EBF 301
Global Finance for the Earth, Energy, and Materials Industries

NYMEX Order Flow


All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner with each party involved fully aware of the details of the transaction. As legally-binding agreements, non-performance under a futures contract can have severe financial and legal consequences. Therefore, most phone conversations are taped to ensure the accuracy of the orders placed as well as the results of the execution of those orders. Standardized order forms are used during order execution and daily "check-outs" occur between brokers and their clients for verification of all trades conducted that day. In this section, we will follow a natural gas futures contract trade from the beginning to end for a producer and end-user wishing to lock-in a fixed price for a 12-month period.

Key Learning Points for the Mini-Lecture: NYMEX Order Flow

While watching the mini-lecture, keep in mind the following key points and questions:

  • All orders must be placed with a “clearing” broker who guarantees the trades.
  • Contracts can be used for pure trading or “hedging” physical and price risks.
  • Energy Trading companies & Financial Brokers provide risk services to their customers.
  • Orders flow from customer’s representative through the financial trading process.
  • Orders with NYMEX can be filled via the traditional “pit” trading or electronic platforms.
  • Less than 2% of all contracts traded ever become physical transactions.
  • Trading is a “zero-sum” game. For every winner, there is a loser (there are two sides to every trade).

NYMEX Order Flow Lecture

The following video is 10:40 minutes long.

EBF 301 NYMEX Order Flow
Click for a transcript.

As mentioned in the introduction to this lecture, we're going to walk through the specific steps of executing a buy and sell order on the floor of the New York Mercantile Exchange. We're going to be doing this during the regular session where there are active traders in the pits doing what they call the open outcry trading. In order to understand what's going on, there are two key terms here that we're going to need to understand.

One is a bid. And it's a motion to buy a futures contract at a specified price. The opposite of that is an offer. Again, a motion to sell a futures contract at a specific price. And that's also known as the asking price. And we use the word motion because the traders are using various hand signals to communicate to one another across the pits, if they're buyers or sellers, what volume, and what price.

So the example we're going to use in this case is a 12-month price, a 12-month "strip" average of $3.50. As mentioned in Lesson Seven, you can go out and you can buy or sell contracts at an average price as opposed to having to buy or sell at each individual month's price. In this case, we're looking at 12 months out. So currently, this 12-month strip is running $3.50. And there's a producer out there who would like to lock this price in, or better, if he or she can get that. So the producer's going to call a trader at the energy company and tell them that they're interested.

So the trader will turn around then and they'll ask the personnel on the fixed price desk to call New York and find out where the market currently is, where are the bids, where are the offers, for this 12- month strip for natural gas. Energy trading companies that have financial derivative trading, they will have a fixed price desk. These are the personnel mostly responsible for dealing with the New York Mercantile Exchange.

So the fixed price desk calls their broker on the floor of the New York Mercantile Exchange to find out the current market quotes and both the bid and offers. Now the person that they're talking to is the clearing broker and, specifically, the phone clerk. If you recall the picture of the floor of the Mercantile Exchange from Lesson Seven, you can picture those phone banks. So this is where that phone call is going to.

The fixed price desk person turns around then and gives the trader the current market quote. The producer then gets that bid and offer from the trader. And given that the market is still in the $3.50 range, the producer decides that he or she would like to lock in the price of $3.50 or better for the next 12 months if in fact it can be executed. The trader now takes the order from the producer and passes it along to the fixed price desk.

Now, at this point in time, the producer is obligated to perform under this contract. In other words, the producer realizes that the energy trading company's going to have to enter into the legally binding contracts on the New York Mercantile Exchange to obtain this fixed price for them. So the producer is going to have to perform by giving the physical gas when the time comes to the energy trading company.

So, the trader gives that order, the sell order, to the fixed price desk. The fixed price desk then calls New York again and, tells the phone clerk with the clearing broker on the floor of the NYMEX that they would like to sell the one month strip $3.50. The phone clerk immediately stamps the ticket that they have, indicating when the order was received from the fixed price desk at the energy trading company.

The phone clerk will then walk over to the pits and hand a copy of that ticket to their broker who is trading in the pits themselves. That pit broker then offers out the 12-month strip into the market at $3.50. Another broker, who has received a buy order from another customer, decides to go ahead and lift the offer on the 12-month strip at $3.50. So keep in mind that, as we mentioned in the prior lesson, it's a zero-sum game. For every buyer, there is a seller.

So, in this case, the producer is having the trading company sell contracts for them. There has to be a buyer across the pit willing to buy those contracts in order for the deal to be consummated. So in this case, there happened to be an interested party on the other hand. And for our purposes, we'll go ahead and assume that it's an end user who's interested in buying the natural gas at $3.50 for the next 12 months.

