Greetings Traders, and welcome back to another In-Depth with Chris
episode. In today's discussion, we'll be talking about
what standardization is as it applies to futures contracts.
It is a term that gets thrown around an awful lot, and it's
one of those terms that not a lot of us spend the time actually going to investigate.
Instead, we usually use context clues to guess what it means.
While we may be close, it doesn't hurt to be aware of
exactly what it is. We're going to cover exactly that in this short video.
If you haven't already, please do me a favor,
click the like and subscribe button down below so I can keep
coming out with content for you all out there.
But without further ado, let's dive on in to standardization.
Financial derivatives contracts can be seen as one of the
most complex investable instruments that we can choose from as traders.
Some people will tell you that in order to trade them successfully,
we should and have an obligation to be familiar with each
contract's specific details and their intricacies.
One of these intricacies is understanding how the standardization process works.
We'll start off with covering the definition of what
standardization of derivatives contracts is.
Standardization of derivative contracts streamlines trade facilitation
or financial transaction execution through a framework of agreements.
Alternatively, it lists the detailed processes needed to
ensure the constant quality of a particular financial offering or a transaction.
It covers all market participants in a transaction, including
investors, fund managers, brokers, and just so much more.
All relevant parties must adhere to the standardization policies
and guidelines, and doing so will help ensure that there's
the adequate quality of whatever particular instrument that we're trying to trade,
that adequate quality is maintained throughout the entire
process. To put this simply, the standardization of derivatives
contracts is really a uniform set of guidelines that all
parties have to accept and adhere to in order to interact
with each other. An example of this would be with derivatives contracts.
These guidelines might include the number of units each contract
covers, or how we determine price, and when we can trade these
contracts, or even the delivery options. It can include all of these things.
Standardization applies to all types of trading activities,
including buying and selling of stocks, commodities, futures
options, and pretty much everything else.
With stock trading, the standardization practices are pretty much
straightforward, while with derivatives contracts, that's when
it gets a little bit more complex due to the specifics of
the traded instruments and their settlement.
The benefits of standardization, or the reasons that we
should be thankful that it's there as traders, is because
it ensures that a product offering has a consistent quality
to other equivalent items in the same class.
Alternatively, it guarantees that the derivatives contracts
will always have the same characteristics, no matter whether
we buy it today or in a month.
Aside from the fact that it's maintaining quality consistency,
the standardization of derivatives contracts also ensures
greater liquidity, trade execution, efficiency, and even cost reduction.
These are all things that, as traders we're usually pretty excited to hear.
Besides this, it also brings clarity to the way we conduct
transactions. That way, each party related to a particular
transaction knows what to expect from it.
In a nutshell, standardization introduces pre-set parameters
within the derivatives market that determines the size,
delivery dates, price, and other characteristics of the particular
contract that we're interested in trading.
Standardized derivatives are also known as exchange-traded derivatives
The most common standardized derivative contracts
are futures and options. The role of standardization
in these classes is really to unify and systematize the way
that they are offered to us in the market.
Some of the most actively traded standardized derivatives include this list here.
I'm sure some of us have seen some of these options at some point or another,
if we're not already involved trading them. We have at the top
the S&P 500 E-Mini, otherwise known as the ES, which
is my personal favorite so we're gonna draw a nice little star over here.
Then we have the crude oil, which is my second favorite.
that is CL. Followed by Eurodollar, which is ED, corn, which
is ZC, soybeans, which is ZS, and then Henry Hub Natural Gas,
which ticker symbol is NG. All of these are very, very common.
Yes, all of these indeed are part of the standardization process.
Because there are over-the-counter derivatives
as well as exchange- traded derivatives,
I thought it would be important to cover exactly what the differences are.
As a rule of thumb, the exchange-traded derivatives are all
standardized. The over-the-counter, which is known as OTC derivatives,
those, on the other hand, are not. Instruments traded
on public markets should adhere to the standardization
guides of that particular exchange.
