An Introduction to Futures Trading

This page is designed to provide an introduction to the futures market in general and the INE EC container freight futures contract in particular. We will introduce the concept of Container Freight Index Futures (CoFIF), the INE EC contract, key aspects of regulated futures markets as well as different approaches to trading for speculative and hedging purposes

CoFIF Market Background

The idea of establishing a container freight futures contract to allow market participants to protect themselves against adverse price changes is nothing new, with the first attempt to establish such a contract dating back to the 2000s. However, to date, no such contract has succeeded.

Back in 2011, the Shanghai Shipping Freight Exchange (SSFE) launched their Container Freight Derivatives (CFD) contract, the most promising attempt so far. It saw some initial interest from speculative traders, but there was little industry participation and trading was limited to domestic Chinese companies.

Most importantly, the SSFE was not a regulated futures exchange and thus lacked an established ecosystem of brokers and traders and the contract was ultimately suspended in 2016 as trading volume quickly dropped off.

Any successful container freight futures contract needs to overcome three distinct challenges to have a realistic shot at becoming an industry benchmark: liquidity, counterparty risk and transparency.

Liquidity

Firstly, major industry participants like carriers would need to hedge large quantities if they were to rely on benchmark contracts for pricing. They would need to be able to get in and out of their positions easily without affecting the entire market. However, if the market is too small, it becomes impossible to trade the necessary volume without causing wild price swings that would disrupt the entire market and ultimately make any attempt at hedging futile.

A lack of liquidity has so far hamstrung the success of the CME and SGX futures based on the Baltic Exchange's FBX11 index. Neither speculators nor hedgers have been willing to take the first step so far and establish initial positions. Hence, bid-ask spreads remain wide, making it challenging to enter and exit positions at the market price.

Much of the speculative trading interest in container freight contracts is located in China, and with limited access to overseas futures exchanges, international contracts may struggle to attract them to get a new contract off the ground and establish sufficient liquidity for industry participants to join.

Counterparty Risk

Secondly, any market needs to be properly regulated and safeguarded to ensure that contracts can be enforced and each market participant can be confident that their counterparty can't simply walk away from an unfavourable trade. This is where established futures exchanges have a distinct advantage: While marketplaces like the SSFE may call themselves 'exchanges', they are not the same as regulated futures exchanges.

Futures exchanges are strictly supervised by market regulators and have a variety of tools in place to compensate market participants in case any traders default on their obligations, including investor protection funds, initial margins and daily price limits. Most importantly, regulated futures markets rely on a centralised clearinghouse to novate all trades, that is, to act as the legal counterparty for every buyer and seller and thereby guarantee the performance of all contracts traded on the exchange.

Transparency

Lastly, any contract needs to be transparent and properly reflect the underlying reality of the physical market as futures prices cannot be dictated by unpredictable speculative traders and thus removed from the actual spot market price. Unless hedgers can trust the futures market to be tethered to the physical market, they will not be able to use it to protect themselves from volatile shipping rates.

The INE EC Contract

The Shanghai International Energy Exchange (INE) launched its Containerized Freight Index (Europe Service) futures contract in August 2023 with the intention of overcoming the aforementioned challenges and establish a benchmark contract for the Shanghai - North Europe route. Commonly referred to as CoFIF, short for Container Freight Index Futures, or EC, its official exchange product code, the futures contract is different from its predecessors in several ways.

Based on Paid Spot Market Rates

The CoFIF contract is cash settled against the Shanghai Shipping Exchange (SSE) Shanghai Export Containerized Freight Index based on Settled Rates (SCFIS) Shanghai - North Europe route index. Launched during the Covid-pandemic as shipping rates surged to record levels, the index is based on the actual rates paid for containers exported from Shanghai to Hamburg, Rotterdam, Antwerp, Felixstowe and Le Havre, with settled prices submitted to the SSE after the departure of the vessel.

Thus, the contract's final (settlement) price is determined by the real prices paid in the underlying container freight spot market, avoiding the oft-cited concern by industry participants that the market may be overrun or broken by speculators and linking it tightly to the physical market.

A Mandate to Serve the Real Industry

From the day it was launched, the market reception of the new contract was exceptionally strong, with total daily turnover routinely exceeding USD 1bn. The Red Sea crisis then turbocharged interest in CoFIF trading as China - Europe rates rose dramatically following the blockade of the Suez Canal.

This primarily brought new speculative traders into the market, but, given the INE's government-issued mandate to serve the real industry, it quickly took action to rein in excessive speculation by raising margins and reducing daily new open position limits for speculative traders.

