Futures Trading 101

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An index futures contract is a contract on a financial index or stock.  Every index has a different multiple on which to base the price for the futures contract.

For someone who has a stock portfolio and wants to hedge the risk, it would be time to use the S&P 500 Index.  It would result in a portfolio which has locked-in gains at an interest rate which is positively risk-free.

This feature protects stocks against price fluctuations which happen in the broader market.  It would also give traders some leverage in handling their stocks.

Full-size futures and E-mini index futures

Full-size futures are regular futures contracts which require very high margins.  They could overwhelm an average trader, especially one who’s a beginner.  E-mini index futures cover the same contracts but as smaller versions.  The smaller contract gets traded for a fraction only of the margin price for the larger contract.

To put it in perspective, you could trade within a margin of $3,000 to $5,000 on a smaller contract instead of on one as large as a regular S&P futures contract worth $20,000 or more.

This lower margin of risk is enticing enough for most traders to engage in index futures, especially when the market they choose to trade in is very volatile.  This is one situation when a trader deems it best to hedge surely than to risk speculating.

Hedgers and speculators are said to be such great observers of the futures markets.  The best of them are experts on how fellow traders behave and on how the market operates.  To participate in the futures market with more confidence and vigor, let’s put you in a position of strength.  Let’s find out how to hedge and speculate best!

Let’s get this straight:  Interest rate futures have nothing to do with a borrowing rate at all.  When you buy an interest rate futures contract, it allows you as the buyer to lock-in a desirable future investment rate.  This keeps your debt obligation within control even as the values of interest rates change.  Such an underlying security on your debt is priceless.

How an interest rate futures contract works

Here’s how this type of futures contract works.  When the interest rate moves lower, the contract seller would pay the buyer for that lower interest rate at that given time.  When the interest rate goes higher, the contract buyer would pay the seller an amount which is more rewarding.  Instead of receiving whatever rate was specified in the futures contract, the seller would receive a better benefit.

A price index for interest rate futures

You need to be accurate in measuring the gain or loss in an interest rate futures contract.  That’s why a futures price index of this sort was devised in the first place.

If you are buying, subtract the futures interest from a baseline of 100 to compute the figure for your index.  When interest rates fluctuate, so do price indices.  You would observe that indices go higher as interest rates go lower, and vice-versa.

How to compute gains versus losses

The most common base price move would be a tick value of .01 which equates to 1 base point.  Other contracts may also have a tick of half a base point depending on the agreement.

Put simply, a tick upward would mean a gain in your contract.  A move downward would equate to a loss.

There is a way for traders to hedge their position in an interest rate futures contract.  You will have your fill of hedges, speculations, and pricings in Chapter 4.

In the U.S. market, interest rate futures are usually traded on the Chicago Mercantile Exchange or CME.  Some of the most common short-term interest rate futures you would encounter are as follows:

• Eurodollars. Three Month Eurodollars are actually U.S. dollars presently deposited in foreign commercial banks.  Banks are able to fund U.S. dollar loans when foreign purchasers need them without the effect of currency exchange rates.  It is currently the most highly-traded futures contract of all.

• Euroyens. Consider them very similar to Eurodollars.  They represent Japanese yen deposited outside Japan.

• One Month Libor. This also reminds you of a Eurodollar contract.  However, you’re talking about huge sums of money like a 3 million dollar deposit.

• One Month Fed Funds. Non interest-bearing, these deposits are lent out as funds to other Federal Reserve member banks but only on an overnight basis.

13 Week Treasury Bills. You get more security from risk-free investments such as quarterly T-Bills which are backed by the U.S. government.

We’ve defined commodity as any article whose trading value lies in its raw form before it is even manufactured into a more refined and finished product.

Let’s cite a clear example.  Crude oil in its raw form is a commodity which is processed into gasoline as a finished product.

This brings us now to futures on energy commodities.  If you want two of the most popular energy futures, would the thought of crude oil and natural gas steam you up?  Would you warm up to the idea of a third alternative which is heating oil?

Search online and you would find a wealth of energy product listings which enumerate an assortment of energy commodities you can trade with.  Aside from crude oil and gas, have you considered ethanol, electricity-related commodities, or other green environmental products?

The pros and cons of energy futures

Energy futures satisfy our requirement of being very liquid and trendy.  There is so much activity in the fuel market, and everyone’s so interested in its current prices.  The prospects are good and the future’s looking up for sellers because fuel buyers and oil manufacturing companies are here to stay.

