What Are Futures?
In the United States, trading futures began in the mid-19th century with the establishment of central grain markets where farmers could sell their products either for immediate delivery, also called the spot or cash market, or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner of today’s exchange-traded futures contracts.
Both forward contracts and futures contracts are legal agreements to buy or sell an asset on a specific date or during a specific month. Where forward contracts are negotiated directly between a buyer and a seller and settlement terms may vary from contract to contract, a futures contract is facilitated through a futures exchange and is standardized according to quality, quantity, delivery time and place. The only remaining variable is price, which is discovered through an auction-like process that occurs on the Exchange trading floor or via CME Globex, CME Group’s electronic trading platform.
Although trading began with floor trading of traditional agricultural commodities such as grains and livestock, exchange-traded futures have expanded to include metals, energy, currencies, equity indexes and interest rate products, all of which are also traded electronically.
Definition of futures
Standardized contracts for the purchase
and sale of financial instruments or physical commodities for future delivery on a regulated commodity futures exchange.
A private, cash-market agreement between
a buyer and seller for the future delivery of a commodity, at an agreed upon price. In contrast to futures contracts, forward contracts are not standardized and are non-transferable.
A market where cash transactions for the physical or actual commodity occur.
The first global electronic trading system for futures and options has evolved to become the world’s premier marketplace for derivatives trading. With continual enhancements, the platform has effectively enabled CME Group, already known for innovation, to transform itself into a leading high-tech, global financial derivatives exchange.
Who Trades Futures?
Conventionally, traders are divided into two main categories, hedgers and speculators. Hedgers use the futures market to manage price risk. Speculators on the other hand accept that risk in an attempt to profit from favorable price movement. While futures help hedgers manage their exposure to price risk, the market would not be possible without the participation of speculators. They provide the bulk of market liquidity, which allows the hedger to enter and exit the market in an efficient manner. Speculators
may be full-time professional traders or individuals who occasionally trade. Some hold positions for months, while others rarely hold onto a trade more than a few seconds. Regardless of their approach, each market participant plays an important role in making the futures market an efficient place to conduct business. The following pages will provide brief profiles of the most common types of market participants.
What Types of Traders are There?
Hedgers have a position in the underlying commodity. They use futures to reduce or limit the risk associated with an adverse price change. Producers, such as farmers, often sell futures on the crops they raise to hedge against a drop in commodity prices. This makes it easier for producers to do long-term planning. Similarly, consumers such as food processing plants often buy futures to secure their input costs. This allows them to base their business planning on a fixed cost for core ingredients, such as corn and wheat. other examples include: airlines hedging fuel costs or jewelry manufacturers hedging the cost of gold and silver. This makes it easier for these companies to manage price risk and stabilize the cost passed on to the end-user.
Many speculators are individuals trading their own funds. Traditionally, individual traders have been characterized as individuals wishing to express their opinion about, or gain financial advantage from, the direction of a particular market. Electronic trading has helped to level the playing field for the individual trader by improving access to price and trade information. The speed and ease of trade execution, combined with the application of modern risk management, give the individual trader access to markets and strategies that were once reserved for institutions.
A portfolio or investment manager is responsible for investing or hedging the assets of a mutual fund, exchange-traded fund or closed-end fund. The portfolio manager implements the fund’s investment strategy and manages the day-to-day trading. Futures markets are often used to increase or decrease the overall market exposure of a portfolio without disrupting the delicate balance of investments that may have taken a significant effort to build.
A hedge fund is a managed portfolio of investments that uses advanced investment strategies to maximize returns, either in an absolute sense or relative to a specified market benchmark. The name hedge fund is mostly historical, as the first hedge funds tried to hedge against the risk of a bear market by shorting the market. Today, hedge funds use hundreds of different strategies in an effort to maximize returns. The diverse and highly liquid futures marketplace offers hedge funds the ability to execute large transactions and either increase or decrease the market exposure of their portfolio.
Why Trade Futures?
Futures provide a fast and cost-effective way for you to access financial and commodity markets around the clock. Increased interest in global markets has accelerated media attention and attracted the interest of traders from around the world. From their study of the markets, traders develop a perspective on the direction of commodity prices, energy prices, metal prices, currencies, interest rates and stock indexes. CME Group offers products across all major asset classes giving you a direct and transparent method to act on your insight and participate in market trends.
Leverage on futures contracts is created through the use of performance bonds,
often referred to as margin. This is an amount of money deposited by both the buyer and seller of a futures contract and the seller of an option contract to ensure their performance of the contract terms. The performance bond may represent only a fraction of the total value of the contract, often 3 to 12%, making futures a highly leveraged trading vehicle. Therefore, futures contracts represent a large contract value that can be controlled with a relatively small amount of capital. This provides the trader with greater flexibility and capital efficiency.