Risk Management

Due to the strong regulatory overview it has of the market, the INE was able to distinguish between hedgers and speculators and enact targeted measures to maintain a stable market environment. The immediate result was a drop-off in daily trading volume as speculative trading became more capital-intensive, but the futures market was prevented from drifting too far away from the underlying spot market.

As the market gradually priced in the existing disruptions, the restrictions were loosened and volumes quickly picked up again. The industry-first approach of the Chinese exchanges means they are willing to forego fee income from speculators to maintain an orderly market, and industrial hedgers tend to benefit from reduced initial margin requirements and exemptions from standard position limits to account for their hedging needs.

In addition to these pro-active risk management measures by the exchange, INE market participants are also covered by the China Futures Market Monitoring Centre (CFMMC)-managed Futures Investors Protection Fund in case of defaults by traders or brokers. Thus, with its own centralised clearinghouse to novate all trades and backing from the investor protection fund, the second key challenge - proper regulation and enforcement of contracts - is also addressed by the INE's CoFIF contract.

Glossary

Hedging with CoFIF

Hedging involves taking a position in the futures market to offset a position in the physical market. Ideally, by taking an opposite position in the futures market, any loss in one market will be offset by an equivalent profit in the other market.

In reality, a perfect hedge, where any loss is precisely offset by a profit in the other market, is difficult to achieve, so hedging should instead be seen as a risk management tool that can reduce large price swings in volatile markets or lock in a fixed price.

Different market participants have different needs, so it is important to design hedging strategies in a way that suits the hedger's physical business. Hedging strategies can be designed to remove most price risk, or they can be partial and simply reduce the hedger's exposure to the spot market with a reduced exposure to the spot market price.

In the Chinese futures market, hedgers commonly benefit from reduced exchange fees, larger position limits and lower margins. This reflects both the exchanges' mandate of 'serving the real industry' and the generally lower risk-profile of hedgers, given that any potential losses are largely offset.

The following examples are simplified case studies to introduce futures as a hedging tool for the industrial users. Real applications need to take into account factors such as the hedger's risk appetite, degree of exposure to the spot market and the ability to absorb losses or pass on costs. Internal controls and risk management protocols should be in place to prevent unintended speculative trading that may expose the hedger to losses.

Hedging Example 1: Locking in a High Price as a Liner

Liners are naturally long in the physical market, benefiting from higher rates but suffering when rates fall.

Thus, if a liner has a 5,000 FEU spot rate exposure in the physical Shanghai-North Europe market in August, they may choose to lock in a rate using the futures market by selling the INE EC August contract. If the spot price falls, the liner will lose money in the physical market, but earn money in the futures market from their short position.

If the spot market price then falls to 4,700 in August, the liner will make a loss in the physical market. However, since the futures market settles against the SCFIS spot market index, the INE EC contract will also drop and offset this loss.

Hedging Example 2: Protecting against Price Hikes as a Shipper

Shippers, in contrast to liners, are naturally short in the physical market, benefiting from lower rates but suffering when rates rise.

Thus, if a shipper has a 500 FEU spot rate exposure in the physical Shanghai-North Europe market in August, they may choose to lock in a rate using the futures market by buying the INE EC August contract. If the spot price falls, the shipper will save money in the physical market, but lose money in the futures market from their long position. However, in case rates rise, they will lose money in the physical market while benefiting from their futures market profit.

If the spot market price then falls to 4,700 in August, the shipper will save money in the physical market. However, since the futures market settles against the SCFIS spot market index, the INE EC contract will also drop, losing the shipper money.

Hedging Example 3: Managing Volatility as a Forwarder

Forwarders need to consider price volatility both when buying space from liners and when selling space to shippers. A successful hedge will allow the forwarder lock in fixed prices on both ends. Since INE EC futures are financially settled and do not provide cargo slots upon expiry, forwarders must sill secure cargo slots from a liner when executing a hedging strategy.

Hedging Example 3.1: Forwarders in a Rising Market

Hedging Example 3.2: Forwarders in a Falling Market

Speculating with CoFIF

If market participants have no physical market position to hedge, they may still choose to trade futures to benefit from expected price changes in the financial market. The nature of these trades is purely speculative as there is no offsetting position in the underlying commodity.

Speculative traders can be active in both the financial and physical markets to combine the insights gained by operating in the two markets and profit from having more information than other market participants. However, many financial investors are pure paper traders and do not operate in the physical market, while others, especially industrial market participants, engage primarily in physical trading and use the futures market for hedging purposes only.

In most mature futures markets turnover is many times greater than in the physical market and most trading is speculative, with only a small fraction of contracts held until expiry. This is largely due to the leveraged nature of futures trading: opening a position requires only the payment of initial margin instead of the full contract value.