The downside to it is that most energy futures are large-sized.  Such huge investments are not ideal for low-budget traders, especially beginners.  Your winning edge, though, would be your perceptive grasp of world politics, global economy, and other international issues.

Such issues directly affect how the prices of energy commodities fluctuate.  Thus, energy futures are a volatile yet exciting venture to make if you know how.

How energy futures contracts are trending

Volatile as energy futures are, they continue to trend up and climb higher.  Seldom peaceful, the oil-rich Middle East and its neighboring territories dominate the playing field.  Crude oil futures are able to trade at $90 per barrel and beyond the hundred mark.  Prices can trade up $4 one day then plunge $3 the next.

As for natural gas, the commodity and its price are not as volatile.  The trends are more long-term depending on how mild or harsh the weather is.

In the previous chapter, we’ve become more aware of how commodities can be bought and sold at an agreed price by means of futures trading.  The trade is based on the premise that the commodity will be delivered on a future date which has already been specified.

The meaning behind a commodity

At this point how would we define a commodity?

The word trade is as old as time such that anything which can be exchanged is practically called a commodity.  But in the financial world, the word commodity takes on new meaning.  It refers to raw materials more than finished products.

Defining commodity futures

In futures trading, the term commodity futures can be defined as contracts where one party buys or sells a commodity from or to another party at a set price.  There is a specified quantity agreed upon, and both parties are obliged to settle the contract by cash on a fixed delivery date.

Learning more about commodity futures contracts

Futures Trading 101 would tell you to learn more about a commodity futures contract.  You have to know more about how commodity futures operate and how the market behaves, whether you are a buyer or a seller.

Farmers who are the commodity producers and food processing companies who are the commodity buyers all use futures contracts.  It assists them in securing the current market price for their goods.

For any farmer, such a move protects him when prices fall unexpectedly before harvest time.  Because agricultural prices trend and tend to fluctuate, a commodity futures trader would speculate on a good price hoping to make a great profit.  The word “speculate” again crops up.  Because it matters that you do your speculations well, we’ve devoted the next chapter to a discussion on it.

Commodity futures – their number and impact

As part of the futures industry, commodity futures significantly affect so many lives.  With people numbering by the millions and billions, it exerts such a great impact on the world.  Closest to home, it affects the food we eat, the clothes we wear, and the materials we gather for our shelter.  Wheat, cotton, and lumber would represent these needs, respectively.

It used to be that futures trading focused so much on agricultural products, but the market has been revolutionalized into one that includes machinery, transportation, and currency, among others.  They, too, affect how food gets distributed and how economies become more productive with exchanges and trades.

In such a growing industry, there are a number of additions to commodities aside from your typical agricultural grains and livestock.  To date, cheese and skimmed milk products have just been recently added.  The consumable edible oil, crude palm oil, has also slipped through lately.

Predicting commodity futures

When you talk about commodity futures, you are trying to predict the future direction of your commodity price as to whether it will go up or down.  A commodity price can either go higher, lower, or remain the same as you look to the future.

This is where the challenge lies.

As a beginner trader, you have to make sure that the market you choose is one that is liquid AND trendy.  Liquidity means it has high trading volume and much activity going on.  It should also be an active market which trends up or down.  Only then would you be able to hone your skills as a futures trader.

Futures trading requires practice so you should optimize on websites which offer free practice accounts on commodity futures.  How can you resist such freebies when the market data are real but the money is not?

Once you’re ready for the real thing, you can fund an account and arrange the paperwork with a broker.  From there on, you can select a market to trade with and a contract month to begin.

Choosing commodities to trade with

Food futures are a safe choice to being with.  However in the futures market, they are less liquid and they have less trading volume.  Metal commodities especially those of gold, silver, and copper are even better choices.  They are literally a goldmine for beginner traders to explore.

If you’re interested in trading with futures which are very liquid AND trendy, you can never go wrong with agricultural commodities like wheat, corn, and cotton.  In a green and health-conscious society, oats, rice, and soybeans are also gaining good ground.

What exactly makes these agricultural commodities so liquid and trendy?  Well, it’s the fact they they’re very much affected by variables like seasonal changes, climate conditions, and local production matters as to critically decide your profit in a major way.

Commodity futures despite the risk

Put futures and trading together, and they involve to a reasonable amount of risk.  You will have to put up a margin, meaning a partial amount of your contract value.

Usually you would buy 10 percent, and then the rest could be borrowed from your broker.  When the commodity price increases, you gain; when the price decreases, you lose.  When you keep losing, your broker would issue a margin call which prompts you to add more money to your account lest the broker close out your transaction.