What do we mean by “leveraged”?
The E-mini S&P 500 Stock Index futures contract could have a value of $67,500, but you would be able to buy or sell this contract by posting a performance bond of about $6,000, which is only 9% of the contract value.
The ability to leverage may remind you of buying stocks on margin. However, in equity markets, buying on margin means you borrow money to make the purchase. In the futures markets, your performance bond is not partial payment for the product. It is good-faith money you post to ensure you are able to meet the day-to-day obligations of holding that position. Both buyers and sellers in futures post performance bonds. Positions are then marked-to-market on a twice daily basis, where profits are credited and losses are debited from your account.
What is a Performance Bond?
The minimum amount of funds that must be deposited by a customer with his broker, by a broker with a clearing member or by a clearing member with the Clearing House.
Trading futures may offer specific tax advantages compared to other instruments such as stocks. Be sure to discuss your particular tax obligation with your tax advisor.
How Does a Trade Work?
Before we go through specific examples, there are some key terms and concepts you need to understand.
By definition, each futures contract has a standardized size that does not change. For example, one contract of corn represents 5,000 bushels of a very specific type and quality of corn. If you are trading British pound futures, the contract size is always 62,500 British pounds. The E-mini S&P 500 futures contract size is always $50 times the price of S&P 500 index. Specifications for all products traded through CME Group can be found at cmegroup.com.
Contract value, also known as a contract’s notional value, is calculated by multiplying the size of the contract by the current price. For example, the E-mini S&P 500 contract is $50 times the price of the index. If the index is trading at $1,425, the value of one E-mini contract would be $71,250.
The minimum price change in a futures or options contract is measured in ticks. A tick is the smallest amount that the price of a particular contract can fluctuate. Tick size varies from contract to contract. A tick in the E-mini S&P 500 futures contract is equal to one-quarter of an index point. Since an index point is valued at $50 in the E-mini, one tick is equivalent to $12.50.
Some futures markets impose limits on daily price fluctuations. A price limit is the maximum amount the price of a contract can move in one day based on the previous day’s settlement price. These limits are set by the Exchange and help to regulate dramatic price swings. When a futures contract settles at its limit bid or offer, the limit may be expanded to facilitate transactions on the next trading day. This may help futures prices return to a level reflective of the current market environment.
Futures contracts follow a practice known as mark-to-market. At the end of each trading day, the Exchange sets a settlement price based on the day’s closing price range for each contract. Each trading account is credited or debited based on that day’s profits or losses and checked to ensure that the trading account maintains the appropriate margin for all open positions. As described in the “Why Trade Futures?” section on page 9, your position in the market is secured by a performance bond. A performance bond is an amount of money that must be deposited with your broker
to open or maintain a position in a futures account. This good-faith money helps to ensure that all market participants are able to meet their obligations. It helps maintain confidence in the financial integrity of the Exchange as a whole. The practice of marking accounts to market helps ensure that your account maintains sufficient capital to meet margin requirements on a daily basis.
If you add to a position or sustain a loss and your account no longer meets the performance requirements, you will receive a margin or a performance bond call from your broker. The margin call will require that you either add money to the account or reduce your positions until the minimum performance bond requirements are satisfied. Brokerage firms may suspend trading privileges or close accounts that are unable to meet their minimum performance bond requirements.
Mark-to-market is an important safety measure that provides additional protection for you and your brokerage firm. Combined with other financial safeguards, mark-to- market is a major benefit of doing business on a regulated exchange.
Jack has purchased two E-mini S&P 500 contracts. He will now monitor his position as well as the fluctuations of the market. In addition to this, Jack will place a limit order above the market to take profits if the market moves higher and a stop loss below should it move against him.
Exiting the Market
Jack entered the market on the buy side, speculating that the S&P 500 futures price would move higher. He has three choices for exiting the market:
1. Offset Position
offsetting his position is the simplest and most common option for Jack. He entered the market by buying two E-mini S&P 500 futures contracts, so he can offset his position by selling two contracts. If he had entered the market by selling two contracts, he would offset the sale by purchasing two. To limit the risk of holding a position overnight, many individual traders exit all positions and go home flat (no position) at the end of every trading day.
2. Roll Position
All futures contracts have a specified date on which they expire. Longer-term traders who do not want to give up their market exposure when the current contract expires can transfer or roll the position to the new contract month. In our case study, if Jack wanted to stay long in the E-mini S&P 500 contract as the December expiration approached, he could simultaneously sell the December contract and buy the following March contract. In this way, Jack would offset his position in the December contract
at the instant that he takes an equivalent long position in the March contract. To put it another way, he would effectively roll his long position from the December contract to the March contract.
