Not all exchanges or markets accept all the types of orders mentioned above. For example, sometimes during volatile trade in crude oil at the NYMEX, only market orders are accepted. If you have any questions as to what is and what isn’t acceptable, it is best to consult with your account representative.

When considering order execution it is also important to note that at any time in a market there are two prevalent prices, the one that traders are willing to buy (the bid) and the one that traders are willing to sell (the ask). In liquid markets the bid/ask is usually very tight. Conversely, in illiquid or thin markets the difference can be quite wide.

Electronic vs. Open Outcry

Before the explosion in information technology, trading in most futures markets took place on the exchange floor. However, over the last several years electronic trading has made its mark as the manner in which all markets will eventually trade. While open outcry markets on the exchange floor are quickly becoming a thing of the past, it is important to know some of the pitfalls that they pose for the online trader.

While there are several ways that orders get routed on the exchange floor into the hands of a broker in the pit or ring, the most common manner is through the TOPS system. The way it works is that when an order is placed electronically it prints out on a terminal next to the broker. He then takes it and either executes it immediately, or places it with other orders he is holding to be filled at a later time based on what the market price does. While the system is much more efficient than it used to be, there remains the issue that human beings cannot function at the same speed as an electron. Unlike a computer, a broker can only handle so many orders at one time.

When volatility and order flow reach a critical level in open outcry markets, the exchange rules allow for trading to be declared in fast market conditions. When this occurs, brokers are no longer held responsible (not held) for limit orders. Furthermore, under such conditions, the general rules for the timeliness of order execution no longer apply. Under a normal trading environment, brokers have a maximum limit of time to execute stops and market orders (usually 3 minutes). However, in fast market conditions that limit is waived.

Another disadvantage of open outcry markets arises from the fact that because orders are held by a human being, communication about their status is more limited. With electronic trading platforms a trader knows immediately if and where he/she is filled. Consequently, with open outcry it can be difficult at times, especially in a fast market, for a trader to know where he/she stands.

While there are definite advantages to electronic trading in general, there are some important limitations that traders should be aware of as well. Probably the most important issue is one of liquidity. Whereas most open outcry markets have many participants that facilitate competitive order execution, there are many electronic markets that have little or no real trade. Fills on market and stop orders in such thin conditions can be brutal to a trader’s bottom line.

The deficiencies of open outcry not withstanding, there are numerous such markets that offer excellent trading opportunities with no real electronic alternative. This provides a trader the difficult choice of participating, or standing aside due to possible difficulties with order execution. As a wise old sage once told me, If you wan’a dance, you got’a pay the band.

Settlement

At the most basic level a futures trade is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. While most traders exit these contracts before they come due (usually referred to as expiration), there are certain aspects to the settlement of outstanding contracts that a trader needs to be aware of.

There are two basic types of futures settlement, cash and delivery. Delivery is probably the most commonly recognized form, but not necessarily the most prevalent. As the name implies, delivery means that the buyer (long) will be presented with a certified receipt representing the underlying commodity or financial instrument in return for the full value of the specific contract. For example, an individual taking delivery who was long March soybeans at $11.00 would be presented with a certified receipt for 5,000 bushels of beans stored in a warehouse certified by the Chicago Board of Trade. In return, he would pay the seller (short) $55,000. To avoid taking delivery on a futures contract, a buyer (long) needs to exit his/her position before what is termed First Notice Day. That date represents the first day that a seller (short) can deliver the underlying physical commodity or financial instrument to the buyer (long). As First Notice Day differs from one market to the next, it is important that traders be aware when that specific date is. Sellers (shorts), unless they intend to deliver the underlying physical, need to be out of their position by expiration day.

An easier and increasingly more common way for settlement in financial futures is referred to as cash. In this case the contract settles for an amount of money equal to what the derivative’s market value would be if it were physically settled. Trader’s positions are then simply offset at the expiration price. Consequently traders with positions in cash settled markets at expiration have their account balance adjusted to reflect the closing price on the last day of trading. Such a method is common in markets where physical delivery would be difficult or overly expensive to implement. For instance it would be cost prohibitive to actually deliver all 500 of the stocks traded in the S&P industrial index.

