Lesson 3 - The New York Mercantile Exchange (NYMEX) & Energy Contracts
Lesson 3 Introduction
Overview
In 2008, the price of crude oil on the New York Mercantile Exchange (NYMEX) hit an all-time high of $147 per barrel. And, within (6) months, the price had fallen to about $35. Again, in 2014, oil was over $100/Bbl in June only to fall to below $50/Bbl by December. While many factors led to these "peaks and troughs, the nature of futures trading and the exchange itself made this possible. The New York Mercantile Exchange has been around since the late 1800s. Financial energy commodity contracts, such as futures contracts, are traded on the New York Mercantile Exchange, and it is still the most influential financial energy commodities exchange in the world. Futures contracts are financial tools to hedge against the price fluctuations. In this lesson, we will explore the history of the exchange, how it functions, who participates, what commodities are traded and futures contracts. In this lesson, we will also learn about the NYMEX order flow. Standardized Order Forms are used on the floor of the NYMEX during order execution. 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.
Learning Outcomes
At the successful completion of this lesson, students should be able to:
- explain the history and development of the exchange;
- identify the components of a standard NYMEX contract and which commodities are traded;
- list the specific contract specifications for:
- natural gas,
- crude oil,
- heating oil,
- unleaded gasoline;
- describe the importance of the “price discovery” function provided by the exchange of energy commodities;
- know the difference between “pit” and electronic trading;
- recognize various exchange “floor” personnel and players;
- explain NYMEX - order execution & electronic trading:
- list the order flow from the physical customer through the exchange,
- recognize that very few contracts ever actually get delivered physically,
- explain the electronic trading and "high-frequency trading" for futures contracts;
- identify information about the futures market including risks, functions, regulators, margins, motions, price, short and long positions;
- explain the concept of the “zero-sum” game in financial contracts;
- recognize and research the various factors impacting supply and demand for natural gas and crude oil for this week, and assess their potential impact on market pricing for each factor.
What is due for Lesson 3?
This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.
- Quiz
- Lesson 3 activities as assigned in Canvas
Questions?
If you have any questions, please post them to our General Course Questions discussion forum (not email), 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.
Reading & Viewing Assignments: Lesson 3
Reading Assignment:
- Seng - Chapters 3, 4, 5
- Errera & Brown - Chapter 2, "Market Mechanics" in preparation for this week's quizzes.
- "A Brief Review of the History of Futures [1]”. You can find this article in Canvas Module Lesson 3.
Optional Materials
Please take some time to review the optional materials. They will give you context for the rest of the lesson.
Optional Readings
Investopedia Article and Video
Futures Contract [2]: read the article about futures contracts and watch the 1:37 minute video
What Are Futures Video (20:30 minutes)
So, in this video, we're going to take a look at the futures market—basically the derivatives market, as it's called, which is made up of these things: futures, options, and covered warrants, which I cover in another video, and swaps, which I've also done in another video. Once you've got the hang of these three groups of products, you basically have all the planks required to understand derivatives.
So, what are futures? They're talked about in the context of commodities, indices, shares, and bonds. Let's start with the basic principles using a commodities-based example, and I'll use this example to illustrate all the key features. Bear with me if I use a little bit of artistic license in terms of the way the example works.
Okay, so let’s set up an example of forward contracts. Someone would use, first of all, something called a forward contract, because a future is just an exchange-traded forward contract. Forward contracts are very straightforward to understand. Most producers, most manufacturers, have a use for something in the forward market, and the reason is they worry about price. This is a way, basically, to take out price risk.
Okay, so let’s see how that would work. Imagine we've got producers and manufacturers. Say, a couple of slightly undernourished-looking chaps here—one is a producer, and the other is a manufacturer. Now, producers normally worry about prices falling. If you’re producing, mining, and producing a commodity, for example, wondering about what you'll eventually sell it for, you worry about falling prices. Whereas people manufacturing, using commodities such as, say, aluminum—which we’ll use in a moment—tend to be more worried about prices rising. They need to buy ahead. If you're Audi, for example, making cars out of the stuff, you need to be buying ahead for production in six months or a year's time, and your worry is: what happens if the price spikes in the meantime? Do I just chance it and wait six months to see what I end up paying, or should I do something about it?
So, here’s an example of how a simple forward contract will enable both parties to take away their respective concerns. A forward contract would simply be the producer saying to the manufacturer, "Well, look, I'll tell you what—why don't we just say that I agree to sell one ton of aluminum (I’ll just call it Al) when you need it in three months’ time, and we'll fix a price of, say, $25,000 per ton."
All right, so that's a bit spidery, but it says, "I agree to sell one ton of aluminum (Al) in three months at $25,000." The manufacturer thinks, "Great, that locks in my buying price." The producer is thinking, "Great, that locks in my selling price." Contract done. Two people involved—one as a buyer, one as a seller.
Basically, someone’s going to win, and someone’s going to lose in the sense that in three months' time, the market price of aluminum might be less than $25,000—who knows? At the London Metals Exchange, for example, if it’s less, then the buyer is going to wish they hadn’t signed this contract. If it’s more, then the seller's going to wish they hadn’t signed the contract. But that’s life! At least with this contract in place, both of them know how much the aluminum is going to be priced at when they come to deliver and receive it in three months' time.
So, at the end of three months, all that happens very simply is this: in order for the contract to be honored, as you’d expect, the producer sends one ton of aluminum (that’s a picture of a truck, by the way) to the manufacturer, and $25,000 goes the other way. And that’s a forward contract—useful to both parties. In this scenario, both parties are hedging their exposure to aluminum prices by locking in an agreed price three months ahead of when the aluminum is actually going to be ready for delivery.
Okay, so let’s take that a stage further. Let’s take that further on market price and say, "Right, go back to the beginning." So, we still have a producer and a manufacturer. Let’s say we still have contract number one, and let’s say that when this contract is signed, back at the start of the three-month period, the market price of aluminum is $22,000. So, the market price is the price they've agreed three months down the line. You might say that's slightly unrealistic in practice, but let's go with this example.
So, the contract is signed, and the manufacturer is thinking, "Great! I know I can buy aluminum in three months’ time at $25,000—that’s pretty similar to today’s market price." One month passes.
One month later
That's the start of the example. Now, let's say one month later (1 M later).
All right, the market price has changed. So, the market price of aluminum is now $30,000 a ton at the London Metals Exchange, or wherever you're getting the price from.
Okay, one month into this contract, we have a winner and a loser already. The manufacturer is thinking, "Brilliant! This contract means I can buy aluminum for $25,000, but the market price has already risen to $30,000, and we're only one month into this contract." Meanwhile, the seller is thinking, "Damn! I really wish I hadn't agreed to sell for $25,000 when the market price is $30,000. If I could sell now, I could make more money."
So, imagine this scenario: the producer puts a phone call into the manufacturer and says, "Um, I'd quite like out of that contract; it's got two months to run, and I'd quite like out of it now." The manufacturer might just say, "Tough. It's a contract—you are going to deliver one ton of aluminum to me in two months' time, and it's going to be at that price."
Or, the manufacturer might say, "You know what, I'm prepared to do a deal here." The producer is worried that if the price keeps rising, this contract only gets worse and worse for them, losing more and more money. The manufacturer, on the other hand, might be thinking, "This is just a price spike that's not going to last. I see the price dipping in the next couple of months quite sharply." So, actually, they’re happy to be out of this contract too—although they’re not going to say that out loud.
Let’s imagine that both sides want out of the contract early. What would need to happen? If this is a futures market, here's the answer: you can't rip up contracts because they're binding between these two parties. However, you can do something called novation, which is a technical term where you simply replace one contract with another.
So, let’s see how that would work and the end effect of it.
One month in, with two months left to run, what happens? The same two parties are involved, but now a second contract is drawn up. This time, the manufacturer says, "All right, here’s the deal I'm prepared to do with you. I agree (manufacturer talking now) to sell you one ton of aluminum in two months' time (since the original contract has only got two months left to run) at, well, let’s set the new market price, say, $30,000." So, the manufacturer says, "I'm prepared to set up a second contract to run alongside the first one."
The producer thinks about it and says, "All right." Now, this process of setting up a second contract that almost cancels the first one is called novation in the futures market. But who cares about the term? What's the effect of it?
Three months later, what’s going to happen?
All right, that’s from the start of the example. Now, we go to the end of the example. This is the beauty of what we’re going to call the futures market. Here's the painful way of sorting this out, and when you think about it, it’s not a sensible way to do it, but it’s possible.
You could take each contract separately. Contract number one requires the producer to sell a ton of aluminum to the manufacturer at a price of $25,000. Let’s leave that one to one side for a moment. So, the producer thinks, "Right, okay, I’ve either got to have a ton of aluminum on site ready to go, or I’ve got to go and find a ton of aluminum, so I can deliver it to the manufacturer and honor this contract. Otherwise, I get sued."
