Trading Futures Contracts: What You Need to Know
If you are a beginner, entering a futures market might seem very intimidating. This makes sense because not everybody needs to be trading futures, and most futures contracts have price volatility way above most conventional stocks and bonds.
So often, we’re afraid of what we don’t know. A great number of futures contracts find their basis physically at ground level or below earth, such as crude oil, gold, or soybean contracts. The short- to long-term futures market turbulence is enough to give investors a great deal of information about global occurrences.
In this article, we’ll get you started on understanding the futures market and how it operates, toward possibly even trading futures someday.
Definition of Futures Contracts
A futures contract is a legally binding obligation to buy or sell a standardized asset on a specific day or during a specific month. Futures are almost always traded on an exchange; the largest futures exchange in the US is the CME Group.
How Futures Contracts Work
Most futures contracts are “standardized,” or nearly identical, and they stipulate a few things, including:
- Quantity and quality of an asset.
- Unit pricing of the asset and the minimum price movement, or “tick size”.
- Date and location of physical “delivery” of the underlying asset, although that is rarely the case since most contracts are liquidated before the fact.
Who Trades Futures Contracts and Why?
The community of futures traders is broad. It may be easier for all participants to trade when there are this many different parties and individuals trading futures and providing access. The first class of traders are commodity producers and processors, or “commercials” as they are known; examples of this type may have included grain millers, miners of precious metals, and oil companies. In addition to regular traders, there are the “speculators,” which include large banks, hedge funds, and full-time traders.
The many players in the market are purchasing and selling futures for different reasons. For example, a grain processor would be interested in “hedging,” or protecting it against the possibility of a severe summer drought in the midwest regions of the United States which may send corn and soybean costs skyrocketing.
In contrast, speculators try to make money by “buying low and selling high” (or vice versa). In a basic futures trading strategy, they hope to profit from price swings in the futures contract, much as they do in the stock market.
Speculators and commercials give liquidity to the futures market for it to operate. They offer a large pool of ready merchants against ready purchasers.
How Do Futures Exchanges Work?
Exchanges provide a central marketplace for buyers and sellers to congregate, first physically and today virtually. For much of the first 150-plus years, traders conducted business by shouting and, on occasion, wild gesturing while wearing brightly colored jackets and standing in tier-level “pits” on the trading floors. Virtual trading has largely supplanted the so-called open outcry trade today.
Another major function that exchanges accomplish in “ensuring” that futures contracts are executed is the operation of “clearinghouses,” backstops, or “counterparties” in every transaction. The main goals are to ensure market confidence and to minimize if not totally eliminate, counterparty risk.
Margin in Futures Trading
Margin buying is borrowing money from a broker to purchase stock. It allows the investor to margin trade for more shares than he otherwise could.
In futures, it works a bit differently but on a similar principal basis: the amount that a trader must deposit in good faith while trading futures is the initial margin requirement. It may be considered a form of a performance bond, which ensures that both the seller and the buyer of futures contracts will satisfy the endpoints of their obligations. Initial margin requirements typically amount only to a tiny fraction of the notional value of the corresponding contract and vary by product and by volatility in the market. This kind of leverage is not suitable for all investors due to the high risk involved.
With greater leverage, relatively small movements in the futures contract’s price can quickly create much larger losses.
When trading futures, an investor is typically required to pay the necessary initial margin kept at the clearinghouse of the exchange and to establish an account with a futures commission merchant.
This means that as a futures trader, prices moving against your position will result in a margin call. This would prompt you to add more money to your account. In addition, if you do not come up with adequate money fast enough, then your futures positioning will be liquidated.
The amount of equity in your account is not a measure of your downside financial risk. You may be subject to liquidation of any or all of your positions at any time if the equity in your account falls below the required levels of margin.
