In this article, we look more closely at how futures contracts are traded. As noted above, futures contracts trade on a futures exchange either in a pit or on a screen or electronic terminal. Pit trading is a very physical activity. Traders stand in the pit and shout out their orders in the form of prices they are willing to pay or accept. They also use hand signals to indicate their bids and offer^.^ They engage in transactions with other traders in the pits by simply agreeing on a price and number of contracts to trade. The activity is fast, furious, exciting, and stressful. The average pit trader is quite young, owing to the physical demands of the job and the toll it takes on body and mind. In recent years, more trading has come off of the exchange floor to electronic screens or terminals. In electronic or screen-based trading, exchange members enter their bids and offers into a computer system, which then displays this information and allows a trader to consummate a trade electronically. In the United States, pit trading is dominant, owing to its long history and tradition. Exchange members who trade on the floor enjoy pit trading and have resisted heavily the advent of electronic trading. Nonetheless, the exchanges have had to respond to market demands to offer electronic trading. In the United States, both pit trading and electronic trading are used, but in other countries, electronic trading is beginning to drive pit trading out of busines. A person who enters into a futures contract establishes either a long position or a short position. Similar to forward contracts, long positions are agreements to buy the underlying at the expiration at a price agreed on at the start. Short positions are agreements to sell the underlying at a future date at a price agreed on at the start. When the position is established, each party deposits a small amount of money, typically called the margin, with the clearinghouse. Then, the contract is marked to market, whereby the gains are distributed to and the losses collected from each party.
A party that has opened a long position collects profits or incurs losses on a daily basis. At some point in the life of the contract prior to expiration, that party may wish to re-enter the market and close out the position. This process, called offsetting, is the same as selling a previously purchased stock or buying back a stock to close a short position.
The holder of a long futures position simply goes back into the market and offers the identical contract for sale. The holder of a short position goes back into the market and offers to buy the identical contract. It should be noted that when a party offsets a position, it does not necessary do so with the same counterparty to the original contract. In fact, rarely would a contract be offset with the same counterparty. Because of the ability to offset, futures contracts are said to be fungible, which means that any futures contract with any counterparty can be offset by an equivalent futures contract with another counterparty. Fungibility is assured by the fact that the clearinghouse inserts itself in the middle of each contract and, therefore, becomes the counterparty to each party.
For example, suppose in early January a futures trader purchases an S&P 500 stock index futures contract expiring in March. Through 15 February, the trader has incurred some gains and losses from the daily settlement and decides that she wants to close the position out. She then goes back into the market and offers for sale the March S&P 500 futures. Once she finds a buyer to take the position, she has a long and short position in the same contract. The clearinghouse considers that she no longer has a position in that contract and has no remaining exposure, nor any obligation to make or take delivery at expiration. Had she initially gone short the March futures, she might re-enter the market in February offering to buy it. Once she finds a seller to take the opposite position, she becomes long and short the same contract and is considered to have offset the contract and therefore have no net position.