Let’s take the scenario where the producer thinks, "Oh, damn, I have a contract to fulfill. I better find a ton of aluminum." So, the producer goes into the open market. Let’s say the market price hasn’t changed in the last couple of months and is still $30,000. The producer finds a ton of aluminum at $30,000, then delivers it under this contract for $25,000, honoring contract number one.
Effectively, there’s now a ton of aluminum sitting over here, and the producer is already $5,000 down, having paid $30,000 to get the ton of aluminum and then only received $25,000 from delivering it. But now the second contract kicks in. The manufacturer turns the same ton of aluminum straight around and delivers it back to the producer for $30,000, honoring that contract.
The producer, not wanting a ton of aluminum, then sells it at the market price of $30,000. Now, this is one way of sorting out these two contracts. But frankly, why would you bother? Could you not just put them both in the bin to start with, all right, and have the producer pay $500 to the manufacturer? If neither party was actually interested in the physical delivery of aluminum, they could use these two contracts as a way of hedging price changes in aluminum. All that would happen is the producer, having locked in to sell at $25,000 and buy back at $30,000, has effectively lost $500 when these contracts expire, and the manufacturer has made $500.
Now, you might say, "Well, actually, these two parties might have an interest in selling and buying aluminum, so it's realistic." But I could change these into Trader One and Trader Two instead. They could set up the first contract with no intention of ever delivering aluminum, then set up the second contract when the price changes, still with no intention of delivering or receiving aluminum, and put both contracts in the bin. Trader One pays Trader Two $500, and the job is done. That would be called gambling on the price of aluminum, and that's the basis of futures markets contracts, which, in theory, can be bought and sold by anybody in the market. They don’t have to be manufacturers or producers. This process of novation I described allows anyone to theoretically gamble on the price of something like a commodity. In this case, $500 was won by Trader B and lost by Trader A.
Now, just to finish off this little video, let’s illustrate how that works. If that setup works for two people in the market, could it work for three? Here’s the beauty of futures markets: when you set up a contract, you don’t have to cancel it with the same person. If that sounds a bit strange, bear with me on this one.
I'm going to introduce three players into the market. Let’s see how that would work. With a bit of artistic license, instead of writing out all the details, I'll use L for Long and S for Short (selling), which will simplify things. Imagine you have three players in the market—A, B, and C—to show how futures markets could take these principles one step further.
Let’s set a market price for an asset traded on the open market, something simple like $10. It doesn’t really matter what the asset is; it could be a commodity, just for argument's sake.
Here's how it could work:
Day One: These are three traders in a futures market, none of whom want to take delivery of the asset. A thinks, "I want to bet on the price of this asset rising, so I’m going to set up a contract to buy it"—called a long position—at $10. It takes two people to make a contract, so B thinks the price of this commodity will fall and is happy to take the other side of that contract with A. In summary, A agrees to buy the asset in three months for $10, which I’ll summarize as Long $10. B has agreed to sell the asset in three months for $10, just like my aluminum example, but with shortened jargon.
Day Two: The market price for the asset is now $12. A is thinking, "Great, this is looking good. I've agreed to buy the asset for $10, and the market price is already $12, so if I demand the asset at $10, I’m already theoretically $2 up." B is thinking, "I've agreed to sell for $10 already, but the price is now $12. Damn." It’s like the aluminum producer in the last example.
A then decides, "This is a futures market—I’d like to take out my $2 profit now." So, A sells a contract at the new price of $12. B, however, might think, "I don’t want to close my position and realize a loss, so I’m not interested."
But here’s the advantage of a market. Trader C walks in and says, "Yeah, I’m prepared to take a gamble on the price of this asset. I think it’s going to keep rising, so I’ll buy the other side of A's contract for $12."
This leaves two players in the market. A has closed out by being both long and short in the same commodity, just at two different prices. A has effectively closed out any commitment to buy or sell the asset, leaving B betting on prices falling and C betting on prices rising.
Day Three: The price rises to $14 for the same asset. B and C decide to close out their positions, neither wanting to take or make delivery of the asset. How does that work? B, having sold a contract, would need to buy it back at the new price of $14, and C, having bought a contract originally, would need to sell it at the new price of $14.
This is just to illustrate how a futures market could work with three players.
What’s the overall result?
The asset in question has not been bought or sold by anyone—this is purely speculative.
All parties have closed out their open positions. You can't close out by being long twice or short twice; you need to be long and short—in other words, you need to buy and sell.
So, here’s the breakdown of the outcomes:
- A is sitting on a profit from buying at $10 and selling at $12, with a net profit of $2.
- B, having committed to sell this asset at $10 and needing to buy the contract back at $14, is down $4.
- C agreed to buy at $12 and exited by selling at the new price of $14, gaining a profit of $2.
So, here’s my point. Basically, everyone’s closed out their positions, and the math adds up: -4 + 2 + 2 equals zero. So, if you like, it all balances out. No aluminum, copper, gold, silver—whatever you like—has actually changed hands between any of these people. All they’ve done is used the futures market, organized by an exchange, to take a punt on prices. There have been two winners and one loser—a big loser, as it happens. And that’s how markets work. If it works for three people, it can work for 2,000, provided there’s always somebody in the market prepared to take the opposite view to yours. Normally, in markets, that’s the case.
So, to recap: Futures are based on forwards. Forwards are commonly used by producers and manufacturers in the real world to fix the price at which they take or make delivery of an asset. Those principles can be taken a step further and converted into tradable futures contracts. The advantage of futures contracts is that you don’t have to move any assets around, whatever those assets might be, in order to speculate on the price of them changing. That introduces the idea that as many people as you like can be involved in a futures market. It also introduces the idea that the volume and value of contracts traded on something like, say, copper, can far exceed the amount of copper that’s physically on the planet. Because, if this works for three people with no copper, aluminum, or gold moving around the market, then presumably, it could work for 10 million people doing the same thing.
And finally, a word of caution: Were you, as a professional trader, to leave a futures contract open by mistake, it has been known to happen. In the early days of futures trading in the American Midwest, one "muppet" at a bank left open a commitment to buy 20,000 head of cattle. The day arrived, and he hadn’t entered into the opposite contract that would have closed out his position, so he got a phone call from what’s called a clearinghouse saying, “Where would you like your 20,000 head of cattle?”
Now, clearly, you can’t drive them up Wall Street, if that makes sense—and by the way, you don’t just buy the head; you get the whole beast. So, that particular bank had to write a big check to find somewhere—a ranch and cattle hands—to put 20,000 head of cattle delivered under a futures contract they’d forgotten to close out.
In summary
On a futures market, just like the forwards example I gave you, you can, if you want, enter into contracts where you physically end up buying or selling a commodity. But it’s perfectly possible to use them for purely speculative purposes as well.
The New York Mercantile Exchange
Financial energy commodity contracts are traded on the New York Mercantile Exchange (NYMEX). The New York Mercantile Exchange building is located on the Hudson River in New York City and owned and operated by CME Group of Chicago (Chicago Mercantile Exchange & Chicago Board of Trade). NYMEX has offices in other cities as well (Boston, Washington, Atlanta, San Francisco, Dubai, London, and Tokyo.) The New York Mercantile Exchange [3] started in the 1800s. There were scattered markets for the goods in large cities. You can picture a city like New York City and agricultural products being brought in and sold in various parts of it. So, some entrepreneurial businessmen decided that they needed a central exchange. So, in 1872, it was founded as the Butter and Cheese Exchange. In 1880, it was changed to the Butter, Cheese, and Egg Exchange. And then, finally, in 1882, it was changed to its present name, the New York Mercantile Exchange.
Later products would include yellow globe onions, apples, potatoes, plywood, and platinum. Platinum is the only one of these products which is still traded today on the New York Mercantile Exchange. Today, it trades crude oil, heating oil, gasoline, propane, natural gas, platinum, and palladium.
For a quick overview of the Exchange, view this "This is NYMEX" video (2:20 minutes).
[MUSIC PLAYING]
PRESENTER: New York City, financial capital of the world. Home to global giants in banking, investing, and finance.
AUDIENCE: We only have four and 1/2.
AUDIENCE: Sell 20 and 1/2.
PRESENTER: Where there is always a transaction on the table, money on the line, and business never sleeps. It's also home to the New York Mercantile Exchange where billions of dollars in commodities are traded every day, but one way or another, impact business and consumer alike.
[MUSIC PLAYING]
[CALLS AT MERCANTILE EXCHANGE]
PRESENTER: What appears, at first glance, to be pure pandemonium, is in reality, a very structured business, as highly choreographed and orchestrated as any Broadway show. The New York Mercantile Exchange is a marketplace for buying and selling futures and options contracts in commodities. For instance, energy products such as crude oil, natural gas, gasoline, home heating oil, propane, and electricity, as well as metals like gold, silver, copper, aluminum, and platinum.
