I would like some explanation as to how a trader closes a futures position.
If trader A (short) and B (long) are in a futures contract and trader B would like to close the position, he would have to go short and sell a similar contract. Does the exchange take care of finding another trader who is going long? Or does the exchange become the buyer and seller for future positions.
Assuming these are standardized and regulated contracts, the short answer is yes. In your example, Trader A is short while Trader B is long. If Trader B wants to exit his long position, he merely enters a "sell to close" order with his broker.
Trader B never goes short as you state. He was long while he held the contract, then he "sold to close".
As to who finds the buyer of Trader B's contract, I believe that would be the exchange or a market maker. Therefore, Trader C ends up the counterparty to Trader A's short position after buying from Trader B. Assuming the contract is held until expiration, Trader A is responsible for delivering contracted product to Trader C for contracted price. In reality this is generally settled up in cash, and Trader A and Trader C never even know each other's identity.
Ignoring the complexities of a standardised and regulated market, a futures contract is simply a contract that requires party A to buy a given amount of a commodity from party B at a specified price. The future can be over something tangible like pork bellies or oil, in which case there is a physical transfer of "stuff" or it can be over something intangible like shares.
The purpose of the contract is to allow the seller to "lock-in" a price so that they are not subject to price fluctuations between the date the contract is entered and the date it is complete; this risk is transferred to the seller who will therefore generally pay a discounted rate from the spot price on the original day.
In many cases, the buyer actually wants the "stuff"; futures contracts between farmers and manufacturers being one example. The farmer who is growing, say, wool will enter a contract to supply 3000kg at $10 per kg (of a given quality etc. there are generally price adjustments detailed for varying quality) with a textile manufacturer to be delivered in 6 months. The spot price today may be $11 - the farmer gives up $1 now to shift the risk of price fluctuations to the manufacturer. When the strike date rolls around the farmer delivers the 3000kg and takes the money - if he has failed to grow at least 3000kg then he must buy it from someone or trigger whatever the penalty clauses in the contract are.
For futures over shares and other securities the principle is exactly the same. Say the contract is for 1000 shares of XYZ stock. Party A agrees to sell these for $10 each on a given day to party B. When that day rolls around party A transfers the shares and gets the money. Party A may have owned the shares all along, may have bought them before the settlement day or, if push comes to shove, must buy them on the day of settlement. Notwithstanding when they bought them, if they paid less than $10 they make a profit if they pay more they make a loss.
Generally speaking, you can't settle a futures contract with another futures contract - you have to deliver up what you promised - be it wool or shares.
For exchange contracts, yes. A trader can close a position by taking an offsetting position. CME's introduction to Futures explains it quite well (on page 22).
Exiting the Market Jack entered the market on the buy side, speculating that the S&P 500 futures price would move higher. He has three choices for exiting the market:
- Offset Position Offsetting his position is the simplest and most common option for Jack. He entered the market by buying two E-mini S&P 500 futures contracts, so he can offset his position by selling two contracts. If he had entered the market by selling two contracts, he would offset the sale by purchasing two. To limit the risk of holding a position overnight, many individual traders exit all positions and go home flat (no position) at the end of every trading day.
- Roll Position All futures contracts have a specified date on which they expire. Longer-term traders who do not want to give up their market exposure when the current contract expires can transfer or roll the position to the new contract month. In our case study, if Jack wanted to stay long in the E-mini S&P 500 contract as the December expiration approached, he could simultaneously sell the December contract and buy the following March contract. In this way, Jack would offset his position in the December contract at the instant that he takes an equivalent long position in the March contract. To put it another way, he would effectively roll his long position from the December contract to the March contract.
- Hold Contract to Expiry All futures contracts have an expiration date. One of Jack’s options is to hold his contracts until they expire. However, doing so would have certain implications. Some contracts call for the physical delivery to an approved warehouse of the underlying commodity or financial instrument. Others, like the E-mini S&P 500, simply call for cash settlement. Every futures contract specifies the last day of trading before the expiry date. Investors need to pay attention to this date because as the date approaches, liquidity will slowly decrease as traders begin to roll their positions to the next available contract month.
Futures exchanges are essentially auction houses facilitating a two-way auction. While they provide a venue for buyers and sellers to come together and transact (be that a physical venue such as a pit at the CME or an electronic network such as Globex), they don't actively seek out or find buyers and sellers to pair them together.
The exchanges enable this process through an order book. As a futures trader you may submit one of two types of order to an exchange:
Market Order - this is sent to the exchange and is filled immediately by being paired with a limit order.
Limit Order - this is placed on the books of the exchange at the price you specify. If other participants enter opposing market orders at this price, then their market order will be paired with your limit order.
In your example, trader B wishes to close his long position. To do this he may enter a market sell order, which will immediately close his position at the lowest possible buy limit price, or he may enter a limit sell order, specifying the price at or above which he is willing to sell. In the case of the limit order, he will only sell and successfully close his position if his order becomes the lowest sell order on the book. All this may be a lot easier to understand by looking at a visual image of an order book such as the one given in the explanation that I have published here: Stop Orders for Futures
Finally, not that as far as the exchange is concerned, there is no difference between an order to open and an order to close a position. They're all just 'buy' or 'sell' orders. Whether they cause you to reduce/exit a position or increase/establish a position is relative to the position you currently hold; if you're flat a buy order establishes a new position, if you're short it closes your position and leaves you flat.