So, once the counterparty across the pit has gone ahead and lifted the order, the broker now hands the order back to their phone clerk. And the pit brokers also then have an official form that they have to fill out for the New York Mercantile Exchange, which includes the details of the transaction. So the phone clerk now time stamps the ticket, as in they've had it timestamped when the order was received, and it again is stamped with the time when the order is actually filled.

So, phone clerk calls the trader's fixed price desk. The trader's fixed price desk receives the fill from the floor of the NYMEX and repeats the fill verbally to ensure that there's no error. So the clearing broker phone clerk and the trading company's fixed price desk repeat the details of the transaction so that there's no mistake as to exactly what has occurred. And as mentioned in the prior lesson, the phones are also recorded.

So, if there's any dispute at the end of the day when it comes to checking out the trades between the energy trading company and their broker, they can pull the tapes, as we say, if there's a discrepancy and have it resolved that way. OK. The fixed price desk, now having confirmed the order, passes along the fill to the trader. The trader now passes along the completed order to the producer.

So, the producer has gotten done what the producer wanted. So the producer is now what we call hedged if natural gas prices decline below $3.50 over the next 12 months. So they can't get a price any lower than $3.50. However, because of that, they give up any upside. In other words, the producer you cannot get a price higher if the market does move up. But in this situation, the producer liked $3.50. And they wanted to make sure that prices didn't fall on them.

Here are some more terms that are frequently used in terms of New York Mercantile Exchange trading. We already covered the ask and the bid. A bull, a lot of you have already heard this term. But it's actually someone. It's a person who anticipates an increase in price or an increase in volatility. (Volatility is a measure in the magnitude of price change, as well as the frequency of the change in price). And they are the opposite of a bear. A bear, again, is a person who anticipates a decline in price or volatility. And they are the opposite of a bull.

Backwardation. It's a market situation in which the futures prices are lower in each succeeding delivery. It's also known as an inverted market. It's the opposite of contango. So let's take, for instance, the September crude oil contract. If right now it was the highest price, and October was lower than September, and November was lower than October, and so forth, we would have a backward- dated market. Because the normal situation is, the prompt month or near month, and for several months going out, prices do rise.

A broker. A broker is a party or company which is paid a fee for transactions in the financial and physical markets. Brokers do not take title to the contracts. They do not take title to the commodity being traded. They simply join counterparties together and they extract a fee for doing so. They are truly middlemen. The cash market is the market for a cash commodity where the actual physical product is traded.

So, we've mentioned a couple of times, we differentiate between financial and physical or cash marketplaces. When I talked about the pricing publications, they cover the cash market. The CFTC, that's the Commodity Futures Trading Commission. This is the federal agency responsible for the oversight of all commodities trading, not just energy commodities. The contango market. This is the opposite of the backward dated market. It's a market situation which the prices are higher in succeeding delivery months than in the prompt month.

To cover. We use that term to talk about a trader or company who happens to be short futures or options positions. In other words, they've sold contracts in anticipation of prices falling. And so that open position is known as a short position until such time as they buy those contracts back and cover that open position. A derivative is a financial instrument derived from a cash market commodity, a futures contract, or other financial instruments.

The New York Mercantile Exchange contract for natural gas is derived from natural gas itself, the commodity. And the same applies to the other energy commodities on the NYMEX. The last trading day. It's the last day of trading for the prompt month contract. Currently, for natural gas, it's three working days prior to the next calendar month. We covered the deadlines for each of these in Lesson seven.

Long. This is a market position based on owning contracts which must be sold, or the delivery of the underlying commodity must be accepted. It's the opposite of short. So a trader or a company who takes a long position, they're buying contracts in anticipation of prices rising. And then they will sell those contracts hopefully at a profit. The offer, we mentioned already. We talked about what an offer is.

Open outcry is the name given to the pit trading. OK. For NYMEX purposes, it's a method of public auction for making verbal bids and offers for contracts in the trading pits or trading rings of commodity exchanges. It is totally different than electronic trading platforms. The short. This is a market position based on selling contracts which must be brought back or the delivery of the underlying commodity must be made. It is the opposite of long.

So again, this is where traders are selling contracts in anticipation of prices falling. They'll buy them back and make a profit. We mentioned earlier the idea that when they are short, they'll have to cover those positions by buying the contracts back. Strike price. We will get more into this when we talk about options. But it's the price at which the underlying futures contract is bought or sold in the event that an option is exercised. It's also called an exercise price.