But what does that matter to me, you might ask. Here's an example. Oil refiners sell fuel-- mainly gasoline, heating oil, diesel, and jet fuel. Airlines buy large quantities of jet fuel. It's similar to heating oil, and the two products are often priced within a few cents of each other. As price protection against unexpected increases in the cost of jet fuel, an airline can buy a heating oil futures contract at today's known price for use in the future.
If prices rise tomorrow, the airline saves money by having locked in a lower fuel cost. That's called hedging. The fuel savings could mean lower airfares for you and me. The same principle applies to heating oil we use to keep our homes warm in winter, and the gasoline we buy for our cars. When companies protect themselves from volatile prices, they can help pass along those savings to their customers.
Price transparency is a key advantage to doing business on the Exchange. Everyone knows the price of all contracts being bought or sold. This benefits the entire marketplace and builds confidence and credibility for business and consumer alike.
90 bid!
Futures Contracts and NYMEX
Futures contract
Forward and Futures Contracts Crude Oil (11:02)
Okay, let’s start reviewing what futures are, and before that, I will need to explain forward contracts first. So, forward contracts: let’s say on the left-hand side we have an oil-producing company, and on the right-hand side, we have a refinery which consumes oil and produces some refined products. So, on the left-hand side, we have a producer that sells the oil, and on the right-hand side, we have consumers that buy the oil.
Let’s say right now the refinery needs some crude oil, and the producer has some oil. They just sell and buy, and that’s it. Okay, but this is an ongoing business activity, right? The producer knows that for any time in the future, they know the production rate and how much crude oil they will have in the future. Also, the refinery, this is a continuous production process, they know they’re going to need crude oil for almost any time in the future, right? Both of these are concerned about market fluctuations, and they want to make sure they have a market for the produced crude oil or that they can have the crude oil they need. They are also concerned about the price. The producer is concerned that if the price drops, they’re going to lose money. On the other side, the refinery is concerned that if the price goes up, they’re going to lose money, and they want to hedge their risk against price fluctuations.
So, what they can do is negotiate a contract called a forward contract, and they can discuss three things: time, price, and quantity. Let’s say we are going to sign a contract that sometime in the future, let’s say in November, at the locked price of 50 dollars, the producer is going to deliver a specific quantity of crude oil, let’s say 5,000 barrels, to the refinery. So, they have a contract that locks the price for delivery at some time in the future, and they can have many of these. This is called a forward contract. By doing that, they first make sure the producer has a market for crude oil, and the consumer knows for sure they will have crude oil in November. Also, they know the price is locked. The price is locked at 50 dollars. The price doesn’t change.
Okay, what are the restrictions or limitations of these forward contracts?
First, let’s say these two entities, the producers and consumers, are not exactly the same size. Let’s say the refinery is very large, or the producer is a very large producer, and one of them is a lot smaller or larger than the other one. Then, they have to go and probably find 10 other counterparties to negotiate and sign the contract with each of them, and they have to do it for almost every month, and so on and so forth. It’s doable; it is still an ongoing activity in the financial market, but it’s not the most efficient way of doing it.
The other problem with this is, let’s say this contract is signed to deliver the crude oil in November, and the price is locked at 50 dollars. Let’s say a couple of months before November, the price of crude oil goes up to 60 dollars. If it goes to the market, it’s 60 dollars, but under this contract, it is locked at 50 dollars. Because it is locked, the producer loses money. If there was no contract, the producer could have sold it in the market at 60 dollars. So, the producer will get more and more upset, thinking, “Okay, I am losing money under this contract,” but there is no way they can cancel the contract. On the other side, if the price of crude oil starts going down, the producer is happy, but the consumer cannot cancel the contract and go and buy the cheaper oil in the market. They have to pay the 50 dollars locked price. So, the problem is: they cannot cancel the contract at all.
So, this is the kind of introduction to how there is a better, more efficient type of contract needed based on the forward, and that’s going to be called futures, which I’m going to explain in a bit.
Okay, now let’s make some changes and move toward that more efficient contract, which we’ll call futures later on. The first thing that we want to do is introduce a third party here. Let’s say we call this third party an exchange, a businessman, businesswoman, or a company. Instead of the producer going and trying to find consumers, these producers will just go and sign a contract with this third party. The consumer, the refinery, will also go and sign the contract with this third party. This solves the problem that they don’t need to go and find, let’s say, 10 more consumers and sign individual contracts with them.
Let’s make some more adjustments. Let’s say we make these contracts standard. You remember in the previous slide I said these forward contracts are case-based? They are signed for a specific case between these companies, and their contract terms are negotiated between these two entities.
Now let’s introduce a type of contract where all the terms are standard; there’s nothing negotiable. These are all fixed in place, and nobody can change them. The quantity is fixed, the delivery point is fixed, the price is fixed, which I’m going to talk about in a bit. Everything is fixed under these contracts, except the delivery date. The delivery date goes by the incremental month. It’s either January, February, March, and so on. The only difference between these contracts is the delivery date or expiration date. When we make these contracts exactly similar, there’s no need for any negotiation back and forth. We will have these standard contracts, and what we can do is have all the other entities join this market and trade these contracts.
So, we will end up with an exchange in the middle, which will have these contracts that are all standard, exactly the same. We have these players, the actual producer, the refinery, and the oil producer, who can also join as one of these players in the market. They can either buy these contracts or sell them. If they buy this contract, we say their position is long. If they sell this contract, their position is short.
If they buy the contract (long position), they have to take the delivered crude oil; they will receive the crude oil when the contract expires. On the other side, those players, those entities who sold the contract (short position), have to deliver the crude oil, the amount of crude oil, at the expiration date.
Because all these contracts are exactly the same, these are called futures. They have a fixed quantity of one thousand barrels of crude oil, the delivery point is fixed (Cushing, Oklahoma), and the spec is WTI (West Texas Intermediate), which is low sulfur, sweet crude oil. The expiration date goes by the month: January, February, March, and so on. The price is set by these trades, by these market movements, sell and buy, supply and demand. If somebody does not like the loss they are making based on the price movement, they can get out of the contract anytime they want. They don’t have to wait until the expiration date. If the prices are going up and the position is short, they can immediately close the position by buying back, by closing the position with the exchange.
The entities who are long these contracts, the entities who bought the contracts, will make money, will profit, when the price goes up. On the other side, if an entity has a short position, they will lose money. If the price starts to go down, the long position will lose money, and the short position will make money.
An important point here is that these contracts are binding. The entity, the party that is short, the party that sold this contract, has to deliver crude oil at the expiration date. If that party is not an oil-producing company, or if that party is not interested in delivering or cannot deliver the crude oil, they have to close their position, they have to cancel the contract. How? If they are short, they have to buy back; if they are long, they have to sell.
Futures contracts are financial tools to hedge against the price fluctuations. Producers and consumers can use futures contracts to lock the price of a commodity in the future and let the speculators and traders trade the contracts (we will learn this in lesson 7). Consequently, producers and consumers are hedged against the price change and the risk is transferred to the traders and speculators. Traders and speculators bet on the price movements and gain or lose regarding the price behavior. Note that a contact has two sides, and when a trader wants to sell the contract, there has to be a buyer and vice versa. Trading futures contracts is a zero-sum game. If a trader gains profit, the other trader has to lose.
The definition given by the New York Mercantile Exchange is “...a legally binding obligation for the holder of the contract to buy or sell a particular commodity at a specific price and location at a specific date in the future.” The key word here is future. These are known as futures. We are buying and selling energy commodities at a future date and time. And again, this is a legally binding obligation. This is what makes exchanges a sound place to conduct business. If you fail to perform under a contractual obligation with the New York Mercantile Exchange, there are both financial and legal ramifications.
The components of a standard NYMEX energy contract are as follows.
- the name of the commodity and exact specifications of the commodity (for example WTI crude oil, natural gas, heating oil, unleaded gasoline;
- the quantity and volume of the commodity (for example, 1,000 barrels for the crude oil futures contract);
- the price, is determined by the market and is normally what we are most interested in;
- the location that the commodity has to be delivered;
- and then the date, the date that the commodity has to be delivered. At what future point in time do we wish to buy or sell the energy commodity?
Here are the links to the crude oil [4] and natural gas [5] features in NYMEX. These links take you to the crude oil futures quotes [6] and natural gas futures quotes [7] in NYMEX. You can click on the “About This Report” at the bottom right of the table to find the column head explanations. Reported information in the table will be explained later in this lesson.
The trades on the New York Mercantile Exchange between the counterparties are conducted under the International Swaps and Derivatives Association, or ISDA, 2002 Master Agreement. This is a standardized contract under which all financial energy commodity contracts are traded.
