All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner where each party involved is fully aware of the details of the transaction.There are specific nuances in the flow of the orders themselves. As legally-binding agreements, non-performance under a futures contract can have severe financial, and legal, consequences. Therefore, most phone conversations are recorded to ensure the accuracy of the orders placed as well as the results of the execution of those orders. Standardized Order Forms are used on the floor of the NYMEX during order execution. Daily "check-outs" occur between Brokers and their clients for verification of all trades conducted that day. In this lesson, we will follow a natural gas futures contract trade from the beginning to end for a producer and end-user wishing to lock-in a fixed-price for a 12-month period ("strip"). In addition, electronic trading is becoming the main way in which these transactions are executed these days and the traditional "pits" are quickly becoming a thing of the past. In addition, "High Frequency Traders" (HFT) are using super-computers with complicated algorithms to trigger thousands of trades in mere nano-seconds. They have only added to the volatility in the marketplace.
At the successful completion of this lesson, students should be able to:
This lesson will take us one week to complete. There are a number of required activities in this module. The chart below provides an overview of the activities for this lesson. For assignment details, refer to the location noted.
All assignments will be due Sunday, 11:59 p.m. Eastern Time.
REQUIREMENT | LOCATION | SUBMITTING YOUR WORK |
---|---|---|
Reading Assignment: Chapter 3 Video on High Frequency Trading |
Errera & Brown Mini-lecture page |
No submission |
Mini-lecture: NYMEX Order Flow | Mini-lecture: NYMEX Order Flow page | No submission |
Lesson Activity: "Trading Places" video | Lesson Activity page/Canvas | Submit to activity in Canvas |
Lesson Quiz Fundamental Factors (on-going) |
Summary and Final tasks page Summary and Final tasks page |
Submit through Canvas Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.
Errera & Brown - Chapter 3
All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner with each party involved fully aware of the details of the transaction.As legally-binding agreements, non-performance under a futures contract can have severe financial, and legal, consequences. Therefore, most phone conversations are taped to ensure the accuracy of the orders placed as well as the results of the execution of those orders. Standardized Order Forms are used during order execution and daily "check-outs" occur between Brokers and their clients for verification of all trades conducted that day. In this lesson, we will follow a natural gas futures contract trade from the beginning to end for a producer and end-user wishing to lock-in a fixed price for a 12-month period.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The lecture slides can be found in the Modules under Lesson 4: NYMEX Order Execution & Electronic Trading in Canvas.
As mentioned in the introduction to this lecture, we're going to walk through the specific steps of executing a buy and sell order on the floor of the New York Mercantile Exchange. We're going to be doing this during the regular session where there are active traders in the pits doing what they call the open outcry trading. In order to understand what's going on, there's two key terms here that we're going to need to understand.
One is a bid. And it's a motion to buy a futures contract at a specified price. The opposite of that is an offer. Again, a motion to sell a futures contract at a specific price. And that's also known as the asking price. And we use the word motion because the traders are using various hand signals to communicate to one another across the, pits if they're buyers or sellers, what volume, and what price.
So the example we're going to use in this case is a 12 month price, a 12 month "strip" average of $3.50. As mentioned in lesson seven, you can go out and you can buy or sell contracts at an average price as opposed to having to buy or sell at each individual month's price. In this case, we're looking at 12 months out. So currently, this 12 more strip is running $3.50. And there's a producer out there who would like to lock this price in, or better, if he or she can get that. So the producer's going to call a trader at the energy company and tell them that they're interested.
So the trader will turn around then and they'll ask the personnel on the fixed price desk to call New York and find out where the market currently is, where are the bids, where are the offers, for this 12 months strip for natural gas. Energy trading companies that have financial derivative trading, they will have a fixed price desk. These are the personnel mostly responsible for dealing with the New York Mercantile Exchange.
So the fixed price desk calls their broker on the floor of the New York Mercantile Exchange to find out the current market quotes and both the bid and offers. Now the person that they're talking to is the clearing broker and, specifically, the phone clerk. If you recall the picture of the floor of the Mercantile Exchange from lesson seven, you can picture those phone banks. So this is where that phone call is going to.