Furthermore, as contracts approach their expiry date, this margin requirement is typcially raised by the exchange to ensure anyone holding the expiring contract is capable of paying the full value of the contract. Thus, trading volume and open interest gradually shift over to the following contract months.

The presence of both speculators and hedgers in the market is fundamental to its effective functioning as every single trade requires two parties willing to hold opposite positions - a buyer and a seller. A liquid market also makes it easier for hedgers and speculators to open or close large positions without significantly impacting the market price.

Directional Trading

If a market participant holds the view that the price of a specific contract will likely rise or fall, they can express this view in the futures market by taking a directional position, i.e. buying or selling that contract. Buyers will benefit when the price of the contract rises, while sellers will profit if the price falls.

This is the simplest position a market participant can hold and the potential profit or loss can be calculated as follows:

• Example 1

  A bought 10 INE EC 2408 contracts at 2000, then sold them for 2500

  Profit = (2500 - 2000) × 50 × 10 = 500 × 50 × 10 = 250,000

• Example 2

  B bought 10 INE EC 2408 contracts at 2000, then sold them for 1800

  Profit = (1800 - 2000) × 50 × 10 = -200 × 50 × 10 = -100,000

• Example 3

  C sold 10 INE EC 2408 contracts at 2000, then bought them back for 2500

  Profit = (2000 - 2500) × 50 × 10 = -500 × 50 × 10 = -250,000

• Example 4

  D sold 10 INE EC 2408 contracts at 2000, then bought them back for 1800

  Profit = (2000 - 1800) × 50 × 10 = 200 × 50 × 10 = 100,000

Calendar Spread Trading

Calendar spreads allow traders to express a relative instead of an absolute view of the market by avoiding the impact of overall market movements. Instead, the profit/loss comes from the relative performance of different contract months.

For example, if a physical market participant notices strong demand for cargo in December, this may be a sign that Q1 demand in Europe is overall stronger than expected and this may put pressure on freight rates to rise. Just like before, the market participant could simply buy EC 2412 contracts, wait for prices to rise in response to the demand pickup and then sell the futures at a higher price.

However, this demand increase is not happening in a vacuum - other factors could affect freight prices in general, such as a resolution to the Red Sea crisis and re-opening of the Suez Canal for Asia-Europe cargo. The price impact would likely be significant and outweigh the impact from increased demand for imports from China in Europe and the above directional trade might incurr a loss.

As the market participant has no chance to predict the occurrence of such geopolitical events, a simple directional position may be unsuitable in this scenario. Instead, they could use a calendar spread to express their conviction that the December contract is likely to perform better than the October contract.

By buying EC 2412 while simultaneously selling EC 2410, the market participant can express this relative view independent of whether the overall freight rates rise or fall. All that matters is that EC 2412 would rise relatively more or fall relatively less than EC 2410 because of the added effect of stronger demand from Europe in December.

Unexpectedly, the Red Sea crisis is resolved, enabling unimpeded Suez Canal transits. Capacity employed on routes around the Cape of Good Hope becomes available again for shorter Suez Canal voyages, increasing supply and prices fall across the board. However, the our expectation of stronger December demand also materialises and so while EC 2410 falls by 40%, EC 2412 performs relatively stronger, falling only 35%. We now sell EC 2412 and buy back our EC 2410 contract to close our position:

• Sell 1 lot EC 2412 at 0.65 × 2146.8 = 1395.4
• Buy 1 lot EC 2410 at 0.6 × 2238.0 = 1342.8

Using our profit/loss formula from above, we get:

• December profit = (1395.4 - 2146.8) × 50 × 10 = -751.4 × 50 × 1 = -37,570
• October profit = (2238.0 - 1342.8) × 50 × 10 = 895.2 × 50 × 1 = 44,760
• Net profit: -37,570 + 44,760 = 7190

Had we only bought the December contract, we would have been exposed to the overall market impact, but we essentially hedged against this by selling the October contract. While our December long position lost money, our October short position was profitable; and because December demand still increased, that loss was smaller than the October profit.

Note 1: This 'hedge' is imperfect: because the October and December contracts have different prices, an equally large change in percentage terms would still lead to a (small) non-zero net profit/loss.

Note 2: An important implied assumption in this case is that the resolution of the Red Sea crisis would in fact impact all contract months equally.

Esunny User Guide

Participants will use the Esunny trading platform to execute trades in a simulated environment based on the real INE marketplace. Esunny comes with access to market data, technical analysis and trading tools and allows users to keep track of their real-time account balance and trading profits & losses.

Rules

Further information can be found in the Competition Terms & Conditions. Any errors, omissions, or discrepancies in competition related materials and trading activity that occur before, during or after the competition are subject to resolution by BANDS without exception.