Functions of Energy Contracts
Price Discovery
One of the primary functions of energy contracts on the New York Mercantile Exchange is that they provide us price discovery. We can establish a price for crude oil, natural gas, heating oil, and unleaded gasoline at any future point in time. Years back, prior to the advent of the New York Mercantile Exchange, no one could really tell what the price was at any point in time. Most trades were conducted over the telephone. But now, with the New York Mercantile Exchange, at any point in time, you can look up the live trading.
The New York Mercantile Exchange is owned by the Chicago Mercantile Exchange, or the CME Group. If you go to cmegroup.com [8], you can find the commodity prices. Under the "Trading" tab, you can find the commodity and then the commodity futures contract.
Hedging
In addition, this allows us to perform what we call hedging. Hedging is to reduce risk in a transaction. In the case of the futures contracts, it helps us to reduce our price and/or physical risk. We may be concerned about high prices if we're a consumer of energy commodities. We may be concerned about low prices if we are a producer of energy commodities. We may also be concerned about receiving physical supply or having to guarantee physical market. The New York Mercantile Exchange contracts guarantee that.
Futures Market Characteristics
Remember from microeconomics [9] that a perfectly competitive market has the following characteristics: 1) Nobody has market power 2) Product is homogeneous 3) Information is perfect and 4) There is no barrier to enter and exit. Indeed, such a hypothetical market with all these characteristics doesn’t exist in the real world. However, the futures market is one of the closest markets to the perfect competition. There are many buyers and sellers. There is no or very limited government intervention in this market. There is no significant barrier to enter and exit the market, except the legal and financial responsibility of market participants. Traded products are futures contracts that are standard and homogeneous for each commodity. In addition to these, cost of information is relatively low. All these features make the futures market an efficient market. And from microeconomics, we know that in an efficient market 1) price is determined by the market dynamics, 2) price represents the true value of the good, and 3) price fluctuates around the true value of the good. These happen because the futures market is highly related to the cash market. A portion (even though it’s a very small portion) of the futures contracts ends in actual delivery.
Note that an important feature of the futures contracts is, gains and losses to each party are settled every day. This is called marking to market or daily settlement. It’s equivalent to closing the contract each day and opening another one on the next day. When opening the position, either long or short, each party only pays a small amount of money, which called margin requirement. The margin is used for daily gain or loss (daily settlements) due to the price changes. And if the loss is more than the amount in the margin account, the party has to immediately deposit more money into the account.
The following lecture will take you through the history of the NYMEX, the type of trading that occurs ("pit" vs. electronic), the major players, the commodities traded, and futures contract specifications.
NYMEX Contract Lecture
Figure 1 displays the NYMEX building located on the Hudson River in New York City and the NYMEX trading floor, where all the trades occur. Watch the video lecture at the bottom of this page to learn more about the NYMEX futures contracts.
Key Learning Points for the Mini-Lecture: NYMEX Contracts
While watching the Mini-Lecture, keep in mind the following key points and questions:
- NYMEX contracts are legally binding obligations to buy or sell commodities.
- Contracts are standardized.
- Each commodity contract has volume, price, location, and date.
- The NYMEX trades 5 energy commodities along with 2 precious metals.
- Trading occurs both in the “pits” of the Exchange, as well as electronically.
- Margin requirements discourage many from "speculative" trading.
- The Exchange has a unique set of symbols to identify the commodity/month/year.
- All prices are quoted in US dollars and cents.
- Each commodity has a specific delivery point.
- West Texas Intermediate Crude (WTI) is the standard traded on the NYMEX.
- Futures contracts provide “price discovery.”
- Market participants include “commercial” or those interested in the physical commodity, and “non-commercial,” or “speculators.”
The following video lecture is 20:30 minutes long.
Some of the common terms used by NYMEX. An ask-- an ask is a motion to sell at a specific price. It's the same as an offer. So ask and offer are interchangeable. It's your asking price. What do you wish to get in the marketplace for your commodity? And notice this is a motion because they're addressing the idea of the physical trading that takes place in the pits, the movement of hand gestures back and forth as traders buy and sell. A bid, then, is the opposite. It's a motion to buy at a specific price. What is your bid for the energy commodity?
A bull-- in this case, we're talking about a person. It's one who anticipates prices will increase or volatility in the market will increase. They're the opposite of a bear. A bear is one who anticipates a decline in price or the volatility in the marketplace. Obviously, the opposite of a bull.
This is a picture of the New York Mercantile Exchange trading floor. It just so happens in the foreground is the natural gas trading pit. Off to the left, barely seen, is the crude oil trading pit. Notice the various colors of jackets around the floor. I will identify who some of those are in a minute. But the yellow jackets, for the most part, those are NYMEX compliance personnel. The multi-colored jackets, the blues, the burgundies, some of the other colors, represent brokers, what are known as clearing brokers on the floor of the New York Mercantile Exchange. They have posted credit, and they have licenses to trade on behalf of their clients.
So we have the floor brokers, which I mentioned. We have locals. These are the individuals and firms and in some cases funds that have a large amount of money and wish to trade. They are speculators. They're not interested in the physical commodities whatsoever. They're interested in price movement, and wherever the price is moving, that's where they want to be.
Ring reporters and ring chairmen-- we'll drop back here a second, and I will show you. The ring reporters are in the yellow jackets near the trading rings themselves. There is a podium, if you can tell, situated above the natural gas pit with some personnel in yellow jackets. Those are the ring chairmen. Their primary responsibility is to oversee the activity of the pits and to resolve any disputes. Since we have people who are yelling orders back and forth to one another and using paper slips, sometimes mistakes can be made, and if there's a disagreement over the actual details of a trade, the ring chairman is supposed to step down and resolve that trade between the two counterparties.
We have floor committee members. Those are basically NYMEX committee members. The New York Mercantile Exchange also has compliance people. And the Commodity Futures Trading Commission is the regulatory body for energy financial derivative trading. They have their own personnel on the floor as well. And then there are hundreds of line staff from the New York Mercantile Exchange.
We'll now talk about each one of the specific contracts for energy commodities. The first is crude oil. The symbol is CL. We refer to this as West Texas Intermediate, or WTI crude. It is low sulfur, and so, therefore, is given the nickname sweet crude. The NYMEX contract for crude oil was initiated in 1983. Every contract represents 1,000 barrels, which is the equivalent of 42,000 gallons of oil. Price quotes on the New York Mercantile Exchange are all US dollars and cents, in this case per barrel. A minimum price fluctuation-- that is, the amount that the price has to move for a trade to take place-- is a penny, or $10 a barrel.
The delivery point for crude oil under this contract is what's known as FOB, or free on board, or delivered to the seller's facilities at Cushing, Oklahoma and to any pipeline or storage facility with access to Cushing Storage, TEPPCO, or Equilon pipelines. So if you buy or sell crude oil contracts on NYMEX for a particular month, you are obligated to either receive the crude oil or deliver the crude oil at Cushing, Oklahoma.
Deliveries are to be made uniformly across the month. This is the contractual obligation. The idea here is to make all parties deliver as equally as possible. The actual obligation-- for instance, if I sold 30 contracts for the month of September, that means 30,000 barrels of crude oil-- the Exchange would like me to deliver that at 1,000 barrels a day. However, if I cannot, my real legal obligation is 30,000 barrels for the month.
The trading hours on NYMEX for what we consider to be the open outcry or pit trading, the general session where the traders are in the pits yelling orders back to one another, run from 9:00 AM to 2:30 PM Eastern Standard Time. The Chicago Mercantile Exchange also has an electronic trading platform known as Globex, and this is virtually 24 hours a day, seven days a week. It starts at 6:00 PM on Sunday evenings and ends at 5:45 PM on Friday, Eastern Time.
Crude oil can be traded for up to nine years. And then we also have products that are known as strips. These are available for terms of 2 to 30 consecutive months. In essence, strips amount to an average price. If I wanted to buy six months' worth of crude, rather than go out and have my broker quote me one month's price at a time, they'll just give me an average price across the six months. Therefore, I am purchasing a six-month strip of crude oil.
The last trading day, every contract expires. Again, we are talking about future contracts. So currently, the closest future contract is September. The crude oil contract, then, settles three business days prior to the 25th of the month. So just in case the 25th is a non-trading day, either a weekend day or a holiday, the settlement occurs three business days prior to the business day that is prior to the business day ahead of the 25th. I know that sounds very confusing. I can't quite figure it out myself half the time.
Margin requirements. This is a big issue here. You can see that if you want to buy or sell crude oil contracts, for every single contract that you wish to enter into, you have to have $5,100 in a margin account. That's a safety net against losses that you could incur. This protects your clearing broker and protects the New York Mercantile Exchange from default by you as a counterparty.
