Basics

Let’s dive into the foundational basics of futures and futures contracts!

1. What is a Futures Contract?

  • A futures contract is a legal agreement to buy or sell a specific asset (called the "underlying asset") at a predetermined price on a set date in the future. These contracts are standardized, meaning they have specific terms such as quantity, quality, and delivery date, set by the exchange.

  • Futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME), where buyers and sellers can engage in these standardized contracts. The exchange acts as an intermediary, ensuring that both parties fulfill their obligations.

2. Common Assets Traded in Futures

  • Commodities: Futures were initially created for commodities like oil, gold, silver, grains (like wheat, corn), and livestock. This lets producers or consumers lock in prices to hedge against future price fluctuations.

  • Financial Assets: Today, futures contracts cover financial assets like stock indexes (e.g., S&P 500 futures), currencies (e.g., EUR/USD futures), and interest rates. These allow investors to hedge against or speculate on the future value of these financial instruments.

3. Purpose of Futures Contracts

  • Hedging: Many participants use futures to manage risk. For example, a wheat farmer might sell wheat futures to lock in a price and protect against a drop in wheat prices. Similarly, an airline company might buy oil futures to lock in fuel costs, avoiding potential price spikes.

  • Speculation: Traders and investors also use futures to profit from price movements. They do this by taking positions based on their predictions of the market. For instance, a trader might buy oil futures if they believe oil prices will rise, aiming to sell later at a higher price.

4. Key Components of a Futures Contract

  • Contract Size: This is the quantity of the underlying asset in the contract. For instance, one crude oil futures contract on the CME represents 1,000 barrels of oil. Each type of futures contract has a specific size.

  • Expiration Date: Every futures contract has a set expiration date. Futures contracts do not last indefinitely. When the expiration date is reached, the contract can either be settled or rolled over (where you take a new position in a later expiration contract).

  • Tick Size: This is the minimum price movement in a futures contract. For example, in crude oil futures, the tick size is usually $0.01 per barrel, equaling $10 per contract.

  • Leverage and Margin: Futures allow trading with leverage, meaning you only need to put up a small fraction of the contract's total value, called the margin requirement. This leverage can magnify both gains and losses, which is why managing risk in futures trading is essential.

5. Pricing of Futures Contracts

  • Futures prices are influenced by several factors, including supply and demand, interest rates, storage costs, and the current ("spot") price of the asset.

  • Unlike stocks, futures prices can fluctuate based on expectations of future supply and demand rather than just current conditions. For instance, weather forecasts can impact grain futures, or geopolitical events can influence oil futures prices.

6. Settlement Types: Physical vs. Cash Settlement

  • Physical Settlement: In physically settled contracts, the buyer agrees to receive the actual commodity upon contract expiration. For example, buying a physically-settled crude oil contract would mean receiving 1,000 barrels of oil on expiration day.

  • Cash Settlement: Cash-settled contracts do not result in the actual delivery of the asset. Instead, the difference between the entry and exit price is settled in cash. Stock index futures, like the S&P 500 futures, are cash-settled.

7. Going Long vs. Going Short

  • When you "go long" (buy a futures contract), you’re agreeing to buy the asset at the agreed-upon price on the expiration date, betting that prices will rise.

  • When you "go short" (sell a futures contract), you’re agreeing to sell the asset at the agreed-upon price, betting that prices will drop. If the price decreases, you can buy the contract back at the lower price, profiting from the difference.

8. Mark-to-Market (Daily Settlement)

  • Futures contracts are settled daily. This process, called mark-to-market, means any gains or losses are added or deducted from your margin account at the end of each trading day. This process ensures that traders maintain enough funds in their account to cover potential losses.

9. Margins and Risk Management

  • When trading futures, you’ll need to post initial margin (a percentage of the contract’s total value) to open a position. As the trade progresses, you may need to add more funds (maintenance margin) if your account value falls below a certain level due to daily losses.

  • Proper risk management is key in futures trading because leverage amplifies both potential profits and losses. Using stop-loss orders and setting maximum loss thresholds for each trade can help manage this risk.

Example of a Futures Trade:

Let’s say you decide to go long on a crude oil futures contract because you think oil prices will rise:

  • Contract Size: 1,000 barrels of oil

  • Price per Barrel: $80

  • Total Value: $80,000 (1,000 barrels * $80)

  • Initial Margin Requirement: Suppose it’s $8,000 (10% of the contract’s total value)

If oil prices rise to $85 per barrel, the contract’s new value is $85,000, giving you a $5,000 profit ($85,000 - $80,000). With leverage, this is a significant return relative to your $8,000 initial margin. However, if prices fall to $75 per barrel, you would incur a $5,000 loss.

This overview gives you a solid start on the fundamentals of futures and how they operate. For further research, you might want to look into specific contract details for assets that interest you, as well as study risk management techniques that can help you navigate the leverage and volatility involved in futures trading.