You can prevent this from happening by monitoring your position.  Keep close tabs on the market to cut your losses.  Close the transaction yourself when you’ve made a profit.

As with any trade in the market, futures trading is all about buying low and selling high.  The guesswork is not as simple as it would seem because it is actually based on a projection of future prices.

Any futures investor tries to make good predictions. He makes trading decisions based on what he thinks would happen to the price in the future.

A wise trader is quick to notice when prices fluctuate.  He always puts himself at an advantage by buying or selling just in time.  He manages to cut his losses and make some profit.

When individual and corporations transact these exchanges online, neither of them get to view the goods.  Neither of them also get to own anything tangible, unlike with stocks wherein you actually get to own shares.  Futures are more a matter of speculating on how well these goods will do in the market.

To speculate means to choose an investment even when it poses a higher risk.  Contrary to traditional trading, you are opting to risk more than the average.  It is an offshoot of having foreseen or predicted a favorable price movement.  Speculation is often accompanied by so much anticipation.  If you can wait until Chapter 4, we’ll brief you with more!

Futures trading does not necessarily have to happen on the trading floor because both the buyer and seller may not have that interest in producing or buying said goods.  For instance, agricultural goods get bought and sold over and over again in the course of trading yet they never really reach the trading floor.

Besides agricultural products, there are other types of goods involved in futures trading.  These goods are called your futures trade commodities, and they can be classified into five different types:

1. Agricultural futures. By far this is one of the largest and most basic of all futures markets.  Topping the staple goods in farming would be wheat and corn.
2. Energy futures. The global economy banks precariously on energy futures.  Think about crude oil and natural gas, and you will have the most bankable of fuel trades.
3. Currency futures. With worldwide commerce happening 24/7, most experts would agree that forex futures trading undoubtedly ranks high as the largest futures trading market.
4. Interest rate futures. Here is a steadily growing market which is becoming more aware of how money can be made from bonds and interest rates themselves.
5. Food futures. Who would argue with the fact that food is the most basic commodity necessary for human consumption?  That’s the very reason why foods as basic as coffee, milk, and sugar would also top the list of some of the fastest-moving basic commodities around.

With a choice ranging from agricultural commodities to financial commodities, no wonder the futures market is such a thriving business especially for seasoned traders.  The mere thought of all of these commodities with their potential value can be very engaging to any trader, beginner or otherwise.

However, if you are a novice who has not had much experience in futures trading, it would be advisable for you to concentrate initially on just one or two commodities.  Capitalize on those goods which are your strengths and which suit your trading style.

In order to assure yourself that you will take good risks and enjoy your career as a trader, let’s get to know the different types of futures ONE BY ONE.

In futures trading there tend to be standards in the creation of contracts, such that the terms of new contracts are based on commonly-accepted terms.  This makes the whole process easier, since the terms are usually amenable to both contracted parties and the brokers will have an easier time drawing up contracts.

These terms are slightly dependent on the exchanges market where you plan to base your contract on, as well as the commodity under contract.  For example, a wheat futures contract has a standard unit size of 5,000 bushels, and the contract months are March, May, July, September, and December.  As such, you can only set up contracts with increments of 5,000 bushels on the months mentioned above.

One of the sets of terms that varies is the grade, or quality rating of the commodities involved.  Not all countries follow the same standards for quality in their commodities.  As such, standardized tests or highly-precise specifications are necessary to ensure the quality of the commodity being traded.

Because the common terms of contracts differ per commodity under exchange, we cannot discuss them here.  There is just too much information to cover, and it tends to be quite technical.  Once you have a solid grasp of the basics, then you can read up on the minutiae of futures trading contracts.

Commodity markets are regulated by different bodies across the world.  Generally, a commodity market is governed by some government or semi-government committee overseeing the various aspects of trading in that country.  A short list of such authoritative bodies follows:

• Australian Securities and Investments Commission.  In Australia.
• China Securities Regulatory Commission.  In China.
• Securities and Futures Commission. In Hong Kong.
• Securities and Exchange Board of India and Forward Markets Commission.  In India.
• Financial Services Agency.  In Japan.
• Monetary Authority of Singapore. In Singapore.
• Financial Services Authority.  In the United Kingdom.
• Commodity Futures Trading Commission. In the United States Of America.

The margins that we are talking about here are not the white spaces around content in books and papers, but margins of a different sort.  In the context of finance and trading, a margin is collateral that is deposited to provide some sort of security for the parties involved.  Basically, you put up something you have as collateral, to show your good faith and strengthen your promise to deliver on the contract.

