk associated with both.
Alternatively, as other people have described, we can buy or sell 100,000 therms of gas on a screen-based trading platform - in which case the trade remains anonymous, the parties provide credit support to the exchange, and the exchange manages the counterparty risk.
OK, so, still trying to absorb all of the above, and feeling very stupid indeed (Jockstrap’s explanation comes closest to helping me understand though I gather there’s a nuance in it that is disputable; also thanks Frazzle for helping me understand hedging), can someone describe the work actually done by a futures broker?
Do they do the same thing at all hours of the day or do things change based on how close the market is to shutting for the day? What do they actually do? What sort of emails might they send or receive, phone calls they make, reports they write, etc.?
In an example above someone bought a contract from the exchange and sold it to Cargill. So how would you know that Cargill wants the contract? Also, please explain any jargon used. E.g.: “opened your position” - what does that actually mean in the real world?
you know, we’re talking about a business and it’s hard to understand if you just read or talk about it. i’ll bet you’ll get the hang of it in a few days if you get a job as a broker.
to answer your last questions (they’re repeats but it’s ok if you get different correct versions each time.) a broker simply handles a clien’t order, whether if it’s a buy or a sell. that’s what brokerage is, a simple intermediary for trading transactions.
an open position is a buy that remains with the buyer beyond the settlement date. if you sell on the same day, it’s closed, or covered, or squared or whatever you want to call it (it doesn’t matter what you call it because you no longer have an exposure at risk, you no longer owe anyone, and you already have your money back.)
we do bond trading and we don’t consider unsettled shorts as open positions. they’re just tabbed for squaring within a certain date.
Just a heads up to the OP, and I know you didn’t mean to offend, but you might be turning away some folks who could help out with your question by posing your title in a bit of an offensive way. (“retarded” <> “stupid”)
Is that a subtle way of insinuating that I’m stupid? 
But yeah, you’re right. I apologise, I just thought it was funny at the time.
Thanks mac_bolan for your reply, but you’ve slightly reverted to jargon again without actually explaining precisely what you mean.
E.g. “we don’t consider unsettled shorts as open positions. they’re just tabbed for squaring within a certain date.” To a naif (who actually has reasonably high intelligence in other areas, but is having problems grasping the actualities of the subject) that means absolutely nothing. What are the practical ramifications of that statement?
Or: “a broker simply handles a clien’t order, whether if it’s a buy or a sell. that’s what brokerage is, a simple intermediary for trading transactions.” OK, so how does the broker do this? Do they use a computer-based interface with a screen called “buy stuff”? Do they call someone - who - and if they do, what do they say to them?
There are two main roles a broker might do: hedging and speculating.
Hedging is about helping companies minimize their risk. The oil company and the trucking company in my example above hedged their positions to ensure they still made a profit. For example, lets say you’re a farmer who raises lambs for meat. There are no futures for lambs. There are futures for beef and wool however. The prices of beef and wool are likely to be related to the price for lamb so you may be able to buy these contracts and hedge some of your risk. A broker can provide advice on things like this and help to make sure you are actually minimizing your risk.
Speculating is buying contracts to attempt to make a profit, without being involved in handling any of the underlying commodities. Brokers in this case will do research to try and determine what they think the price of a commodity will be in the future. They will then try and find a contract for that commodity that has a different price. For example the broker might look at weather patterns and decide that it will be a particularly cold winter. Since oil is used for heating, he thinks oil will go to $100 in winter. So he buys oil futures that expire in winter for $90. If he was correct he’ll make $10 but if he was wrong he could lose money.
Brokers can play both roles. It can get a lot more complex than this. When I speak about brokers here I’m really talking about brokerage firms. In these firms different people will have different roles. Some will handle the customers, some will do the research, some handle the accounting etc.
You’re saying “broker”, but the activities you are describing are those of a trader.
A broker’s role is to facilitate trading by bringing prospective buyers and sellers together. He makes his money on commission. The broker may well operate a screen-based trading platform and invite buyers and sellers to post their bids and offers. The broker may also engage in phone-based intermediation of trades, discussing with traders how much they are willing to buy/sell for and trying to bring the two parties to a price they can both agree on.
Individual contractors, for purchase, or sale, production or consumption of the many commodities that exist are in the extreme minority of the huge number of people trading in commodities. Almost all the stories of truckloads of oranges being delivered to surprised investors are apocryphal. The farmer who is actually going to grow wheat needs collateral to pay for costs to produce wheat, and he sells a contract to a futures exchange. He expects to actually have wheat, in some amount. He won’t sell his entire expected harvest as a future contract. Too many risks involved in that, and too much limitation on possible profit. He sells enough futures to avoid paying interest on necessary costs.
While there are exceptions, most futures markets only deal with a small percentage of the volume of spot markets. So, on the day that contracts in a particular type of commodity settle, the spot market can easily absorb the difference either way in shortages, or surpluses of the commodity. The exchanges make sure the market prices reflect that, in order to avoid defaults. They do that by buying and selling the contracts that drive the futures prices. Doing that may cost those exchanges millions, or billions, or make them millions or billions of dollars. But it does not leave them holding bushels of wheat, or hiding from mobs of incensed bakers. What does happen is that a whole lot of folks who bought or sold wheat last year, don’t actually get, or provide any wheat at all. They just make or lose an amount of money that reflects the difference in the actual price of wheat on that date, and the expected price from when the contracts were issued. The wheat farmer got his money when the deal was first made, and might well buy a contract for wheat now, if the price of actual wheat makes that a better deal. If it does, he sells his actual wheat directly to a consumer, for the higher price, and closes out his own contract with the exchange. Or, he delivers the wheat he has, and only gets the lower price for the wheat he did not sell on the futures market. Either way, he is ahead by the interest costs he would have paid to borrow the money last winter.
The broker gets a percentage, no matter which way it goes.
Tris
Let’s say I’m a manufacturer making frozen apple pies and so I buy a futures contract for 10 tons of apples to be delivered to me on Dec 1st for $10,000. Do I get a say in what types of apples I get? Do I know what farms they come from? What if some of them are rotten or underripe? What if some were sprayed with a pesticide I don’t want going into my pies?
It seems hard to square the fungible nature of contracts with the diversity of agricultural produce.
Each market has contract specifications detailing what is deliverable.
Corn
Silver
Lumber
Hard Red Spring Wheat