This also discourages a lot of traders from just jumping in and trying to trade contracts. For example, if a trader wanted to speculate on 10 crude oil contracts-- that's only 10,000 barrels-- that's not a lot of volume, per se. They would have to put $51,000 in a margin account before they could even get started.
Here is the symbol breakdown. When you look at futures screens, or if you see the prices reported in the Wall Street Journal or any other type of publication, you'll see these funny symbols. The first two letters of the symbol represent the energy commodity themselves. So CL represents crude oil. The second letter is the actual month of delivery. For example, U equals September. The final symbol is the number that corresponds to the year. In our example, 2. So the September 2012 contract for crude oil on the NYMEX is expressed as CLU2.
Other symbols that represent energy commodities-- NG for natural gas, HO for heating oil. RBOB represents unleaded gasoline, and then PN for propane. And then here's the breakdown of the symbols that they use. Feel free to use this as a cheat sheet if you ever run across those quotes and can't remember what they mean.
When you look at futures screens, you're going to see column headers that will use these types of terms. When you see the open, that's the opening price at the opening bell. When you see people on television ringing the bell for the open of whatever market it might be-- the stock market, the NYMEX, the Chicago Mercantile Exchange-- as soon as the bell goes off, the very first trade that is consummated, that price is registered as the open for the day.
The high is the highest price that traded that day, including the after-hours electronic trading. The low is the lowest price that traded for that day, including after-hours electronic trading. That gives us the range on the day-- what was the entire range of pricing that day.
When you see last, that's the last trade that just occurred. In other words, what was the last trade that had occurred? The net would be the change in price from that last trade to the one prior to it. So are we going up or are we going down as we're trading currently? And then change-- the change is the change in price from the trade that just occurred, from that last trade, versus the prior day's settlement. What was the final price for the energy commodity the day before, and where do we sit relative to that today? That's what change represents.
We refer to futures contract trading as a zero-sum game. For every buyer, there is a seller. I can't buy crude oil contracts without someone being willing to sell them to me, nor can I sell them without a market. And believe it or not, less than 2% of all the contracts traded actually go to physical delivery. In other words, less than 2% of the contracts will actually be energy commodities exchanged between counterparties. Now, on the one hand, that may sound like a small number, but with each crude oil contract representing 1,000 barrels, and you can trade between 50,000 and 100,000 contracts a day, it does amount to a substantial amount of physical energy commodities being exchanged.
This is what a typical futures screen would look like. These are the headers that I mentioned to you. On the day that I printed this off, you can see the last trade was $92.68 and, represented a drop of $0.19 from the prior day's settle of $92.87 in the far right corner there. We had the opening price of $93.25, and a high and low on the day as well. And the very far right column is the time at which the trade occurred.
Natural gas futures contracts. The contract unit is 10,000 MMBtus-- that is, 10,000 million British thermal units. Prices are quoted in US dollars and cents, and the minimum fluctuation between trades has to be 1/10 of a penny or what we refer to as a tick. Trading hours are exactly the same, but the trading months for natural gas-- you can actually trade natural gas out 12 years if there was, in fact, a need to buy or sell for that long of a period of time.
Last trading day for natural gas contracts, the futures, is the third business day prior to the first calendar day of the delivery month. We do trade options in energy futures contracts. In the case of natural gas, those expire one day prior to the actual contract itself.
The delivery point for buying and selling under NYMEX natural gas contracts is a place known as the Henry Hub in Erath, Louisiana. Texaco has their Henry plant in Erath, Louisiana. Sabine Pipeline Company runs the hub on behalf of the New York Mercantile Exchange. And again, the delivery period is to be uniform across the month of production for which the contracts were exchanged.
This is a schematic of the pipelines going in and out of the Henry Hub. There are various sources of natural gas coming offshore, onshore. There is gas moving to the Northeast, the Southeast, the Upper Midwest, as well as from Louisiana back into Texas. So it made an ideal market hub for indicating various supply and demand.
Settlement price. Every day, the New York Mercantile Exchange will put together a final price for that day's trading. The settlement price is the weighted average of all the trades that occur during the last two minutes of trading in that regular session. Now, when the closest future month, or what we call the prompt month, when that contract expires, they're going to take the total number of trades in the last 30 minutes to come up with a weighted average, and that will be the price for that month. And that month rolls off, as we say, and it's in the history books.
Margin requirements for natural gas are substantially less than crude oil, but the value is substantially less, so there's only $2,100 margin requirement per contract.
This is what a natural gas futures screen would look like. If you ever see one of these on a trading floor or somewhere else, perhaps on someone's screen who trades in these contracts, this is what it would look like.
We're now going to talk about unleaded gasoline, referred to as RBOB. RBOB stands for Reformulated Blend for Oxygenated Blending. What we get at the gas pump-- you usually have the opportunity to get 100% unleaded in very few places. Mostly, it's a 90/10-- that is, it's 90% gasoline, 10% ethanol or some other type of blending component. In some cases, you hear about E85, which is 85% unleaded, 15% of some other additive, normally something like ethanol.
So what's traded on the New York Mercantile Exchange is actually the 100% unleaded. It becomes a feedstock for unleaded because it's only 90% of what we get at the pump unless we're buying 100% unleaded. So it's reformulated blend for oxygenated blending. They're going to blend oxygenators into the unleaded gasoline.
The oxygenators are seasonal in nature, depending on the regions. Again, oxygenators help to burn the gasoline more efficiently and therefore reduce the emissions. Oxygenators are things such as ethane, ethanol, butane, isobutane, and natural gasolines.
Every RBOB contract is 42,000 gallons. US dollars and cents, and the minimum fluctuation is 1/1000 of a penny per gallon. The delivery point is free onboard or delivered into the petroleum products terminals in New York Harbor. Margin requirements-- $8,100 per contract.
Last but not least, heating oil, or HO. It's sometimes referred to as number two fuel oil. Every contract is 42,000 gallons. We are still dealing with US dollars and cents per barrel. Minimum price fluctuation is 1/1000 of a penny per gallon. The delivery point is the same as for RBOB, and that is free onboard or delivered to the petroleum products terminals in New York Harbor. Everything else pretty much remains the same under the standardized NYMEX contracts.
NOTE:
The lecture notes can be found in the Lesson 3 module in Canvas (Lesson 3: The New York Mercantile Exchange (NYMEX) & Energy Contracts.)
Optional Material
Trading Pit Hand Signals
As explained in the video, “ask” is a motion to sell and “bid” is a motion to buy at a specific price. We use the word motion because the traders use hand signals to communicate to one another across the pits. The following video illustrates some of these hand signals. Please watch the 3:37 minute video, Trading Pit Hand Signals [12] below.
Click for a transcript.
Many of Chicago’s “open outcry” trading pits are closing this month. This form of trading was born in Chicago, centered around traders shouting orders to brokers. Eventually, it got so loud a sign language developed in the pits.
PRESENTER 1: If you've ever seen Ferris Bueller's Day Off, when he's up there and they're making all those signs, this was a way for traders to communicate with other traders, with other brokers, with other order fillers.
PRESENTER 2: It's loud, crazy on the floor, and you need to communicate very simply.
PRESENTER 3: There's so much noise that if I said "buy 20" or whatever, they can't hear. So, I have to have some type of a symbol that shows.
PRESENTER 4: Let me get a sight line to a guy. And I'll say, buy 10 (pointer finger pointed at forehead and then quickly moved away from head). And then this guy will tell the broker, buy 10.
So we'll have a guy standing next to the broker. We'll have a guy on the phone. The customer will tell me what he wants to do, and I'll have it flashed in (using a hand signal for buy 10) -- way faster. And it cuts out all the nonsense.
PRESENTER 1: If you wanted to say, buy 100 S&Ps at the market, you would go, buy 100 (fist on forehead). And you'd go like this with your hand (slash hand in front of you, palm down), and that would mean market.
PRESENTER 2: If you're buying, you have your palms in, just like you're grabbing something toward you. If you're selling, you're pushing something away.
PRESENTER 4: We were in the S&P, so they had dimes and nickels. So it was 10 bid (pointer finger up, palm toward you), 15 bid (pointer finger bent at knuckle, palm toward you), 20 bid (pointer and middle fingers up, palm toward you), quarter bid (pointer and middle fingers bent at knuckle, palm toward you), 30 bid-- I'm sorry, 30 bid (pinky, ring and middle fingers up, palm towards you), 35 bid (pinky, ring and middle fingers bent at knuckles, palm towards you), half (all 5 fingers up, facing towards you), doubles (all five fingers bend at knuckles, facing towards you) -- even money (fist pointing towards you).
PRESENTER 5: It could be one (pointer finger up pointing away from you). I mean, naturally, you go right up to one. Or it could be five (all five fingers up pointing away from you), or you could do this, 10 (both hands facing out with all fingers up). This could be 100 (fist on forehead facing out and pushing away from your head).
