In this video from Trade Station entitled “Trading Futures – A Primer,” Michael Burke explains the basics of futures trading, including benefits and risks, the characteristics and specifications of futures contracts, and basic futures trading terminology.
There are many benefits of trading futures. The futures contract is a standardized contract, with a vast universe of trading products out there. A futures contract calls for the delivered quantity of a certain commodity at some future time. It can be a financial instrument as well.
Burke narrates how he started trading in futures 30 years ago, back when electronic trading was non-existent, and he had to use a satellite dish to conduct his business. The industry has come a long way since then, he says, with more access to data and more options, making it an excellent time for traders.
Why do futures exist? In the beginning, the futures market was used as a hedging tool. In the 1800s, Chicago was a commercial center and farmers would come into the city to sell their wheat to urban dealers that would ship the grain to the east. But the farmers were at a huge disadvantage to the dealers as the farmers had no idea what was going on – the dealers had all the power. So the farmers got together to streamline operations, and somewhere between 1870 to 1880, a central marketplace was created where farmers began making contracts. This formed the foundation for the futures market today.
The Benefits of Trading Futures
So why choose futures instead of stock options? Firstly, there is diversification. In futures, you can invest in futures that are completely uncorrelated to the stock market. Gold, oil and interest rates are some things that can be traded through the futures market.
Also, futures trading gives direct market exposure to commodities, access to a 24-hour-trading in liquid markets, transparent pricing system, no shortage or day trading rules, increased leverage that allows more control but extraordinary risks. Futures also offer tax benefits, so unlike trading stocks, you can day-trade futures at 60% with positive tax implications.
What Can You Trade?
There is a wide variety of financial instruments and commodities that can be traded in the futures market. The most popular are stock index futures and bonds available for any time limit. There are currencies, where there is a huge exchange guarantee in all of its financial aspects, making it a very safe trade. There’re gold and silver and all of the other precious metals, as well as oil and gas.
There are agricultural products, especially corn, wheat, and soybeans, but anything from butter to orange juice can be traded too, along with tropical products like sugar and coffee.
It’s a very diverse market, and there is direct participation in these commodity markets that are traded all over the world.
What Is A Futures Contract?
A futures contract is a contract to take delivery of a commodity at a fixed price on a fixed day in the future. Think of it as an agreement between a buyer and a seller for a particular commodity or financial instrument. The price they agree on – one party will buy the commodity, and the other will sell it – is set at the time of the trade and the delivery date for that commodity is fixed in the contract terms.
Most futures contracts trade for short periods of time in monthly cycles. So there are contracts that expire in March, June, September, and December. All futures contracts have an expiration characteristic based on when commodities need to be delivered in the market. For the most part, a futures contract is primarily a financial instrument that allows you to buy or sell a commodity.
Trading futures doesn’t necessarily mean that you are going to take delivery of the gold or crude oil or corn because most people don’t have the storage to actually have them. Almost all futures are offset before the delivery or expiration date. Most of those who use commodities typically buy or sell what they need in the spot markets, and they use the futures contracts simply as a hedging tool to control pricing and their risk in whatever business they’re in. So most futures contracts do not result in delivery but result in a cap settled offset before the expiration date.
That’s what traders do – make sure to take a position and offset that position or roll that position into the next month before any obligation to take delivery of that commodity.
Futures Contract Standardized Terms
Each futures contract that is traded has contract specifications and standardized terms set by the exchange. Each contract is an instrument or a product of the exchange you’re trading on. A lot of commodities are traded on different exchanges. You can trade corn on several different exchanges in the US, for example. But if you trade corn on the Chicago Mercantile Exchange, you have to make sure that you offset that contract on the Chicago Mercantile Exchange because the specifications and contract terms may be different than it is on another exchange. If you buy corn on the CME and sell it on another exchange, they do not offset. Always make sure to offset your positions on the same exchange.
Every contract specifies the quantity of the commodity. For example, a crude oil contract is a thousand barrels of oil, or a gold contract is a hundred ounces of gold. There are different variations on sizes with mini-contracts that are becoming more popular in the electronic futures world. It’s important to understand the characteristics of the symbol and the contract that you’re actually trading.
The exchange also sets the standards regarding quality, type or grade of commodities. Crude oil is a fun one because there are dozens of different types of crude oil in the world. The two that are most traded in the US and the futures world are West Texas intermediate and light Brent blend. Each futures contract has a grade or type of commodity that is specified within that contract – that’s why you have to trade on the same exchange.