While meanwhile, the OTC derivatives are subject to strictly
defined standardization rules and they can be customized.
This characteristic is also what defines the differences between both groups.
Due to their standardized nature, ETDs enjoy higher liquidity,
which are the exchange-traded derivatives.
Furthermore, regulators like the Securities and Exchange Commissions
which is the SEC, oversee the assets that we are trading on
markets like the Chicago Board Options Exchange, the CBOE,
or maybe ICE, or maybe NYMEX.
Another benefit is that clearing houses like the CFTC will guarantee them.
This vote of confidence means that they significantly lower
those associated risks for the participating investors.
Another distinguishing factor is that standardized derivatives
are suited for all types of market participants.
The list ranges from retail investors to institutions like
pension funds, and hedge funds, investment managers, and more.
Whereas the OTC derivatives don't necessarily suit everyone out there.
OTC, by contrast, are much more complex, making it very easy
to get lost and the contract's details because of that ability
for them to be very customizable.
While the lack of standardization makes them more flexible,
it introduces more aggressiveness and complexity to the market
as a whole, which isn't always| exactly the best environment
for a mom-and-pop investor.
The OTC market heavily leans towards institutional investors.
The primary users of the OTC derivatives market are the several
large scale investors, or otherwise known as whales, who trade
there to avoid destabilizing the public market with their
big trades or to simply negotiate better terms outside of the standardized market.
Although the OTC trades usually have massive individual volumes,
they aren't frequent. The trading activity on unregulated markets is much more
infrequent making it a whole lot less liquid.
Many instruments aren't even offered or traded daily on OTC markets
When talking about how futures contracts are standardized, let's take the CME
for example. The exchange has standardized items and specifications
for each futures contract that it's listing and offers for
trading. The specifications include a contract unit, a price quotation,
trading hours, an expiration date, settlement procedures,
lot size, quality, and other essential details.
Furthermore, exchanges also have guidelines that specifically
state the underlying instruments that they can use to create derivatives contracts.
The idea of standardization for futures contracts is to make it
easier for investors to get familiar with everything that
they should know about the instruments that they're interested in investing in.
If we were to take a look at what the standardization principles
mean for futures contracts size, for example, the standardization
principles allow the market to be more accessible.
When we look at things like the standardization for the contract sizes,
it allows the contract to be a reasonable size that
small investors can actually afford.
Things like this allow us as traders to trade, and it's all
because of the standardization process.
Options contracts are standardized as well, and they are
standardized according to the specific guidance of the exchange
that they're trading at.
The standardization specifics depend on the type of underlying
instrument. If we were to take a look at, say, corn options
from, say, the CME, the standardization will cover contract
specifics like the base unit, minimum price fluctuation, trading hours
listed contracts, exercise style, settlement method, and more.
When it comes to options contracts, we would want to know
generally that there are all types of instruments that we have available to us.
The standardization specifics depend on the market that list them.
For example, there are equity options, bond options,
index options, currency options, interest rate options, options
on futures, and even options on the weather forecast.
Standardization in the options market might look something
like each contract represents 100 shares of a particular
company. The fact that there's some type of standardized
procedure where we now can expect each contract to control
100 shares makes it easier on us as the investor because
we have that consistency in our life.
Standardization is a beautiful mechanism for us as traders
to more easily navigate derivatives marketplaces.
It gives us both more liquidity as well as more transparency
into what's going on and how something will go on before
we ever even click the button to execute a trade. We have
the exchange-traded derivatives, and we also have the over-the-counter
derivatives. Remember, the difference here is with the OTC
derivatives, they do tend to favor the whales.
They have the ability to be customized, but they inherently do have more risk,
and the markets are not nearly as liquid or not nearly as
consistent. But until next time, thank you for joining me
as always. In this presentation, we talked about what derivatives
are and what they are as it pertains to the standardization
process, but if you're interested to see what we talk about
next, then you're gonna have to meet me there.
Cheers folks. See you all very soon.
Good luck in the markets. Over and out.