Intro to Futures Trading

When an investor buys common stock, you're taking an equity stake in the company.  Common stocks are usually purchased and held for a relatively long time.  Trading in futures contracts is quite different than trading in stocks.  With futures, you are buying a contract that has a finite lifespan.

In this publication, we're going to provide an introduction to futures trading.  As part of that introduction, we're going to first talk about the structure of these contracts, delivery of commodities, and pricing of options.  Then we'll explain some of the common futures trading terms such as hedges, straddles, calls, puts, and stop loss orders.

Trading in Futures Contracts

There are two basic reasons that trading in futures has grown in popularity.  The first is that these contracts can be used as a hedge against movements in a commodity's price.  In other words, the trader wants to "lock in" the price paid for a commodity.

The second reason futures trading is so intriguing has to do with short term market inefficiencies.  The price of futures contracts can move around quite a bit, even in the short term.  In addition, traders can assume a leveraged position, meaning they only need to put up a fraction of the contract's value.  Price volatility, coupled with financial leverage, can spell big profits for a trader on the right side of a transaction.

Buyers and Sellers of Contracts

Trading in futures involves dealing in contracts, which is an agreement to buy or sell the underlying commodity at a future date and at a fixed price. When you buy a futures contract, or assume a long position, you are agreeing to buy the commodity from the seller when the contract expires.  The seller, in turn, takes a short position and agrees to sell the underlying commodity to the buyer at a future date and at a fixed price.

Over time, there will be certain market events that cause a change in the value of the underlying commodity. To keep this example simple, let's assume there might be an adjustment in supply and demand that moves the price of the commodity up or down.  This movement in price will cause the value of a contract to change, thereby creating the potential for profits or losses among the investors holding contracts.

Taking Delivery of a Commodity

In many cases, the buyer of a contract never takes delivery of the physical commodity itself.  What usually happens is that the buyer and seller liquidate their holdings before the contract expiration date.  To do so, a buyer would need to sell their futures contract, and a seller would need to buy a futures contract.

Brokerage firms keep a close watch on their "open" accounts, and track who has a long or short position in a contract that is nearing maturity.  Before the delivery date, these firms will contact the trader and inform them they either need to close out their positions or pay the full value of the contract and take physical delivery of the underlying commodity.

Drivers of Changes in Futures Prices

As previously mentioned, the law of supply and demand is a driver of changes in the price of futures contracts.  But what are some of the reasons for these changes in supply and demand?

If you think about commodities that depend on farmers, then weather conditions can affect the price of a commodity such as wheat.  Ideal weather in a given year might yield a bumper crop for farmers, and drive down the value of wheat.  On the other hand, a drought might make for a low yield, and drive the value of wheat upwards.

When trading in interest rates or currency futures, the value of the contract will be influenced by the policies and activities of the Federal Reserve or the central banks of a foreign country.  In addition, changes in the general economic conditions of a country can cause movement in this type of contract.

Pricing an Option

Since some of these movements can be forecasted, there is often a "premium" that aligns a cash position with a futures contract.  That is, what it might cost to buy the commodity today versus what it might cost to buy the very same commodity six months into the future.

Although these relationships can be quite complex, an option's price, or its premium, really depends on only three variables:

• The relationship, and time, between the futures price and the strike price
• The overall time to maturity for the option
• The volatility of the underlying futures contract

Futures Contracts are Leveraged Investments

Futures contracts are considered highly leveraged positions.  Traders are putting up a mere fraction (10 to 15% in most situations) as margin, yet they are exposed to the full change in any value of the contract held.  In fact, the money the trader is putting up is not used to purchase a part of the contract; it is to act as a performance bond.

As with all investments that are leveraged, the possibility of excessive gains sparks interest in the futures market.  Just keep in mind that for everyone that benefits from a change in values, there is someone else on the losing end.  Those losses can be just as big as the gains.

Futures Trading Jargon

We're going to finish this introduction to futures contracts with a brief listing of some jargon, or terminology, an investor might encounter when trading in futures contracts.

Short Hedge

A short hedge is simply the selling of futures.  This strategy is used by those that either own the commodity themselves, or in some way might experience a loss if the value of the underlying commodity declines.

Spreads or Straddles

Spreads or straddles are usually assembled by speculators or arbitrageurs seeking to exploit inefficiency in the marketplace.  Simply put, a spread involves the simultaneous buying and selling of contracts that have different characteristics (such as expiration dates).

Calls

A call grants the trader the right to purchase the underlying futures contract at a fixed price, also known as a strike price.  A trader that buys a call does so because they are bullish on the future's price.  In other words, they believe the contract will be more valuable in the future.

Puts

If a trader is buying a put, they are buying the right to sell the underlying contract at a particular strike price at a future date.  A trader that purchases a put is said to be bearish on the value of the underlying commodity.  In other words, they believe the commodity will be less valuable before the contract expires.

Stop Loss and Limit Orders

Limit orders or stop loss orders are pretty common in the futures market.  With this type of order, the trader instructs their broker to sell or buy a contract only if the price reaches a certain value.  Limit orders can be marked "good till canceled" or they can be considered good during a specific trading session.

Protecting Investors with Trading Limits

Finally, the price of a futures contract can move up or down dramatically based on news such as bad weather or political instability.  To protect investors, and provide for a more robust and stable market, the commodity exchanges have in-place daily trading limits for certain contracts.  These are sometimes referred to as maximum daily price limits.

The exchanges use a formula to determine this trading limit, and the limits themselves can apply to a single trading day or activity over consecutive trading days.  The limit basically serves to protect investors from an extremely volatile market.  Keep in mind, however, that limits are not placed on all types of contracts.  For example, stock index futures and currency futures do not normally have maximum trading limits.

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