PRESENTER 3: Now, you're usually holding your deck in the other hand. Your pencil may be in this hand, so you're giving your symbols. But you have your deck or your card, your trading cards, in this hand.
So you don't have two hands to go six or seven. So what we would do is turn a hand sideways. So now this becomes six (pointer finger pointing to the right, palm towards you), seven (pointer and middle fingers pointing to the right, palm towards you), eight (pinky, ring and middle fingers pointing to the right, palm towards you), nine (four fingers pointing to the right, palms towards you).
PRESENTER 2: And then as you go up to 10 (right-hand pointer finger touching forehead), 20 (right hand pointer and middle fingers touching forehead), 30 (right hand pinky, ring and middle finger touching forehead), 40 (right hand four fingers touching forehead), 50 (right hand palm open touching forehead) --
PRESENTER 1: 60 (left-hand pointer finger touching forehead), 70 (left-hand pointer and middle fingers touching forehead), 80 (left-hand pinky, ring, and middle finger touching forehead), 90 (left hand four fingers touching forehead), and 100 (left fist touching forehead).
PRESENTER 3: And later when the big trades came in and the options and the Eurodollars, they even came out with 1,000, which was the crossed hands (fists) in front of your chest.
PRESENTER 2: And then you really want to make a statement on the trading floor, you're going 1,000 (arms crossed in front of you, left with fist, right with pointer finger out), 2,000 (arms crossed in front of you, left with fist, right with pointer and middle fingers out), 3,000 (arms crossed in front of you, left with fist, right with pinky, pointer and middle fingers out).
PRESENTER 4: It's way faster and way easier to do. And you can put orders into different areas, too. You could look at a guy to the right of you. If he wasn't paying attention, maybe the guy next to you would. So create a competition, too, amongst brokers and clerks.
PRESENTER 2: One ear is listening to the marketplace. The other part of your brain is having a conversation, and you're not missing a cue. That's amazing to me.
So I thought this would be just really a good life skill to have. You're in the grocery store. Instead of yelling the amount-- hey, just get five, just five-- no, it doesn't work.
PRESENTER 4: You're out (wave a hand in front of your neck a few times). That was another good one.
PRESENTER 1: Or he'll go like this to a bartender. I need three more beers.
PRESENTER 4: Right.
PRESENTER 5: Or out.
PRESENTER 1: Out.
PRESENTER 5: Out.
[INTERPOSING VOICES]
PRESENTER 1: Cut off. I'm cut off.
PRESENTER 4: [LAUGHING] Right.
PRESENTER 3: Yeah, I always thought that was quite ridiculous. I see these guys going to the bar and says, yeah, cost me $20. I'm thinking you got to-- the same guys that used to go into the bar with their trading jackets on. [LAUGHING] I mean, I always thought that was a little hokey. But no, I never did use the hand signals.
MAN 1: 186.9 halves.
MAN 2: Two dollars. Three or four, all you want.
MAN 3: Cut!
PRESENTER 5: I would try most of the time not to even use the hand signal.
NYMEX Order Flow
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 section, 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.
Key Learning Points for the Mini-Lecture: NYMEX Order Flow
While watching the mini-lecture, keep in mind the following key points and questions:
- All orders must be placed with a “clearing” broker who guarantees the trades.
- Contracts can be used for pure trading or “hedging” physical and price risks.
- Energy Trading companies & Financial Brokers provide risk services to their customers.
- Orders flow from customer’s representative through the financial trading process.
- Orders with NYMEX can be filled via the traditional “pit” trading or electronic platforms.
- Less than 2% of all contracts traded ever become physical transactions.
- Trading is a “zero-sum” game. For every winner, there is a loser (there are two sides to every trade).
NYMEX Order Flow Lecture
The following video is 10:40 minutes long.
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 are 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-month 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- month 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-month 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 checking 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 over 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 are 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 counterparties 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 instruments.
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 brought 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.
Optional Materials
High-Frequency Trading
"High-Frequency Traders" (HFT) are impacting the market in a huge way by using super-computers to execute high volumes in nanoseconds. To get an explanation of HFT and their impact on the market, view this video (21:59 minutes).
[Jad:] Hey, I'm Jad Abumrad.
[Robert:] I'm Robert Krulwich. This is *Radio Lab*, and speed is our subject.
[Jad:] You beat me to it. Actually, that's what this whole next segment is about. See, I had it in my bones just to set it up. I got this idea from my friend Andrew Zolli, who is a fantastic writer, wrote the book *Resilience: Why Things Bounce Back.* We were at a diner, I was telling him about this show, and he says, "You should do something about the stock market."
[Robert:] And you were like...
[Jad:] I was like, "I'm the last person who should do something about the stock market." And he’s like, "No, no, no, forget everything you think you know about the stock market."
Most of us, when we think about stock markets, if you just close your eyes and think about the financial world, what you imagine is a bunch of people in a room wearing funny-colored jackets, shouting at each other, waving bits of paper. This kind of raucous scene—people screaming, trying to figure out what a price is. And we have this cultural iconography of how the financial system works, which is largely divorced from reality.
Because, here’s the first surprise: somewhere between 50% and 70% of all trades that happen on what we think of as Wall Street aren’t executed by human beings as a result of human decisions. They’re actually executed by algorithms at a speed, rate, and scale that is beyond our comprehension. So, I decided I would try to comprehend this new world he was describing.
And, since this is a subject matter that generally makes me, frankly, frightened, I decided to call up David Kestenbaum from *Planet Money.*
[David:] Hey, Jad.
[Jad:] Hello, David K. There could be more than one David, there probably are, on Twitter. In any case, it didn’t click for either of us just how fast, how inhumanly fast trading had gotten until we visited this firm called TradeWorks.
[David:] Nice to meet you, David.
[Jad:] So we go into this little building in New Jersey. It looks like a startup or something, and this guy says, "Hello, my name is Mike Beller. I’m the Chief Technology Officer of TradeWorks." Mike over here sits us down at this computer, opens up this little program that logs exactly what’s going on in the market, insanely specific.
[Mike:] You could pick a stock. We could look at Yahoo, for example. We can literally pick some time of day that we're interested in.
[Jad:] What time is this at?
[Mike:] This is at 11:35:26.97.
[Jad:] Seconds, really?
[Mike:] And in fact, that’s not enough precision for us because we deal in microseconds—millionths of a second. We have another way of measuring time, which is the number of microseconds since midnight of the previous day.
[David:] Can you read that 417 number?
[Mike:] Sure. 417,729,979,559 microseconds since midnight.
[Jad:] Wow. So, do you always have lunch at like 2,305,000?
[Mike:] [Laughter] No, that’d be really early.
[Jad:] How many trades do you do in a day?
[Mike:] It depends a lot. A high-frequency trader might do a thousand trades in a minute. It’s about that tempo, but it’s kind of very bursty.
[Jad:] Now, what happens during those bursts is a bit of a mystery.
[David:] It’s very hard to see what’s going on. Often, says Andrew, it’s the computers testing the market, testing to see if they can find a nibble on the other side. They’ll fire out a bunch of buy and sell orders, and when another computer bites, they’ll quickly cancel the ones that didn’t stick. Like, "Nope, sorry, didn’t want to do that." They’re doing this on a microsecond basis—buy, no sorry, sell, buy, sell, sell again, no, forget about that, buy, nah.
And they create huge volumes of transactions that just disappear into the ether. There are some computer algorithms, he says, whose whole job is to combat other algorithms, fake them out.
[Andrew:] For example, we just had a very good example happen about a month ago in Kraft.
[Eric Hunsader:] That’s Eric Hunsader. He tracks high-frequency trading for the firm Nanex.
[Andrew:] Kraft? Like Kraft cheese?
[Eric:] Yes. What we saw was this algorithm jump into the market, buy up a bunch of Kraft, which jammed the price up, allowing that algorithm to sell at much higher prices to other algorithms. And we calculated out—it cost them $200,000 to push the price up, but they were able to sell about $900,000 of stock, netting a gain of over half a million dollars in a matter of seconds.
[David:] Now, to put that in context, back in the day, you know, 20 years ago when humans still ran the trading pits...
[Larry Tabb:] I’m Larry Tabb, founder and CEO of the Tabb Group. The average time it took to execute a trade was around 11 or 12 seconds back then.
[David:] And when you ask people how we got from 11 or 12 seconds to 417,729,979,559 microseconds since midnight, the answer is kind of surprising.
[Andrew:] But I'll start with the obvious part—at least it’s obvious to people who work in finance. A basic law of the market is that the fastest person usually wins. There’s always a benefit to getting information faster than the other guy.
[David:] This has been going on since Julius Reuter used carrier pigeons to send stock quotes faster than the guy on horseback.
[Jad:] That was in the 1850s.