And of course, every contract is going to have an expiration date, delivery date, and payment terms. Most financial instruments, like stock indexes for example and many other commodities are cash settled, so the contract specifications say there’s no delivery at all where at the end of the term, it’s just going to be a cash settle. But you don’t want the contract to cash settle, but offset your position, so you are flat prior to any of the settlement or delivery dates. As previously mentioned, another term is that the trade must be made on the same exchange.
When you look at a futures symbol, it’s broken up into three parts: the symbol root which describes the futures contract and is unique to every contract on every exchange, the expiration month with a letter code for each month of the year, and the expiration year.
The most valuable thing to learn about the futures market is that just because a futures contract has a December expiration doesn’t mean it’s actually December – the last trading date for that contract could be sometime in November. It’s not like stock options where it’s always consistent; in futures, there are all kinds of crazy dates. Every contract is different, so traders have to be aware because contracts have to be traded before the expiration.
There is also something called first notice date, which is when you give the exchange notice that you’re going to take delivery of a commodity. So the last trading date for almost all futures is the day before first notice date. It’s not always the expiration date that matters; it’s that first notice date. In financial instruments, first notice date and expiration date are often the same but in commodities, it’s very different, because of the way certain commodities need to be delivered into the marketplace. So always check the dates.
If you’re going to trade futures options, that adds another level of complexity. In futures options, those option contracts usually expire on different days than the futures contracts, often before.
When you buy or sell a futures contract, you’re holding a position to either take delivery on a commodity or deliver that commodity to the buyer. If you are not a farmer or a cereal maker, you probably don’t want to do either of those things. Make sure to offset that position at least one day before the first notice date. Most brokers, including Trade Station, are not going to put you in a position where you have to deliver a commodity. Rarely does physical delivery take place in any of these commodities.
Who Trades Futures?
Futures traders can be broken down into two categories: hedgers, who are commercial producers and users, and speculators, who are large and small traders.
Hedgers are farmers, gold miners or oil platform owners. They are transferring risk, meaning they want to set a consistent price for the commodities they are delivering or receiving. Think of it this way: if you are a farmer and have acres of corn, and corn prices are higher than normal, you can go into the exchange and say you’ll be delivering a certain amount of corn and buy futures contracts. So you can sell your corn on a futures market by the sale of a futures contract at the high price. If prices go higher, you won’t participate because you’ve sold your futures at a fixed price. But if prices go down, you’ve locked in that higher price of corn. So whatever price corn is at the time of delivery is offset by the profit or loss that you’ve made on the futures contract.
If you’re a large corporation, on the other hand, like Kellogg’s, you’ll want to lock in the lowest price for wheat at large volumes to control costs using futures contracts. So both producers and users of commodities can use futures to reduce risk and volatility.
The people who accept that risk are the speculators – traders who think that they know where the market is going to go. They are going to buy and sell futures contracts and provide liquidity to the hedgers in exchange for picking the right direction. For example, they will buy corn, and if they think corn is going higher, they’re going to sell corn if they think it’s going lower.
These relationships keep the whole financial ecosystem stable and give everyone room to transact these different commodities and contracts in less volatile, more controlled ways where everyone understands what their risks are. This is what makes everything work in daily life – from the food in restaurants to the gas put in cars.
What makes all this work is the futures exchange. The futures exchange has a lot of different functions, each of which is vital to this process. In the futures exchange world, the first thing they do is bring buyers and sellers together. Today is everything is electronic, so there is a complete transparency with all orders coming in for any futures or commodities, everybody can see orders, and everyone knows who is holding the most contracts, which big traders are short and so on.
As previously mentioned, the exchanges set the rules, terms, and contract specifications. Most importantly, futures exchanges act as the clearinghouse. These are the master bookkeepers for all of the positions. They know every position that exists on their system, and they match it up for buyers and sellers, but more so, they act to financially assure all transactions. So if a buyer and a seller have a commodity come together, the exchange is going to make sure that everybody lives up to their part of the agreement. If one party does not live up to the contract, the exchange is going to step in and make sure that transaction is going through.
Now on to some basic trading terms. Those who are familiar with trading stocks will know “long” or “short.” Long simply means you’re taking a long-term position and expect the market to go up, short means you’re taking a short-term position and expect the market to go down.