Market Players

There are numerous types of participants in most futures markets, but they basically can be broken down into 4 basic categories: commercials, large speculators, small speculators, and scalpers (locals). Commercials generally represent the companies that use or produce the underlying future that is being traded and use that market to hedge their operations. Examples would be Cargill in the grains or Merrill Lynch in the bond market. Large speculators would represent traders who need to report their positions to the Commodity Futures Trading Commission (CFTC) due to the size of their market commitments. Usually these players represent large funds and commodity pools. Small speculators are traders whose position sizes do not meet CFTC requirements for reporting. Day traders would fall into the category of small specs. Finally, scalpers (in open outcry markets they are referred to as locals or market makers) are traders who buy and sell all day long and try and capture the difference between the bid and ask price. These traders rarely if ever hold positions for more than several minutes.

The CFTC releases commitment of trader data every Friday afternoon. The report is broken down into commercial, non-commercial (large specs), and non-reportable (small specs) categories. It reflects the open positions (commonly referred to as open interest) of each group, broken down into both long and short, as of the close of the previous Tuesday. Below is an example of the October 16th 2012 breakdown for the soybean market:

The commitment of traders report provides an interesting snapshot into the current positions of the commercials and big funds. The fact that the data can be compared to the previous week can give you a much better understanding of what the underlying cause of market price movement really was.

Moore Or Less

Back in the mid-eighties there was an unspoken sense of resentment at the CBOT between the full members and the associate members of the exchange. Most of the full members were old time grain traders who had been at the exchange for many years. The old guard so to speak. Associate members were limited to trade in the financial room and most were new to the business. Yet, in the late seventies and first half of the eighties the financial room was the engine of growth for the exchange as interest rate futures volume soared. Many a young bond trader made millions during that time while the guys in the grain room languished with range bound trade and declining volume dominating those markets.

Due to the rules of the exchange, Associate members had little if any political clout concerning manners in which operations at the CBOT were handled. Yet they were responsible for a large chunk of exchange revenue. This brewing disdain came to a head early one spring morning when a young bond trader by the name of Mike Moore walked into the grain room.

Moore who was a big player in the bond pit had recently purchased a full membership, probably as an investment. But today he was going to trade soybeans. After the open Moore began his act, throwing around big numbers and basically getting in the face of anyone who tried to stand up to him. Throughout that day and the next I watched him throw his weight around and generally make a nuisance of himself.

On the third day, as we were all standing around waiting for the 9:30 open a broker standing next to me nonchalantly turned to a group of us and said watch this. I had no idea of what he was talking about until I spied Les Rosenthal standing across the pit directly across from Moore. Les was the epitome of the old guard. A well respected, shrewd trader who had made a fortune over the years, he rarely bothered to stand in the pit. His minions usually did his trades for him. But here he was this morning, with his distinguished white hair and purple trading jacket that was the mark of his clearing firm, standing in the top step. The two of them could not be more opposite. Moore was a tall, brash young trader while Les was the older more reserved type.

After the open the entertainment began. Moore would throw out a million bushels, Les would take it. Another million. Sold! Price wouldn’t budge. All morning Les took the other side of what Moore bought or sold, the two yelling and screaming at each other the whole time. At one point I thought that the two of them were going to literally explode in front of us. The drama continued the next day and the next. However, on the third day, Les was there but Moore was gone. He had returned to the bond room to lick his wounds. Evidently a little more humble than when he started.

Open Interest

Open interest is a metric that the exchanges release every day, although it is not broken down by category like the CFTC does. Still it is a very important statistic that gives valuable insight into the mechanics of the previous days price movement. Along with open interest the exchanges also release volume data, which represents the total number of contracts traded in each market. The importance of this data for market analysis is significant, and will be discussed in further detail later in the course. However for our purposes now, in determining what markets to consider trading, it is important to look for markets with large volume and open interest. It is these markets that generally offer the best liquidity and thus opportunity.

Trading Strategies

As with most things in life, to be successful as a trader you need to have a plan. Later on we will spend considerable time on specific types of trading methods and tools. However, at this juncture it would behoove us to spend a little time and cover some of the basic approaches that different traders can take in analyzing market opportunities. Trading strategies can be broken down into three basic categories, fundamental, technical, and contrarian. While technical analysis has probably been the most popular over the last several decades, the recent growth in information technology has led to an explosion in the amount of resources available to traders in this area of study.

In its most basic form, technical analysis is the examination of price series data for consistently recurring patterns. Most often data is graphically displayed in a standard bar chart format. This consists of a line connecting the high and low, with a small mark placed on the left for the open and the right for the close. Each bar represents whatever specific timeframe the trader is interested in studying and generally ranges from between 5 minutes to 1 month. Often below the price chart analysts will plot volume and open interest. There are also numerous mathematical renditions of the price data that can be overlaid or plotted below the chart, such as moving averages, oscillators and the like. The following bar chart shows December 2012 silver with a volume and open interest plot.