[David:] Here’s a more modern example. Say the latest job numbers come out—U.S. employers added 227,000 jobs in February. If those numbers are good, the stock market is going to go up. So, if you can get the numbers and rush to the market before anyone else, you can buy the stock before it goes up and make a lot of money, right on the "buy low, sell high" principle.
[Jad:] But when the markets turned electronic, which began to happen in the early '90s, this basic law created a situation that was totally bananas.
[David:] What do you mean?
[Jad:] So imagine it’s the year 2000. You’ve got this market in New York—it’s electronic, basically just a building on Broad Street with a giant computer inside, matching buyers and sellers. And you have traders in different parts of the country connected to this market. Some are using automated trading bots. One day, this guy, Dave Cummings, in Kansas, notices his robot keeps getting beat. When it would send a trade to New York, like a buy order, some other robot would swoop in, get there first, and snatch up the trade. And it occurs to this guy, Dave—wait a second, is it because I’m in Kansas? If the other guy’s closer to New York, then his cable would be shorter, so I need to move closer to New York.
[Robert:] No, no, no, because we’re talking about the speed of light.
[Jad:] Well, close to the speed of light, still. Obviously, it’s because he’s in Kansas.
[Robert:] What do you mean "obviously"?
[Jad:] Because the speed of light is like a foot a nanosecond. You’re going to get your ass kicked if you’re in Kansas.
[Robert:] I don’t... how do you know this for a fact?
[Jad:] Yeah, it’s a foot a nanosecond. It takes a billionth of a second to go a foot. It’s 3 * 10 to the—
[Robert:] Why do you act like this is something everybody knows?
[Jad:] I know this because when I was in physics, if I needed to delay a signal by a nanosecond, by a billionth of a second, I just added an extra foot of cable.
[Robert:] Did you really do that?
[Jad:] Yeah, see, the proton-antiproton would collide, and it would create a muon that would go out, and you only wanted to measure—you wanted to filter all the junk so you knew when it was going to arrive roughly, so you had a little window it had to arrive in. But you had to get the timing of the window right, so it meant adding a delay. And we would just add cable—that was the easiest way.
[Robert:] You would literally go get some cable and just splice it in?
[Jad:] Not splice, like, there are LEMO connectors.
[Robert:] Oh, of course, LEMO connectors.
[Jad:] Here’s another way to think about it. Say the time it takes for information to get from Kansas to New York is something like this: [beep-beep sound].
[Robert:] Did you hear that?
[Jad:] Yeah. The first beep is when it leaves Kansas, the second beep is when it arrives in New York. We actually slowed that down just a bit so we can hear it better, but the point is, that is fast. There’s still a little space in there between the beeps, which is the travel time. Very, very little space, but even if these signals are traveling at millions of miles an hour, close to the speed of light, if somebody is a few hundred miles closer to New York than you, and they leave at the same time as you, well, then it’s going to be...
[[Beep-beep-beep sound]]
[Jad:] You hear that? That beep in the middle is some other dude beating you by a few milliseconds. These little differences matter because they’re trying to get in and out super fast, and maybe each trade they’re only making a fraction of a penny.
[Robert:] That’s it?
[Jad:] Says Andrew. But if you’re making a fraction of a penny millisecond after millisecond after millisecond, it can add up, right? But you have to be able to react really fast. So, when this guy in Kansas decided to move his robot to New York to get closer to the big market computer, it started a kind of land grab. There was a real estate bubble around some of these buildings because people were trying to buy physical real estate next to the exchanges so that the cables they would run into the exchanges would be just a few feet shorter than the other guy.
[Robert:] Wait a second, so does this mean, like, if I’m one stop up on the elevator and you’re two stops up, that I have the second-floor advantage?
[Jad:] Theoretically, yeah, that’s what it means. But I don’t know how far this real estate jockeying got because pretty early on, the people who run the market stepped in, and they were like, "Okay, this could get crazy." So they told the machine traders, "Okay, you want to be close to us? Fine, pay us some money; we’ll let you come inside."
[Robert:] Inside?
[Jad:] Inside our box, inside the mother ship.
[Robert:] Is there like some room where all these computers are keeping each other company now?
[Jad:] Oh, yes, there is. If you visit the New York Stock Exchange now—which we did, after going through months of security checks—what you see is the match itself, where the trades actually happen.
[Robert:] Amazing.
[Ian Jack:] Wow. So this is what, a 20,000-foot room?
[Jad:] This is Ian Jack; he’s head of infrastructure at the New York Stock Exchange. He showed us around.
[Ian Jack:] It has a number of rows of racks for customer equipment. In 2006, the New York Stock Exchange opened up this room; it’s the size of three football fields, filled with nothing but rows and rows of servers.
[Jad:] Banks, hedge funds, brokers...
[Ian Jack:] Yeah, a whole number of financial institutions.
[Robert:] Are these things trading right now?
[Ian Jack:] Absolutely. Each of these computers—there were close to 10,000 in the room, give or take—was at that moment analyzing the market, making a decision as to whether to buy or sell, and sending that decision over a cable into an adjacent room, where it gets bought or sold.
[Jad:] No people involved. If you stood still for a few seconds, the lights would go out. They automatically shut off if nothing moved because the assumption was there wouldn’t be people there.
[Robert:] And the whole idea of this place, says Ian, the whole premise is a level playing field.
[Ian Jack:] So any firm can come in here, and they’ll have the same access as anyone else.
[Jad:] And to make sure of that—this is my favorite part—every single rack within this facility has the same length of cabling to get to the network points at the end.
[Robert:] Exactly the same length?
[Ian Jack:] Exactly the same. Everybody gets the same length cabling. Whether you’re one foot away from the network hub or a thousand feet away, you get the same length.
[Robert:] I’m sure they send synchronized test pulses from both your trading computer and Jay-Z’s trading computer, and they make sure they arrive at exactly the same moment.
[Jad:] I like to imagine they have a guy with a tape measurer—that’s the guy you bribe.
[Robert:] Anyhow, you would think that since all machines can now be inside the exchange, literally inside the market building, the speed race would be over, right?
[Jad:] Yep.
[Robert:] No, actually, it only gets worse because the place we visited, the New York Stock Exchange, that’s just one market of many. I didn’t know this, but apparently when all trading went electronic, the markets fragmented.
[Larry Tabb:] It used to be that to trade stocks, you had the New York Stock Exchange, and then there was NASDAQ—really just those two markets.
[Robert:] Says Larry.
[Larry Tabb:] Now, there are 13 regulated exchanges. There are roughly 50 what they call "dark pools" in the marketplace.
[Jad:] Those are non-public?
[Larry Tabb:] Yeah, basically.
[Jad:] So, you’ve got these 60-some-odd different markets, and that’s created all these different speed races between them.
[Jad:] Yeah, here’s a super basic example I talked about with Andrew. In Chicago, you've got this thing called the Commodities Market. Commodities are basic goods like corn, oil, soybeans, zinc, pork—that’s what they do in Chicago. Here in New York, we do equities, and equity is a share of a company. So you have basic goods in Chicago, stocks of companies in New York. Those are different kinds of things, but they’re connected to each other, you know?
[Robert:] Cuz, like, take oil, which is traded in Chicago.
[Jad:] Exactly. A lot of companies depend on oil, and they’re traded in New York. So, say oil goes up in Chicago—you can pretty much bet that right after that, a company like Exxon is going to go up in New York. But it won’t be instantaneous, right? Because information has a speed. Back in the days of the telegraph, as we learned, it took a quarter of a second—about that long—to get from New York to Chicago. Now, with fiber optic cables, it’s about 15 milliseconds.
[Robert:] I love that. I had no idea you could actually hear the time difference.
[Jad:] Yeah, that one, I think, is pretty accurate—15 milliseconds. But say you’re in Chicago, oil goes up, you know it, and you can get to New York in 14 milliseconds. Well, you’ve got one millisecond where you know the future, you know exactly what’s going to happen. You’re not even betting at this point; this is easy money.
So what happened over time was a race of people to provide the straightest fiber line between Chicago and New York.
[Robert:] That’s Mike Beller again from TradeWorks.
[Jad:] He’s part of this race. A couple of years ago, a company came along—not his, unfortunately—and spent some eight-figure sum to cut a straighter fiber line between those two points. And, according to some reports, they blew through a mountain to do it. They did a lot. Where the state-of-the-art for communication lines at the time between the two locations was about 15 milliseconds, they came along and made that state-of-the-art 13.3 milliseconds—a savings of about 1 millisecond each way.
[Robert:] Which is just... an eon.
[Jad:] It’s a thousandth of a second.
[Robert:] That’s not an eon.
[Jad:] Well, it’s an eon when your computer system can make a decision in 10 microseconds, which ours can—that’s 10 times faster. So your computer’s like, “I can do this so fast; I’m just waiting, waiting, waiting, waiting for the news from Chicago.”
