Chapter 2: Mechanics of Futures Markets

Question 1

Define: Contract size

Answer 1

exactly how much of the asset will be delivered under 1 contract

Question 2

Define: limit move

Answer 2

a move in either direction equal to the daily price limit

Question 3

Define: limit up

Answer 3

If in a day the price moves up from the previous day’s close by an amount equal to the daily price limit, the contract is said to be limit up

Question 4

Define: limit down

Answer 4

If in a day the price moves down from the previous day’s close by an amount equal to the daily price limit, the contract is said to be limit down

Question 5

What are “position limits” and their purpose?

Answer 5

Position limits are the max number of contracts that a speculator may hold. Its purpose is to prevent speculators from exercising undue influence on the market.

Question 6

Why does the futures price converge to the spot price?

Answer 6

During the delivery period, if the future price is different from the spot price, traders exploit this arbitrage opportunity. As a result, the futures price will converge to the spot price

Question 7

What is daily settlement or marking to market?

Answer 7

at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss.

Question 8

Define: day trade

Answer 8

The trader announces to the broker an intent to close out the position in the same day.

Question 9

Define: spread transaction

Answer 9

The trader simultaneously buys a contract on an asset for one maturity month and sells (i.e. takes a short position in) a contract on the same asset for another maturity month

Question 10

What is the purpose of the margin system?

Answer 10

Ensure that funds are available to pay traders when they make a profit.

Question 11

What is the settlement price used for?

Answer 11

The settlement price is used for calculating daily gains and losses and margin requirement.

Question 12

What is the difference between trading volume and open interest?

Answer 12

Trading volume is the number of contracts traded in a day. Open interest is the number of contracts outstanding (i.e. the number of long positions or, equivalently, the number of short positions).

Question 13

List and define the patterns of futures.

Answer 13

1) Normal market (sometimes referred to as contango): when settlement futures prices are an increasing function of the maturity of the contract.
2) Inverted market (sometimes referred to as backwardation): when settlement futures prices decline with maturity.
3) partly normal and partly inverted

Question 14

Define: market order

Answer 14

A request to trade immediately at the best price available in the market

Question 15

Define: limit order

Answer 15

The order can be executed only at this price or at one more favorable to the investor.

Question 16

Define: Stop order/stop-loss order

Answer 16

The order is executed at the best available price once a bid or offer is made at that particular price or a less favorable price.
It is designed to place a limit on the loss that can occur in the event of unfavorable price movement

Question 17

Define: stop-limit order

Answer 17

✓It is a combination of a “stop order” and a “limit order”.
✓Two prices must be specified in a stop-limit order: the stop price and the limit price
✓the order becomes a “limit order” as soon as a bid or offer is made at a price equal to or less favorable than the stop price
✓if the stop price=limit price, the order is sometimes called a “stop-and-limit order”

Question 18

Define: market-if-touched (MIT) order

Aka board order

Answer 18

It is easier at the best available price after a trade occurs at a specified price or at a price more favorable than the specified price.
✓in effect, an MIT becomes a “market order” once the specified price has been hit
✓MIT is designed to endure that profits are taken if sufficiently favorable price movements occur

Question 19

Define: discretionary order (or market-not-held order)

Answer 19

It is traded as a market order except that execution may be delayed at the broker’s discretion in an attempt to get a better price

Question 20

Define: time-of-day order

Answer 20

It specifies a particular period of time during the day when the order can be executed.

Question 21

Define: open order (or good-till-canceled order)

Answer 21

It is in effect until executed or until the end of trading in the particular contract

Question 22

Define: fill-or-kill order

Answer 22

It must be executed immediately on receipt or not at all

Question 23

Define: order

Answer 23

Unless otherwise stated, an order is a day order and expires at the end of the trading day.