3. Hold Contract to Expiry
All futures contracts have an expiration date. one of Jack’s options is to hold his contracts until they expire. However, doing so would have certain implications. Some contracts call for the physical delivery to an approved warehouse of the underlying commodity or financial instrument. others, like the E-mini S&P 500, simply call for cash settlement. Every futures contract specifies the last day of trading before the expiry date. Investors need to pay attention to this date because as the date approaches, liquidity will slowly decrease as traders begin to roll their positions to the next available contract month.
In the case of the E-mini S&P 500, trading terminates at 8:30 a.m. Central time on the third Friday of the contract month. Most of the liquidity, however, will have already rolled to the next contract month by the previous Friday.
Pick the Right Contracts
There are many futures contracts to choose from. Which ones might be right for you? Markets have individual personalities and are as diverse as the people who trade them. Keep the following important characteristics in mind when choosing a market to trade:
Certain futures contracts regularly experience a wider daily trading range than others and are therefore considered to be more volatile. This volatility is an important variable in determining risk and/or profit opportunity. For example, soybeans have traditionally had a larger daily price range than oats. Some traders prefer the more volatile contracts because the potential for profit can be greater, while the transactional cost of trading remains essentially the same. other traders, however, find that the least volatile contracts are better suited to their particular strategies because higher volatility means the potential for loss can also be greater.
When you are getting started, be sure to select products that are known to be highly liquid. Trading in active markets where there is enough volume for you to enter and exit your orders without substantially affecting price will help to ensure that you can exit a position just as easily as you enter it. To quickly gauge the liquidity of a market, traders may look at 1) the distance between the best bid and ask prices (also known as the bid-offer spread), 2) the number of orders resting in the market at each bid and offer level and 3) the frequency with which trades take place.
Liquidity can also be described in terms of volume and open interest. Each unit of volume represents a complete transaction. When one trader buys a contract and another trader sells the same contract, that transaction is recorded as one contract traded. open interest refers to the total number of futures that have not been offset or fulfilled by delivery. open interest is calculated by counting the number of open transactions at the end of each trading session. To illustrate, a market with open interest would have at least one market participant who chooses to remain long one
contract, as well as another participant who chooses to maintain the offsetting short position at the end of the trading day. Volume and open interest are reported daily and are used by traders to determine the level of activity in a market for a given day or a price movement.
Some traders consider price moves that occur during periods of low volume to be less important due to the apparent lack of participation by larger market participants. However, the price movement on higher volume suggests that a more substantial market event has taken place. Traders who regularly monitor average daily volume and open interest may gain an interesting perspective into a particular market. It
is generally assumed that markets characterized by high open interest and low
daily volume have substantial commercial participation. This is due to the fact that commercial hedgers tend to hold open positions for longer-term hedging purposes. Conversely, high-volume markets with low open interest tend to be considered
more speculative in nature.
The number of contracts in futures or options on futures transacted during a specified period of time.
The total number of futures contracts long or short in a delivery month or market that has been entered into and not yet offset or fulfilled by delivery, also known as open Contracts or open Commitments. Each open transaction has a buyer and a seller, but for calculation of open interest, only one side of the contract is counted.
Choose a contract that is appropriately sized for your account and your particular trading style. In some cases, you can even choose between the standard size contract and a smaller version of the same contract known as an E-mini. Examples include the popular E-mini S&P 500 contract, the E-mini nASDAQ-100 and the E-mini Dow. E-mini contracts are 100% electronically traded, usually very liquid, and because of their smaller size, require a lower initial margin or performance bond than their institutionally sized counterparts. There are also E-micro contracts, which are even smaller in size.
For example, there are micro-sized contracts available for gold futures, as well as several of the FX products. These are tailored specifically for the individual trader.
The performance bond required to trade a particular product fluctuates and is a function of a contract’s value and price volatility. While you may be comfortable in trading volatile markets, the size of your account relative to the value of the contracts you trade and the performance bond required to do so should be considered when selecting which futures contracts to trade.
Rather than risk your entire trading capital to a single position right off the bat, it is prudent to take smaller positions, involving several trades or contracts. At the same time, be careful not to spread yourself too thin. Depending on the markets and the approach, you may have a difficult time executing your strategy while monitoring a large number of positions. When you are just getting started, it is important to remove as many distractions as possible.
Know your Position
Last, but definitely not least, it is your job to keep track of your positions at all times. Fast-moving markets and periods of high volatility can test even the most seasoned veteran. Keep a detailed journal of all your transactions and have backup procedures in place in the event that your Internet connection goes down. Know your broker’s policy on how to place orders over the phone and who to contact should you have a question about your position. Many brokers will assist you in viewing the transactions that appear on your statement. At the end of the day, however, it is your responsibility to know your position.
* information provided courtesy of CME