One of the major advantages of exchange-traded futures and
options is that the exchange guarantees every contract, thus relieving the
holder of the risk of default by the writer. This means that potential option
buyers are relieved of the burden of evaluating the creditworthiness of the
writer. To protect itself against the risk of default by the writer for futures
and options contracts, exchanges impose substantial capital and stringent
margin requirements on option-writers. Membership requirements and standards
are high and members’ positions are constantly monitored by the futures
exchange. In addition, a futures exchange will maintain a large clearing fund
to meet unforeseen circumstances.
Major international banks have for many years marketed the advantages
and flexibility of futures and options contracts to their multinational
corporate clients. Since multinational corporations have varied demands, not
all of which can be matched by exchanges, banks have found it worthwhile to
offer tailor-made futures and options contracts to meet the specific needs of
their clients. This tailor-made market which allows for negotiation of the
terms of the contract between the buyer and seller of an option is known as the
over-the-counter market (OTC). The OTC market is dominated by major banks and
securities houses, and contrasts with the standardized contracts on offer at
the futures and options exchanges. The major advantage of the OTC market is
that a client’s specific needs with regard to the size, exercise price and
expiration date of the contract can be met.
Open interest is the outstanding number of contracts
obligated for delivery. Consider four traders A, B, C and D, none of whom has
any current position in a futures contract. If trader A takes a long position
in a new contract with trader B taking a short position, then the open interest
rises by one contract. Similarly, if trader C takes a long position in a
futures contract with trader D taking the short position, then open interest
rises by a further one contract.
For most futures
contracts, especially those that involve physical commodities such as gold,
cotton and so on, the physical delivery of the commodity would be a cumbersome
process. To avoid getting involved in the actual delivery process most traders
enter into what is known as a reversing trade prior to the maturity of the
contract. That is, they will liquidate their position at the clearing house so
that they neither have to actually deliver or actually receive the underlying
commodity. In our example, traders A and C are committed to buying the
underlying commodity upon expiry, while traders B and D are committed to
delivering it upon expiry. Trader A may not actually wish to receive the
underlying commodity and trader D may not wish to actually deliver it, and
hence at some date prior to expiry trader A and trader D will take out reversing
trades to liquidate their positions. Trader A will take out a contract to sell
the underlying commodity (at the then prevailing market price). As far as the
clearing house is concerned, then A will have no net position in the futures
market since it has an identical futures contract to both receive and deliver
the underlying instrument. If trader A sold his contract to a new party E then
the open interest would have been left unaffected by A’s trade. If, however,
trader A had sold his position to trader D who was also undertaking a reversing
trade, then open interest would have declined by one since both A and D have
effectively negated their positions with the clearing house.
Jordan Schleider of NQ Trader and EJS
Jordan@nqtrader.us
jordan@ejs.net
http://ejs.net
http://nqtrader.us