John A. Dutton e-Education Institute
NOTE: The lecture slides can be found in Module 3 in Canvas (Lesson 3: The New York Mercantile Exchange (NYMEX) & Energy Contracts)

Optional Materials

High-Frequency Trading

"High Frequency Traders" (HFT) are impacting the market in a huge way by using super-computers to execute high volumes in nano-seconds. To get an explanation of HFT and their impact on the market, view this video (2:29 minutes).

How High-Frequency & Algorithmic Trading open the Floor for a Flash Crash
Click for a transcript.

SPEAKER 1: The problem with high-frequency trading is this. First of all, it's a myth that it hurts the common trader. Somebody that's on E-Trade and wants to buy IBM or some other trade isn't buying it for the nanosecond. They're not worried about that microsecond that they might have gotten and one-hundredth of a penny difference.

If you're an average trader, and you're worried about one-hundredth of a penny, you shouldn't be trading because you can't compete with the big boys. It's just not going to happen. So, most people-- public-- they trade. They buy something. They hold.

And they're looking for a few points or a long-term investment. So, the high-frequency traders really, I agree-- that don't affect them. Where the high-frequency traders affect everybody, and this is where you have what they call the flash crash. And I didn't really look at it as a flash crash.

I looked at it as that it was a vacuum, and some people say it's the same thing. Well, it's really not. When we were in the pit and news would come out, and all of a sudden want to be like 60 bid at 60, at 40, at 20, at even-- there'll be some person like me saying, OK, I'm 95 bid, and they go sold. There'll be another person that'll go 90. Then it will be sold.

And if somebody would come out 85 bid, it will be sold. So, there will be natural stops in the market. Natural volume because with 200 people in the pit, you have 200 different opinions. And everybody either had an opinion-- either it was too sold or too bought.

And the market would have ebb and flow going back and forth. Put in high-frequency trading. They tend to run on the same algorithm program. And when news comes out, they just pull.

SPEAKER 2: Pull out, panic the market drops. Yeah, and that's a real risk.

SPEAKER 1: They can pull out orders in nanoseconds. I can't tell you how many times that news came out, and a broker with 60 bid for 100. And before his clerk could grab him on his neck, I could go sold. OK, you can't do that now with the speed.

And what happens now is that it would be the equivalent of all the locals in the pit, the minute news came out that they would say, we're going to lunch. Have a nice time and see you later. And then the brokers would look.

And I've seen a broker's face when there's no bid when he has to sell something or no offer when he has to buy something. And that's why these vacuums now are just extraordinary. And that is the problem with where the high-frequency trader comes in. No, for 99% of the time, it's actually pretty good that they're there because they're arguing.

They are going back and forth with bids and offers, and I can get into any trade now. You can get into any trader now. Getting out's the problem.

Source: CapitalAccount

Future of the Trading Floor

Please watch the following short video (1:55) about the future of the NYMEX trading floor and how electronic trading is affecting the trading pits.

End of Era: Trading Pits Close
Click for a transcript.

PRESENTER: Even if you've never been to the famed trading pits, chances are, you know what they look like and sound like.



- Sell 30 April at 142!


PRESENTER: Featured in films like Trading Places and Ferris Bueller's Day Off, the trading pits at the Chicago Mercantile Exchange were loud and hectic.




PRESENTER: On July 6th, the futures pit in Chicago and New York, where buying and selling sets the prices for commodities like gold, wheat, and corn, roars one last time. The 167-year-old tradition of open outcry futures operations ends after the closing bell on Monday.

VIRGINIA MCGATHEY: For example, if I'm trying to buy 25 at 4 and a quarter, I would be saying that and also doing the hand signals at the same time. And then the opposite person would be saying, OK, I'm selling you 25 at 4 and quarter. And so, then we'd understand that I was buying and they were selling.

PRESENTER: Virginia McGathey, a grain trader on the Chicago Mercantile Exchange floor, just finished her last shift in the pit. In short, blame the computers. CME Group, which operates the trading pits in New York and Chicago, is shifting to electronic dealing. And CME Group held off on going all digital, even as rivals in New York and London embraced electronic trading.

VIRGINIA MCGATHEY: It's really heartbreaking on a particular level that it's ending this way. And I think, in talking with some of the other traders, the fact that we can't leave a legacy to children and grandchildren, that this is the end of the road-- it's just definitely not the same on a computer, not at all.

PRESENTER: And not all the pits are closing. One exception is the S&P 500 futures market, which remains open on the Chicago trading floor. In another sign of changing times, fans of CME Group can track the company on several social media sites, including Twitter, Facebook, Instagram, and Pinterest.

Source: Wall Street Journal