Futures trading

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Futures trading is the practice of buying and selling futures contracts, either to hedge risk as a commercial producer or consumer of commodities, or to seek gains as a speculator/investor. Futures trading, which years ago was associated with physical commodities like grains, livestock, coffee, sugar, cocoa, precious and industrial metals, etc., today is a much broader market for traders who now can either hedge or speculate on energy products, the direction of interest rates, world currencies, stock index movement, real estate trends, and more.

Obligations when trading futures

When you enter into a futures or option contract through an individual account, you are required to make a payment referred to as a "margin payment" or "performance bond." This payment is small relative to the value of your market position, providing you with the ability to "leverage" your funds. Because trading commodity futures and option contracts is leveraged, small changes in price, which occur frequently, can result in large gains or losses in a short period of time.

Each day, your broker will calculate the current value of futures and option contracts held in your futures account. If the equity in your account has dropped in value to the "maintenance margin level" (approximately 75 percent of the amount required to enter into the trades originally), you must deposit more margin money to bring the margin up to the initial margin level (this is called a "margin call"). This eliminates the need to make repeated margin calls when daily price changes are relatively small.

If you don't meet a margin call within a reasonable period of time, which could be as little as one hour, your brokerage firm may close out your positions to reduce your margin deficiency. If your position was liquidated at a loss, you would continue to be liable for that loss. You can, therefore, lose substantially more than your original margin deposit.

If you are trading in a commodity pool, you have purchased a share or interest in the pool, and it is the pool itself that must make the performance bond payments and margin calls described above. Your contractual obligations as a participant in the pool, including your liability for any losses to the pool, must be described in the pool's disclosure document.[1]

History

Development of Modern Futures Trading

Market Participants

Hedgers are those who are using futures to lessen price risk in a "commodity" they either own or wish to own in the future. Hedgers take a position in a futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change. Or a hedger can buy or sell futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one plans on buying the cash commodity in the future). Hedgers are broad in nature. Agricultural producers and those using agricultural products to produce end products, those in the financial arena and corporations with currency and equity and index risk, oil producers and users, users of precious and industrial metals, and more, all can use hedging to offset their price risk.

Speculators are individuals who trade with the objective of achieving profits through the successful anticipation of price movements. Speculators come in many forms, from those who trade daily (day traders), swing traders who trade at longer intervals over a day or multiple days and weeks, and position traders who hold a futures position for potentially longer periods to take advantage of trends, and more.

Floor Brokers are persons with exchange trading privileges who, in any pit, ring, post, or other place provided by an exchange for the meeting of persons similarly engaged, executes for another person any orders for the purchase or sale of any commodity for future delivery. As trading has become increasingly electronic, floor brokers are a much smaller population than they once were.

Floor Traders are persons with exchange trading privileges who executes their own trades by being personally present in the pit or ring for futures trading. They are also called "locals." Like floor brokers, floor traders have lessen in number with the impact of electronic trading.

Structure of a Futures Trade

Leverage and Risk

Futures contracts are leveraged instruments. Leverage is the ability to control large dollar amounts of a commodity with a comparatively small amount of capital. In futures, this ranges anywhere from, generally, 3-15 percent depending on the volatility of the market. This is a double-edged sword in that a trader can profit handsomely with just a small amount of money, but can also lose more.

Here's an exampe of the kind of leverage in the futures markets:

Example #1: In mid-July 2007, the futures price for soybeans was about $8.50 per bushel, for an underlying value of about $42,500. However, the margin was only $2430, or 5.7% of the underlying value of those 5,000 bushels of soybeans.

Contract: Soybean futures contract
Soybean current level: $8.50/bushel
Value of contract: Contract size X price (5,000 bushels X $8.50/bushel) = $42,500
Minimum exchange margin: $2430 = 5.7% of notional value of the contract
(Exchanges establish minimum margins; brokerage firm can increase margins).

Example #2: NYMEX Crude Oil: 1000 barrels x $75/barrel = $75,000 underlying value = $3,300 margin (4.4%)

Example #3: Comex Silver: 5,000 ounces X $13.50/ounce = $67,500 underlying value = $4,000 margin (6%)

Determining Profits and Losses

Because futures are leveraged, it's useful to see how market movements affect profit and loss. To demonstrate how a move of one tick affects the price of soybean futures, let’s imagine that you buy the futures contract at a price of $8.00 per bushel. One “tick” in soybeans equals1/4 of a cent, which equals $12.50 a contract. Here is how your profits and losses will be affected when the contract trades one tick higher or lower.

$8.00 (Original purchase)
+0.0025 (Up one tick - 1/4 cent)
_______
=$8.0025 (new price of soybeans/bushel at one tick higher)


As seen, if you bought one contract at $8.00 and sold one contract at $8.00¼, your profit would be one point which equals $12.50.


But what if the market moves down by 10 ticks?

$8.000 (Original purchase)
–0.025 (Down 10 ticks - 2½ cents)
_______
$7.975 (New price of soybeans/bushel trading 10 ticks lower)

If you bought one contract at $8.00 and sold one contract at $7.97½ /bushel, your loss would be ten points, which equals $125.

References

  1. Understand Commodity Futures and Option Contracts and Your Contractual Obligations. CFTC.