The fixed price desk person turns around then and gives the trader the current market quote. The producer then gets that bid and offer from the trader. And given that the market is still in the $3.50 range, the producer decides that he or she would like to lock in the price of $3.50 or better for the next 12 months, if in fact it can be executed. The trader now takes the order from the producer and passes it along to the fixed price desk.
Now at this point in time, the producer is obligated to perform under this contract. In other words, the producer realizes that the energy trading company's going to have to enter into the legally binding contracts on the New York Mercantile Exchange to obtain this fixed price for them. So the producer is going to have to perform by giving the physical gas when the time comes to the energy trading company.
So the trader gives that order, the sell order, to the fixed price desk. The fixed price desk then calls New York again and, tells the phone clerk with the clearing broker on the floor of the NYMEX that they would like to sell the one month strip $3.50. The phone clerk immediately stamps the ticket that they have, indicating when the order was received from the fixed price desk at the energy trading company.
The phone clerk will then walk over to the pits and hand a copy of that ticket to their broker who is trading in the pits themselves. That pit broker then offers out the 12 month strip into the market at $3.50. Another broker, who has received a buy order from another customer, decides to go ahead and lift the offer on the 12 months strip at $3.50. So keep in mind that, as we mentioned in the prior lesson, it's a zero sum game. For every buyer, there is a seller.
So in this case, the producer is having the trading company sell contracts for them. There has to be a buyer across the pit willing to buy those contracts in order for the deal to be consummated. So in this case, there happened to be an interested party on the other hand. And for our purposes, we'll go ahead and assume that it's an end user who's interested in buying the natural gas at $3.50 for the next 12 months.
So once the counterparty across the pit has gone ahead and lifted the order, the broker now hands the order back to their phone clerk. And the pit brokers also then have an official form that they have to fill out for the New York Mercantile Exchange, which includes the details of the transaction. So the phone clerk now time stamps the ticket, as in they've had it timestamped when the order was received, and it again is stamped with the time when the order is actually filled.
So phone clerk calls the trader's fixed price desk. The trader's fixed price desk receives the fill from the floor of the NYMEX and repeats the fill verbally to ensure that there's no error. So the clearing broker phone clerk and the trading company's fixed price desk repeat the details of the transaction so that there's no mistake as to exactly what has occurred. And as mentioned in the prior lesson, the phones are also recorded.
So if there's any dispute at the end of the day when it comes to check out the trades between the energy trading company and their broker, they can pull the tapes, as we say, if there's a discrepancy and have it resolved that way. OK. The fixed price desk, now having confirmed the order, passes along the fill to the trader. The trader now passes along the completed order to the producer.
So the producer has gotten done what the producer wanted. So the producer is now what we call hedged if natural gas prices decline below $3.50 across the next 12 months. So they can't get a price any lower than $3.50. However, because of that, they give up any upside. In other words, the producer you cannot get a price higher if the market does move up. But in this situation, the producer liked $3.50. And they wanted to make sure that prices didn't fall on them.
Here's some more terms that are frequently used in terms of New York Mercantile Exchange trading. We already covered the ask and the bid. A bull, a lot of you have already heard this term. But it's actually someone. It's a person who anticipates an increase in price or an increase in volatility. (Volatility is a measure in the magnitude of price change, as well as the frequency of the change in price). And they are the opposite of a bear. A bear, again, is a person who anticipates a decline in price or volatility. And they are the opposite of a bull.
Backwardation. It's a market situation in which the futures prices are lower in each succeeding delivery. It's also known as an inverted market. It's the opposite of contango. So let's take, for instance, the September crude oil contract. If right now it was the highest price, and October was lower than September, and November was lower than October, and so forth, we would have a backward- dated market. Because the normal situation is, the prompt month or near month, and for several months going out, prices do rise.
A broker. A broker is a party or company which is paid a fee for transactions in the financial and physical markets. Brokers do not take title to the contracts. They do not take title to the commodity being traded. They simply join counter parties together and they extract a fee for doing so. They are truly middlemen. The cash market is the market for a cash commodity where the actual physical product is traded.
