Managing trading risk
A London International Financial Futures and Options Exchange case study

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Page 5: Grading and warehousing

London International Financial Futures And Options 4 Image 5When we examine the fascinating details of futures trading we can almost lose touch with the real commodities that are being traded. The trading in commodities must be carried out in the highest quality conditions.

LIFFE ensures that the commodities being traded are tightly monitored and controlled. LIFFE has approved a number of authorised warehouses and warehouse keepers who are responsible for the careful handling and storage of commodities, for their organised sampling, as well as the maintenance of accurate and scrupulous records. For example, cocoa and coffee are graded and sampled by suitably qualified persons appointed by LIFFE. All grain delivered against wheat and barley futures contracts must be segregated from all other grain and kept in a LIFFE registered grain store. 

Clearing and settlement

London International Financial Futures And Options 4 Diagram 3The role of LIFFE’s clearing house, the London Clearing House (LCH) is to manage the orderly flow of transactions between buyers and sellers. LCH becomes counterparty to each contract. This releases the original buyer and seller from any bilateral agreements with each other. The holder of a long position (a bought contract of either calls or puts) can offset this obligation by selling an option of the same month and strike price. Similarly, the seller of an option can simply buy back the same month and strike price. This cancels the 'open' position with the clearing house.

Margins

LCH takes security from members to protect against another member being unable to pay its losses. There are two elements to this margin:

  • Variation margin - these are profits or losses on open positions which are calculated daily in the marking to market process and then paid to or collected from members.
  • Initial margin - this is a returnable deposit required by LCH when opening futures and options positions.


Take coffee as an example
Coffee is an important commodity, with over 50 producing countries and 25 million people employed in coffee trade world-wide. It takes four years before a newly planted coffee tree can provide a reasonable harvest. There are many different types and grades of coffee and the taste or 'cup' is affected by the method of growth/processing.

Coffee is prone to disease, insect and weather-related catastrophes and therefore shows major fluctuations in price. For example, in 1994, there were two major frosts and a drought in Brazil which affected the amount of coffee produced and, therefore, the final price.

London International Financial Futures and Options Exchange | Managing trading risk
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