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  • Overview

    Chapter 4 - Cotton trading - Trading in futures

    Floor procedure

    In traditional open outcry or floor-based trading, the initiation of a contract transaction takes place on the floor of the exchange. Unlike the physical market, no privately arranged deals are allowed. The transaction is negotiated across the floor, giving all participants an opportunity to respond to the current bids and offers. The negotiation is concluded the moment a buyer and a seller agree with each other and the seller registers the contract as a sale to the clearing house. Thereafter, the two traders are responsible only to the clearing house. In this way, the clearing house is a party to every transaction made by both buyers and sellers.

    Automated or electronic trading is different but maintains the transparency of open outcry trading in that all bids and offers can be viewed by all participants. The computer system matches equivalent bids and offers without human intervention. Once the orders are matched, the clearing procedure is exactly the same as the old open outcry system.

    Futures contracts are standardized in that all terms are given, except the exact date of delivery, the names of the seller and buyer, and the price. The market rules are legally enforceable contract terms and therefore cannot be substantially altered during the period of the contract. Every futures contract specifies the quantity, quality, and condition of the commodity upon delivery, the steps to be taken in the event of default in delivery, and the terms of final payment.


    Most futures transactions do not result in physical delivery of the commodity.

    Depending on their strategy, futures traders usually make conscious decisions either to avoid delivery or to accomplish it. That is, they either make an offsetting transaction ahead of the delivery, thereby avoiding physical cotton being tendered to them; or they consciously force the exchange to deliver (tender) physical cotton by allowing the contract to fall due. Delivery must be completed between the first and the last trading days of the delivery month, although the exact terms vary from one market to the other.

    While the futures contract can be used for delivery, its terms are not convenient for all parties. For example, the terms of delivery of futures contract provide the seller with the exclusive right to select the point of delivery. This situation can obviously create difficulties for the buyer. In addition, the actual cotton delivered, while acceptable under the futures contract, may not match the buyer’s specific quality needs.

    Offsetting transactions

    A trader who buys a futures contract and has no other position on the exchange is long. If this purchase is not eventually offset by an equivalent sale of futures then the buyer will have to take delivery of the actual commodity.

    Alternatively, a trader who sells a futures contract without an offsetting purchase of futures is said to be short. Traders who have taken either position in the market have two ways of liquidating it. The first involves the actual delivery or receipt of goods. Most traders choose the second option, which is to cancel an obligation to buy or sell by carrying out a reverse operation, called an offsetting transaction. By buying a matching contract a futures trader in a short position will be released from the obligation to deliver. Similarly, a trader who is long can offset outstanding purchases by selling.

    Open interest. The total of the clearing house’s long or short positions (which are always equal) outstanding at a given moment is called the open interest. At the end of each trading day, the clearing house assumes one side of all open contracts: if a trader has taken a long position, the clearing house takes the short position, and vice versa. The clearing house guarantees the performance of both sides of all open contracts to its members, and each trader deals only with the clearing house after initiating a position. In effect, therefore, all obligations to receive or deliver commodities are undertaken with the clearing house and not with other traders.

    Futures prices

    Futures prices and spot prices.
    Futures markets provide a public forum to enable producers, consumers, dealers and speculators to exchange offers and bids until a price is reached which balances the day’s supply and demand. Only a negligible proportion of the physical cotton trade actually moves through exchange markets. The futures price is intended to reflect current and prospective supply and demand conditions whereas the spot price in the physical market refers to the price of cotton for immediate delivery. In the futures market the spot price normally reflects the nearest futures trading position.

    Carries and inversions.
    When the quotation for the forward positions stands at a premium to the spot price, the market is said to display a carry (also called forwardation or contango). The price of successive forward positions rises the further away they are from the spot position. In order to provide adequate incentives for traders to carry stocks, the premiums for forward positions must cover at least part of the carrying costs of those who accept ownership. Therefore, when stocks become excessive, the futures market enables operators to enter the market to buy the commodity on a cash basis and to sell futures, thereby carrying it. The carry will eventually rise to a level where the premium covers the full cost of financing, warehousing and insuring unused cotton stocks. This level of the forward premium is known as the full carry. The holders of surplus cotton are now covered for the full costs of holding these stocks.

    The size of the forward premium or discount between the various forward trading months quoted at any time reflects the fundamentals of the cotton market. When cotton is in short supply, the market nearly always displays an inversion (backwardation), with the forward quotation standing at a discount to the cash price. This inversion encourages the holder of surplus stocks to supply them to the spot market and to earn the inversion by simultaneously purchasing comparable tonnages of forward futures at a discount to the spot price.

    Differences between forward and futures market prices

    Forward markets are used to contract for the physical delivery of a commodity. By contrast, futures markets are ‘paper’ markets used for hedging price risks or for speculation rather than for negotiating the actual delivery of goods. On the whole, prices in the physical and the futures markets move parallel to each other. However, whereas the futures price represents world supply and demand conditions, the physical price for any particular cotton in the forward market reflects the supply and demand for that specific type and grade of cotton, and the nearest comparable growths.