In the futures world, pricing refers to the value of a contract and the value of minimum moves. Every contract trades differently from the next contract in futures. In the stock world, the stocks trade in penny increments but in futures, the minimum move that the futures will trade in may be different. For example one kind of futures trades in 25-cent increments, and the value of that contract is $50 for every 1-point move. So if it goes up ten points, that’s $500 in profit or loss, depending on whether you’re long or short. So each futures contract has this concept of point-value, big-point value, and it is the number of units of that particular commodity for every point that the commodity moves in the market.
Going back to crude oil, it is a thousand barrels so every time crude oil goes up one point, that’s a thousand dollars per contract either up or down for that account whether you’re long or short. So if crude oil is at $80 in one contract and goes to $90, that’s $10,000 in profit. But if it goes to $70, that’s a $10,000 loss. So traders need to know the minimum movement for that contract and the point value of a commodity.
In the stock world, there’s the concept of trading volume – how many shares are traded each day for a particular stock. In the futures world, the same concept applies. How many contracts are traded today? But in futures, there’s also the idea of open interest. This is the number of open contracts for a particular commodity. This is a number that is reported by the exchange every day at the end of the day for each month.
Contract Maturities and Deliveries
The concept of first notice date has been discussed – the last day you can trade most commodities. The last trading day may be before the FND. As a trader, the position has to be offset the day before FND. You have to know your contract and its specifications, too.
In the futures world, futures trade at different contract months. There is the current month that’s trading, and there’s also the concept of the front month or top month. The front month is the contract that has the most liquidity for volume and open interest at a particular time. So it can be imagined as when a futures contract gets closer to its maturity date, traders move their positions out of that month and into the next month. That conversion from the current month to the next month is called rollover. And at some point, the next month has more open interest than the current month. And when that happens, that contract with the most open interest becomes the front month, and most of the trading starts occurring.
As you get closer to maturity, you’re going to want to know which contract has the most open interest and it’s not always as clear-cut as the next one out. A lot of times, it could be the next month further out with more open interest because it could be a month when the commodities have more physical deliveries. Always check the open interest to make sure you’re rolling into the top month or front month.
In trade futures, all of them are traded in margins. Margin is a good faith deposit; there are no loan fees. It is cash in an account that is set aside as a guarantee against that futures contract. So there’s an initial margin, which is the minimum amount required to open up a particular position set by the exchange. And there’s a maintenance margin, which is usually a little bit less than the initial margin to maintain that open position. Again, this margin is typically a very small percentage of the contract value.
This extreme leverage, sometimes 10, 20, 40 to one can allow you to generate a lot of profit in a very small price move, but it can also create incredible losses in a very small price move. The losses can exceed the margin that was initially put up, especially if the market makes a big move very quickly. A big enough move could even exceed your account balance. Traders are responsible for any losses more than the margin. The margin does not protect from losses in any way.
As talked about earlier, futures contracts trade in multiple months going out. There’s an interesting characteristic of futures trading, which is that some futures contracts and commodities have increasing prices as we go out further in the contract months.
In other words, in gold, for example, the current contract is 1324 and December is at 1327, and June next year is 1337. So each contract gets a little more expensive to trade with gold, so when you rollover, you’re paying a higher price for the next futures contract than the current contract. That’s called contango – when the prices are greater in the future.
But there are also futures contracts where the prices are lower in the future. Stock traders tend to think that the markets have this overall bias to go up, but in the futures world, that’s not always the case. Futures traders for some reasons may actually price commodities less in the future, called backwardation.
Burke shows the screen on Trade Station to present a live example of these pricing concepts. On the screen, E-minis have apparently gone down in prices, as well as in volume and open interests. Gold, however, is going up in price, but volume goes both up and down, along with open interest, with December as the front month.
Trade Station Features
Trade Station was originally designed as a futures analytical platform, and when the company became a broker in 2001, the platform was geared for stock and futures traders. The original DNA is still as relevant today as it was back then.
There are a number of reasons why Trade Station has remained one of the premier futures trading platforms. It has an incredible analytics system with fast, accurate order-entry tools with low commissions. They provide real-time access to all US futures exchanges and Eurex, they have one of the biggest historical continuous contract databases in the industry, they offer free COT data and indicators, and there’s the whole universe of technical analysis tools at your disposal. And the most important thing Trade Station prides itself on is complete platform customization for the way you trade.