So a lot of us were sitting around thinking, what can we do about this? Turns out, there was a way to get from Chicago to New York a little faster because the speed of light through air is a little faster than through a fiber optic cable. So what they’re doing now is building a series of towers to beam the signal through the air from one tower to the next, all the way from Chicago to New York.
[Robert:] So that would bring the travel time down to about... in the neighborhood of around 8 and a half milliseconds?
[Jad:] Yeah, that would be going from this [beep-beep] to this [beep]. I mean, come on, that’s a lot of potential savings.
[Robert:] I can totally hear the difference. Is it helping? Are we fast enough now? Can we... stop?
[Jad:] Um, here’s the thing. That’s Mino Narang, the CEO of TradeWorks. He joined us for part of the interview, and he told us:
[Mino Narang:] Actually, we would love to stop this arms race. Yeah, absolutely. The arms race is a huge drain on resources.
[Jad:] But he says they just can’t.
[Mino Narang:] As it stands, when a new technology comes out that makes it possible to be faster, if I don’t adopt it and my competitors do, I will lose out to them. I have to do it.
[Jad:] And looking at Mino, you could tell this part of the job is just like the plumbing. It just kind of makes him weary.
[Mino Narang:] Yeah, no, couldn’t care less.
[Robert:] Why not just call a truce? Everyone says, "We’re not going to try and go faster. We’re already way faster than any human can think. It’s fast enough. We’re going to stop." Why not call a truce?
[Mino Narang:] Because there’s a thing in game theory called the Prisoner’s Dilemma.
[Robert:] So someone will cheat, you’re saying, basically?
[Mino Narang:] Yeah, you can’t put a gun to everyone’s head and force them to abide by this truce, even though we’d all be better off if you could.
[Jad:] Well, who would be better off?
[Mino Narang:] Look, even though this speed race sucks for us, it’s actually helping you. Because, on a basic level, anytime you replace a human with a computer, things are going to get faster, they’re going to get cheaper. And now that the machines are competing, it’s getting cheaper still. In 1992, it would have cost you about $100 to trade a thousand shares. Now? 10 bucks.
So yes, humans have been completely supplanted when it comes to short-term trading, and humans who complain about that are being disingenuous, okay? They have not been displaced by anything other than the fact that they can’t compete.
[Robert:] You seem like... you’ve had to... you seem defensive.
[Mino Narang:] Well, just because I can explain the economics of the business doesn’t make me defensive.
[Jad:] That also sounded... defensive.
[Narrator:] If Mino did sound defensive, it’s only because he, Mike, and everyone in their industry have had to answer a lot of questions over the past few years about where all this speed is taking us. And those questions always come back to one particular day: May 6, 2010, when things got a little... fruity.
[Eric Hunsader:] We hadn’t had a down day in a long while. The market had been slowly creeping up for quite a while.
[Jad:] And that’s Eric Hunsader again, the analyst who’s been tracking high-frequency trading.
[Eric Hunsader:] He says that day, even though things had been going really well, that day had started off down pretty hard, which made some sense because there was bad news coming out of Athens. People were nervous. But then, at a very specific moment, 2:42 in the afternoon, 14:42 and 44 seconds, all hell breaks loose.
[News Anchor:] Neil, let me just—let me just interrupt for a second because this market is dropping precipitously. It just went -500, it is now... 560 even offer, seven even offer, six half are trading here now, six even trading, see it on the screen. The Dow is losing about... 653 points now, Dow is down 707 points, 81 even are trading here, the 79 trading. Boom, there it goes. Look at this market, it continues to slide. Look at it—835. This is the widest we have seen us in years, now it’s down 900—wow, almost 1,000 points. This will blow people out in a big way like you won’t believe. Cancel all orders! Down 1,000 points! Cancel all orders!
[Narrator:] At 2:45 and 27 seconds, an emergency circuit breaker shuts off for 5 seconds. And that was the end of the slide. When it went out and stopped for 5 seconds, that was the bottom of the market—1,000 points down. Several hundred billion dollars vanished in two and a half minutes.
Equally weird, when trading started again, the market bounced right back up. About two and a half minutes later, it was 600 points higher than the bottom. It was like, *boing.*
These kinds of swings had happened before, but never that fast. And speed is one thing. Arguably, what’s more troubling is that we still, two and a half years later, don’t really know what happened. I mean, the SEC investigated for months, released this giant 84-page report where they essentially blamed the whole thing on one bad algorithm—that this guy in New York was trying to sell a bunch of stocks, told his computer to do it, and his computer just did it a little too aggressively.
[Eric Hunsader:] No, that’s not how it went down at all.
[Narrator:] Eric doesn’t agree. He thinks what happened is that all the high-frequency computers just clogged the network.
[Eric Hunsader:] Really, the cause of the flash crash was system overload.
[Jad:] Cuz he says a basic feature of these computer algorithms is when they detect that the network is slow, they pull out. You know, one of the maxims on the street is, “When in doubt, stay out, or pull out.” And so if you’ve got this one computer selling a ton of stock and no computers left to buy, that creates a vacuum. Now, there were people who argued that high-frequency trading had actually made the situation better. Cuz, you know, Andrew says the markets did bounce back right up to the top. The computers self-corrected.
[Robert:] Perhaps.
[Jad:] But the point is, nobody had any idea. And that’s what gets him—that we’re in a situation now where, when things go wrong, they go wrong in the blink of an eye, and then it takes us years to figure out what happened.
[Robert:] The question that comes up is, have we crossed some kind of Rubicon? Have we passed into a realm where the complexity, the speed, the volume of all this stuff makes it no longer human-readable?
[Jad:] We just don’t know what the system is doing and can’t, in principle, find out when things go wrong.
[Music fades]
Future of the Trading Floor
Please watch the following short video (1:55) about the future of the NYMEX trading floor and how electronic trading is affecting the trading pits.
PRESENTER: Even if you've never been to the famed trading pits, chances are, you know what they look like and sound like.
[VIDEO PLAYBACK]
[CROWD ROARING]
- Sell 30 April at 142!
[VIDEO PLAYBACK]
PRESENTER: Featured in films like Trading Places and Ferris Bueller's Day Off, the trading pits at the Chicago Mercantile Exchange were loud and hectic.
[VIDEO PLAYBACK]
[CROWD ROARING]
[END PLAYBACK]
PRESENTER: On July 6th, the futures pit in Chicago and New York, where buying and selling sets the prices for commodities like gold, wheat, and corn, roars one last time. The 167-year-old tradition of open outcry futures operations ends after the closing bell on Monday.
VIRGINIA MCGATHEY: For example, if I'm trying to buy 25 at 4 and a quarter, I would be saying that and also doing the hand signals at the same time. And then the opposite person would be saying, OK, I'm selling you 25 at 4 and quarter. And so, then we'd understand that I was buying, and they were selling.
PRESENTER: Virginia McGathey, a grain trader on the Chicago Mercantile Exchange floor, just finished her last shift in the pit. In short, blame the computers. CME Group, which operates the trading pits in New York and Chicago, is shifting to electronic dealing. And CME Group held off on going all digital, even as rivals in New York and London embraced electronic trading.
VIRGINIA MCGATHEY: It's really heartbreaking on a particular level that it's ending this way. And I think, in talking with some of the other traders, the fact that we can't leave a legacy to children and grandchildren, that this is the end of the road-- it's just definitely not the same on a computer, not at all.
PRESENTER: And not all the pits are closing. One exception is the S&P 500 futures market, which remains open on the Chicago trading floor. In another sign of changing times, fans of CME Group can track the company on several social media sites, including Twitter, Facebook, Instagram, and Pinterest.
Summary and Final Tasks
Key Learning Points: Lesson 3
- The New York Mercantile Exchange is a market for crude oil, natural gas, heating oil, unleaded gasoline blend-stock, propane, platinum, and palladium.
- Futures are legally binding obligations that require delivering or receiving the commodity.
- Each contract lists commodity/price/date/location.
- The most important function of the Exchange is “price discovery” and transparency.
- Each commodity has its own delivery hub.
- WTI is the standard crude stream for futures contracts in crude oil.
- Only licensed brokers can trade on the Exchange.
- Trades have to be conducted with Clearing Brokers.
- There are two classes of market participants, “commercial,” or those interested in the physical commodity, and “non-commercial,” or “speculators.” Commercial entities use the contracts to "hedge" their price and market risk.
- Most trading is purely for financial gain, as only a small number of contractual obligations are fulfilled in the physical (cash) markets.
Now that we are familiar with the workings of the Exchange and futures contracts, we will walk through the cash market and its relationship to the financial market in the next lesson.
Reminder - Complete all of the Lesson 3 tasks!
You have reached the end of Lesson 3. 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.