How Standardization and Daily Settlement Make Futures Tradable

# Trading futures, how does it work in practice?


# Trading futures, how does it work in practice?












If my understanding is correct, then owning a future essentially means owning a contract which obliges to buy/sell something at a certain time for a certain price.

But what I don't understand is how, in practice, trading futures works. When I look at video's of people trading futures they buy and sell futures just like they would stock; by placing buy and sell orders. But this does not make to me: all stocks of a certain company are equivalent, so of course all can be bought and sold at the same price. But future's are not all the same, since some are contracts for price X, while others are contracts for some different price Y. So if you and me both own a future to buy oil in December of this year, it is very well possible that our futures have different values. So how can futures be traded as a "fixed product" with a "fixed price" just stocks, when future for the same product can vary drastically in value?

## Answer by nbbo2 (score 5, accepted)

https://quant.stackexchange.com/a/65557

"a contract which obliges [someone] to buy/sell something at a certain time for a certain price"

This correctly describes a forward. A forward contract has a delivery price written in it. So my forward contract entered into today might say I am obliged to buy Gold at 1861 an ounce, while yours which was written a few days ago might say 1802. With each forward contract potentially different it becomes difficult to trade these contracts in a secondary market.

A solution to this was found in Chicago IL in the 19th century (some say it was even earlier in Osaka, Japan) resulting in the creation of Futures Exchanges for trading agricultural products. The exchange standardized the terms of the contract, so that for example 1 contract corresponds to 100 ounces of gold, etc. To solve the "different prices" problem the exchange introduced the "daily marking to market".

At the close of every day publishes the "settlement price" for the contract, based on the average market price in the last few minutes of trading. After the market closes all contracts are effectively rewritten to use this settlement price as the delivery price. The exchange also enforces a process so that the winners and losers in this process compensate each other via cash payments (the so called daily mark to market). So at delivery your delivery price is the latest settlement price. In the meantime you will have received profits (in cash) if the delivery price went up or losses if the delivery price went down.

Effectively this means that the current delivery price is whatever is the consensus in the marketplace. If you want to get out of your commitment you can just enter a commitment in the opposite direction and the exchange will offset the two, leaving you with no position.

## Answer by demully (score 2)

https://quant.stackexchange.com/a/65558

Short answer, trading futures is equivalent to trading a stock, because the futures are indeed equivalent. The only real difference is that the stock is perpetual; but the future expires at a known (but common) point in time.

So imagine I decided that I would (for sh1ts-and-giggles) gamble 1 FCOJ contract (ie orange juice, as per Trading Places) with a different broker every day for a month, flipping a coin for direction at 3.20pm every day (when Grandma died, and she so-loved orange juice). Because of "CounterParty Collatteral" (CCP) rules, I don't have 20 trades a month, with different prices for each broker. The brokers and I settle every trade on the exchange, so the effect for both of us is no different than if we'd bought/sold it from/to the market every time, just like a stock.

There is no difference really, except obviously from the leverage ;-) DEM

[Where, meant in utmost generosity, I think you might benefit from looking at this is in the distinction between forward and futures prices. Forwards will indeed have differing prices; but there is only one futures price for any futures contract, no different than for the underlying stock or ton of OJ ;-)]