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This chapter is from the book

The Exchange, 'open outcry' and the clearinghouse

Much of the public does not understand that the Exchange does not set the prices of the traded commodities. Actually, the prices are determined in an open and continuous auction on the Exchange floor by the members who are either acting on behalf of customers (you and me), the companies they work for (if a hedger), or themselves (for their own account). The process of the auction has been around for more than 100 years is called open outcry. (It has already been replaced outside of the United States and is losing market share in the U.S. to electronic trading primarily for financial futures.).

Open outcry is not like the typical auction at Sothebys, where a single auctioneer announces the bids. At the Exchange, people are not only competing to buy, but also to sell, and they all can be doing this simultaneously. Every floor trader is his own auctioneer. The democratic feature of open outcry is that only the best bid and offer are allowed to come forward at any point in time. If a trader is willing to pay the highest price offered, he yells it out, and by Exchange rules, all lower bids are silenced. By Exchange rules, no one can bid below a higher bid, and no one can offer to sell higher than someone else's lower offer. Although each trader in the pit can see who the other floor trader is, customers remain anonymous. At times, customers who are entering or exiting a large position act through multiple floor brokers so as not to tip their hand. Because this is an anonymous auction, prices quoted on futures Exchanges are accepted widely and are used as reference prices for the underlying commodity. This process is known as price discovery, because anyone, anywhere, can discover the price. For commodities not traded on the Exchange (tungsten, cobalt, bananas, and onions, for example), a few large players can set the price, and the bid-to-offer spread (the difference between where the buyers can buy and the sellers can sell) is generally much wider than the Exchange-traded commodities. As a result, middlemen can take a greater percentage out of the middle, making many of these thinly traded cash markets much less efficient, which is one of the benefits of a futures Exchange to a free society. By helping to manage risks and broadcast prices, a well-run business can bring its goods and services to market at the lowest possible price more efficiently.

How is the price determined?

Conspiracy theorists would tell you price is determined by the big banks or the oil "seven sisters;" a clergyman might tell you that it's God. A simpler explanation is supply and demand, or in other words, buyers and sellers. If the buyers are more aggressive than the sellers, prices go up. If the sellers are more eager, prices go down. In a free market, prices are determined by what the seller can get from the buyer. Prices are made by what someone is willing to pay for a given product. You might think any given price is too low or too high, but at any point in time, the market sets the price, and there's an old adage that says that the market is always right.

How do the participants know they will get paid?

Investors trade futures to make money. Commercial interests use futures to lessen the risks in their businesses. Both groups want to make sure that if they make money on their transactions, they get paid. This is the job of the Exchange—to guarantee each trade. Although a trade may be conducted between two parties on the floor, it is ultimately the Exchange's responsibility to act as the seller to every buyer and the buyer to every seller. Each Exchange is made up of many member firms, some of the largest and best capitalized names in banking, brokerage, and private industry. They all individually and collectively guarantee against default by any one party. Each player in the marketplace, whether he is a farmer from Des Moines or an automobile manufacturer in Stuttgart, must deal through a clearing member. Each participant must post a good-faith deposit (margin). If a doctor in Los Angeles buys 10 gold contracts, for example, he is required to have on account (or to quickly send in) the margin money required for 10 gold contracts to his broker. His broker is either a clearing member or dealing through one. Whether he sends the money or not, the clearing member is still obligated to post this margin money at the Exchange. The seller of the 10 gold contracts could be a mine that is hedging or another speculator who believes prices will fall, but regardless, the short is required to post the margin, and so is his clearing firm. The Exchange must know that participants have sufficient funds to handle losses they could potentially experience in the markets.

The margin is determined and set by the Exchange. It is generally stable, but it can be and is changed by the Exchange based on market volatility and risk. Margin is generally the amount of money the Exchange determines sufficient to cover any one-day price move. It should be noted that the Exchange determines the minimum margin necessary to hold each contract; however, any one brokerage firm or clearing firm can charge an individual customer a higher margin rate than the minimum if it feels it requires additional protection against customer default. As an additional safeguard, the clearing members contribute to a pool of funds, a guarantee fund, that can be used in the event that any one member defaults. Although individual customers of clearing firms, and even clearing firms at time, have defaulted, there has never been an Exchange default. If an Exchange defaulted, it would mean the members collectively defaulted, and we would all be trouble because the entire global financial system would be in jeopardy. The bottom line? Don't be concerned about being paid if you win.

What are they doing on the floor?

You probably have seen photos or films of the Exchange trading floors. These 'floors' have already been replaced in Europe by computer terminals. In the years to come, these trading floors may all become relics of the past, but, for now, some of the world's largest Exchanges based in the United States still use floor traders. Traders, many wearing wildly colored jackets, stand in the trading rings around a bar or in pits arranged like amphitheaters, with steps descending to the center. They gesture wildly, screaming out bids (buys) and offers (sells). Meanwhile, men and women who work for the Exchange are silently punching keys on computer terminals or, in some cases, hand-held computers. These people are reporters, who are listening for completed transactions so that they can broadcast the price to the information vendors who, in turn, transmit the price to quote machines around the world. You'll also see people running back and forth and around the floor, you'll see huge wallboards that flash a series of ever-changing numbers. The shouting, gesturing, and jumping around by the pit traders gives the floor a chaotic appearance to the uniformed. In reality, it is quite orderly. The people who are running are carrying customer orders from the clerks, who receive them by telephone from buyers and sellers around the world, to the floor brokers in the pits who will bid, or offer, the order in the pit to the other floor brokers who also have orders to buy or sell. Also, the "runners" are taking confirms, or completed trades, back to the phone clerks, who then report back to their customers.