    Prices in both physical and futures markets tend to move together because traders in futures contracts are entitled to demand or make delivery of physical cotton against their futures contracts. The important point is not that delivery actually takes place but that delivery is possible, whether this course of action is chosen or not. Any marked discrepancy between the prices for physicals and futures would attract simultaneous offsetting transactions in the two markets, thus bringing prices together again.

    However, buying futures in the hope of using the cotton against physical delivery obligations is extremely risky because the buyer of futures contracts does not know the exact storage location or the origin or quality of the cotton until delivery is made. The cotton that is finally delivered may be unsuitable for the buyer’s physical contractual obligations, leaving it with more rather than less risk exposure. On the other hand, physical cotton on a forward shipment or delivery contract that is of an acceptable quality can usually be delivered against a short position on the futures market as the buyer can choose the origin and where to make the physical delivery (or tender). This feature makes futures contracts particularly suitable as a hedge against physicals.

    Types of orders

    Fixed price order for the same day means that an exchange member is asked to buy or sell a given number of lots (contracts) for a particular month at a set price, for instance, two lots (200 bales) of cotton for December at 62 cents per pound. The contract must be completed during the day on which the order is given. If possible, the broker will buy at a lower price but never at a higher price; or sell at a higher price but never at a lower price. This ensures that clients will get the desired price if a contract is made, but they run the risk of not having a contract made at all if the floor trader cannot execute the order on that day.

    Fixed price, open order is a similar order, except that the instructions stand for an indefinite period of time until the order is satisfied or cancelled by the client. This type of order is popularly known as ‘good till cancelled’ (GTC).

    Market order is an order that gives brokers more flexibility, and allows them to make a contract for the best possible price available at the time.

    Different orders are often made subject to certain conditions. For example, a broker may be instructed to make a contract if the price reaches a certain level. Orders that are conditional on specific terms set by the client can also be made. Examples of such orders are: those to be carried out only at the opening or closing of the market; or those to be carried out within a certain period of time. (Orders have to queue at the opening and closing of the market and are therefore not all filled at the same price, particularly when trading volume is high in an active market. If one stipulates a price then an order may not be executed if that price is not touched, or is exceeded.)

    Market orders and fixed price orders for the same day are the most common but orders are also made to suit the requirements of clients. Clients who follow exchange movements closely frequently revise their orders in response to changing market conditions. Those less involved in hourly market movements usually place open orders, or orders subject to certain conditions. For example, a stop-loss order – which is triggered into action as soon as a predetermined price level is reached – limits the client’s losses relative to the level at which the order is executed. Placing more general conditions on the order gives brokers greater flexibility to react to changes in the market and leaves the final decision to them.


    Open position or open interest is the number of contracts registered by the clearing house which are not offset by other contracts or tenders when the contracts become spot (the nearby contract month). For example, a cotton trader may have a position with the clearing house of 30 purchase contracts and 40 sales contracts. Some of the purchases and sales may be for the same delivery month but the trader may have labelled them as ‘wait for instructions’ if those contracts represent separate hedging transactions for that trader. This means the trader will enter into additional futures deals to offset them once her or she unwinds the physicals against which the original hedge was taken. In other words, the open position of that particular operator remains 70 lots until some of the contracts are offset or ‘washed out’.

    The clearing house reports only the total of all operator positions, rather than the position of any one member, which is left to the broker to report. CFTC’s commitment of traders (COT) report breaks down the total open interest on the NYBOT Cotton No. 2 contract by category of traders. Large traders are called reportable, while small traders are non-reportable. The COT report then further breaks down the open interest by commercial and non-commercial reportable traders. It is a very handy tool for exporters to get an idea of the long or short positions of the large speculative hedge funds.


    Trading deposits (margins) are required upon initiation of a futures trade. Further deposits may be required daily to reflect the changes in the price of the contracts when the market moves against a trader’s position. If additional funds are required to restore the original margin (currently $1,200 per cotton contract for hedgers, equivalent to 2.4 cents per pound or about 4% of the contract’s nominal value) then variation margins must be paid in unless adequate security, for example treasury bills, were deposited when the account was established. Conversely, if the futures price move is favourable to the trader, the gains transferred into the account above the margin requirement level become immediately available to the trader.

    Original and variation margins are adjusted from time to time for the following reasons: to reflect increased or decreased market levels; to add security to volatile positions, particularly in months carrying no limit; and to discourage excessive concentration of trading positions in any one month. Investors should note that margin requirements can be changed without prior notice.

    Financing margins

    Financing margin calls on open contracts can make the use of futures markets very expensive for producers and exporters, partly because variation margins are always paid in cash. Any user of futures markets should be aware that unanticipated calls for variation margins can be costly in terms of demands on their cash flow and the interest foregone on cash deposited with the clearing house. Therefore, a user should carefully consider how margin calls will be financed before entering into any commitments. For example, when the market closes ‘limit up’, in other words 3 cents above the previous close, this translates into a variation margin of $1,500 per contract, so an exporter with a short of 10 contracts against physical stocks of 226.8 tons would have to pay $15,000 within 24 hours to meet the margin call. Of course exporters would benefit from the increased value of their physical contracts in a situation like this, but might not always find it easy to convince any but the most experienced commodity finance banks of the validity of this argument.