So we've mentioned a couple of times, we differentiate between financial and physical or cash marketplaces. When I talked about the pricing publications, they cover the cash market. The CFTC, that's the Commodity Futures Trading Commission. This is the federal agency responsible for the oversight of all commodities trading, not just energy commodities. The contango market. This is the opposite of the backward dated market. It's a market situation which the prices are higher in succeeding delivery months than in the prompt month.
To cover. We use that term to talk about a trader or company who happens to be short futures or options positions. In other words, they've sold contracts in anticipation of prices falling. And so that open position is known as a short position until such time as they buy those contracts back and cover that open position. A derivative is a financial instrument derived from a cash market commodity, a futures contract, or other financial instrument
The New York Mercantile Exchange contract for natural gas is derived from natural gas itself, the commodity. And the same applies to the other energy commodities on the NYMEX. The last trading day. It's the last day of trading for the prompt month contract. Currently for natural gas, it's three working days prior to the next calendar month. We covered the deadlines for each of these in lesson seven.
Long. This is a market position based on owning contracts which must be sold, or the delivery of the underlying commodity must be accepted. It's the opposite of short. So a trader or a company who takes a long position, they're buying contracts in anticipation of prices rising. And then they will sell those contracts hopefully at a profit. The offer, we mentioned already. We talked about what an offer is.
Open outcry is the name given to the pit trading. OK. For NYMEX purposes, it's a method of public auction for making verbal bids and offers for contracts in the trading pits or trading rings of commodity exchanges. It is totally different than electronic trading platforms. The short. This is a market position based on selling contracts which must be bought back or the delivery of the underlying commodity must be made. It is the opposite of long.
So again, this is where traders are selling contracts in anticipation of prices falling. They'll buy them back and make a profit. We mentioned earlier the idea that when they are short, they'll have to cover those positions by buying the contracts back. Strike price. We will get more into this when we talk about options. But it's the price at which the underlying futures contract is bought or sold in the event that an option is exercised. It's also called an exercise price.
The video is located in Lesson 4 under Modules in Canvas.
This movie was released in 1980. Although it is old, it still does a great job of illustrating what goes on in the "pits" of commodity exchanges. In this movie, the Duke brothers are rich commodity brokers. Dan Akroyd works for them and Eddie Murphy is a street bum. The brothers have a bet about one's genetics or their environment shaping their future. To test their theories, they ruin Akroyd's life and put Murphy in his place. When Eddie (William) discovers the bet he tells Akroyd and they plan to ruin the Dukes. They manage to find out that the Dukes are getting the Department of Agriculture's report on the orange crop before it is released to the public. Akroyd and Murphy steal the report from the Duke's man and replace it with a false one. The two then go to the NYMEX and out-trade the Dukes. The Dukes think their report, when released, will show crop damage and that will make FCOJ futures rise.
Several concepts of futures trading can be learned from this one clip....."going long", "going short", fundamental information (the crop report), "Locals" (the traders who jump into the action started by the Dukes), margin calls. You can also see the prices posted as the trades occur...."Open", "Last", etc.
Answer the following questions about the movie clip.
This activity is due at 11:59 pm on Sunday and is worth up to 20 points on the EBF 301 grading scale. Each question is worth 2 points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [1] for additional information and grading rubric.
Video Activity: Submit your answers as a word document to the "Trading Places Video Activity" in Canvas.
Fundamental Factors: Submit your work as a single word document o the Lesson 4 Fundamental Factors Activity in Canvas.
Now that we have studied the NYMEX, financial derivative contracts, and the order execution, we will learn how prices are determine and reported in the cash market place. Later, we will explore the methods used by producers and end-users to reduce their price and supply risk, otherwise known as "hedging."
Log into Canvas and complete the Lesson Quiz. The quiz covers Chapter 3 Errera & Brown and this lesson.
You have reached the end of this lesson Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.
Links
[1] https://www.e-education.psu.edu/ebf301/680