In some pits, the orders are flashed into the pit directly from phone clerks who are using hand signals or, at times, just plain, old-fashioned yelling. In the pits, the floor brokers, who are holding bids, are crying out to other brokers in the ring how much they are willing to pay and at what quantity they are willing to purchase. Sellers are crying out their offers with price and quantity. When a buyer and seller meet, they cry out "Sold," "Done," or "Take it!" These are the words the reporter is listening to hear, and when these words are heard, the reporters report the price (not the quantity), and this price is then transmitted almost simultaneously around the world electronically. Each floor broker wears a badge with a number of letters to identify himself to the other brokers. When a trade is completed, or executed, each selling broker must record each transaction on a card or hand-held computer that shows the commodity, quantity, delivery month, price, and the badge number or name of the buyer on the other side of the transaction. In some of the more active pits, thousands of contracts are bought and sold each and every minute. The transaction then is sent to the data-entry room, where operators key the data into the Exchange's central computer system. Because both sides of the transaction are submitted in the same manner, there is a dual audit trail.

What's the difference between a floor broker and the broker you'll use to place your orders?

A floor broker is buying and selling futures on the floor, either entirely for himself or filling orders for his customers, who are the brokerage houses. He cannot take customer orders from the public, but he can fill them. The Exchange has strict rules for floor brokers who trade for their own account or filling customer orders. The basic rule is that brokers can never trade for themselves ahead of customer orders. A broker off the floor is licensed by the government to execute trades for the public. Your broker calls the floor (or submits an order via the Internet) to have trades executed on your behalf. The same rule applies to the broker who places orders for you. He cannot trade for his own account ahead of your customer order. The customer always comes first.

Most of the trading is done during the official hours the trading floor is open; however, all the major Exchanges, for most of their major contracts, also have in place after-hours electronic trading systems, which are active after the trading floor is closed. These are computer terminals where transactions can take place electronically, and the contracts created are the same as those created during normal trading hours, so they can be sold or bought the next day or whenever (in other words, offset), on the Exchange floor.

How Do the Floor Brokers Do It?

When you see pictures of the traders in the pit, here's what you're looking at:

  • Palms in, or "I'm a buyer."

  • Palms out, or "I'm a seller."

  • Hands away from body, with arms outstretched, fingers moving, or "Here's my price." (Prices 1–5 are quoted with vertically extended fingers, prices 6–9 are quoted with fingers horizontal, and a closed fist indicates a zero price.)

  • Hands held near head, or "This is how many I want."

Of course, these brokers are all yelling, too. Do mistakes ever happen? Well, we're dealing with human beings, right?

Sal, an experienced floor broker, tells the story of a novice floor broker in the deferred cattle futures (the months that are traded thinly) who wrote the book on how not to open a market. The day after a bearish Cattle on Feed Report, the broker had orders for 30 contracts to sell and only five to buy. He bid 20 lower for the five and offered 30. A local trader sold the five immediately and, seeing that the other markets were sharply lower, screamed an offer to sell 50 contracts 100 lower. The novice panicked and offered his 30 contracts limit down. The local bought his five back (limit down) for a tidy profit. The novice had to answer as to why the opening range was 130 points, and he made both sides of it!

Here's a quote recently heard from a Feeder Cattle broker on a volatile, wide-ranging, whipsawing-type day:

"I've 10 left. I'll pay half on 10, sell 10 at a quarter [the lower price]. Anybody want 'em?"

Sal tells this other story of what he terms the best order he ever received as a floor broker. He was working for the now-defunct Mitchell-Hutchins. "I was told to go into the bellies, don't bid for the front contract, but just start buying the rest. I was also told to report back to the desk every 15 minutes and report how I was doing. I was told to keep my ears open for any large offers to sell that came into the pit, and if I heard them, I was supposed to buy 'em, and after they were gone, bid higher. My final instructions were, by the end of the day, 'Have the bellies limit up!'"

Here's a quote from a pork belly trader:

"If God told me bellies would be limit up tomorrow, I would still go home long only five contracts."

Open outcry versus electronic

My first 20 years in this industry were almost wholly involved with the traditional open outcry, auction-style trading methods, and this is evident by much of what I write in this book, as well as in many of the stories from traders' lore. However, as Bob Dylan once said, "The times, they are a changin'," and although just a few years ago all futures trading took place in open outcry pits, today the volume for purely electronic markets has outpaced the traditional. Whereas the physical commodities at the U.S. Exchanges (oil, agricultural, and so on) are still primarily open outcry, virtually the rest of the world's Exchanges are purely electronic. There are no trading pits; instead, computer terminals match up trades. The advantages of the electronic markets include low cost of execution and clearing and a perception of a more level playing field (because it is first-come, first-served with an electronic timestamp). Some industry experts predict all futures trading will eventually go electronic. They just may be right, but this is probably still many years away for the United States.

Although electronic execution of trades may make for better speed and efficiency, the new technology will not help with your trading decisions; that's what this book is designed to help you with.

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