In futures trading, margins are important because of the risks involved in prediction.  Who knows if things will really turn out according to plan?  As such, parties need to deposit collateral, just in case they cannot make it all the way to the end.  In futures trading, there are a few major types of margins:

• Clearing Margin.  This is meant to safeguard the interests of customers by giving the providers (or sellers) incentive to uphold their obligations to performing well.
• Customer Margin.  This is required from both buyers and sellers, and the value for this is calculated based on market risks and the value of the contract.  Sometimes referred to as a performance bond margin.
• Initial margin.  This is what is needed to start a futures position.  The value can change as the market prices move, and at times of high volatility, calls can be made within the trading day.  If the item exchanged in the futures contract is traded on commodity exchanges, then the concerned authorities are the ones to set the rate for this margin.
• Maintenance Margin.  This is a set minimum amount that a customer must maintain in his margin account.

Futures typically have “true-ups” or periodic partial settlements within the contract period, which allow both parties to keep close track of developments.  The amount for these margins is usually set at around 5 to 15 percent of the value of the contract.

Futures exist for two main reasons: one is to secure a financial flow, while the other is to make a gambit for great profit.

The first reference to a futures contract was made by Aristotle, that great philosopher.  He related the story of Thales, who we could only describe as an ambitious businessman.  This first story is an example of the second purpose for futures contracts.

Thales had pretty good foresight and could make good predictions regarding the olive harvests.  Feeling that the upcoming olive harvest would be huge, he decided to negotiate with the owners of olive presses in the locale.

Olive presses are used to press olives for their oil, which is a staple in many Aegean and Mediterranean cultures.  Still, when there are no olives, these presses basically stay still and aren’t worth a whole lot.

Thales knew this and thus offered to deposit money with the press owners.  Because the olive season was still in the future, Thales was able to negotiate a lower price.  The owners took him up, because they were not very sure about just how large the olive harvest would be.  Thales got a contract for exclusive use of the presses when the olive harvest rolled around.

When the olives came to fruition – literally – Thales then rented out the presses at rates that he controlled.  The crop was a good one, and all the presses were wanted for use, all at the same time.  This meant a payoff for Thales, and all in all he made a tidy profit, in addition showing just how foresight and risk-taking can improve profit.

The following is a paraphrasing of Historical events in Japan that are also related to futures trading.  In fact, it is an example of an exchanges market, as well as a forerunner of modern banking systems in Japan.

In the Edo Period of Japan’s history, rice was the main medium of exchange.  Rice was the very foundation of the Japanese economy, and it was even used to pay the samurai for their services in guarding nobility.

In the 1730s, the price of rice plummeted as a result of poor-quality harvests and trade issues (most likely abusive merchants taking advantage of poor farmers).  The samurai went into panics, since this meant that they made that much less money, after their rice was converted into coin.  At the same time, conspirators and high-profile merchants worked to keep rice hidden away from the public, artificially keeping prices low.

People were going hungry and riots increased both in frequency and size.  The shogunate was forced to step in on numerous occasions, setting price floors and ceilings, while keeping a watch on devious merchants.

The Dojima Rice Exchange was officially organized by the shogunate in 1773.  This rice exchange demonstrated the economic effects of setting limits on prices and the use of contracts of financial value – basically staple prices, interest rates and paper money.

The merchants in the Dojima Rice Exchange would hold rice in their warehouses, exchanging it for money, and they also held accounts for many samurai and nobles, in essence becoming a sort of bank.

Farmers could expect to make a certain amount of money for the rice they brought.  The government also had its own warehouses, where the stored rice could have been set aside for emergencies.

In the end, the Dojima Rice Exchange was a regulating body that kept prices and the economy quite stable, keeping the flow of finances relatively steady for everyone.  The Dojima Rice Exchange was dissolved completely in 1939, as the Government Rice Agency took over its responsibilities.

To answer the question of who trades futures, you need to consider the scale and types of futures involved.  From the basic point of view though, there are two types of entities that enter futures trading.

• Hedgers.  Hedgers are the people who are relying on low price fluctuations.  Their position is one that seeks a stable income regardless of actual outcome – basically, they want to make their cash flow predictable and thus make in-depth planning possible.  Generally, hedgers are the persons who have interests in the commodities, such as producers, cooperatives, et cetera.
• Speculators.  Speculators are basically the people who want to capitalize off of price changes, making educated gambles with their money.  Speculators cover a more generic lot of investors, who usually do not have practical use for receiving or delivering the underlying asset.

For soft and hard commodities (agricultural and mined products respectively), the futures traders include cooperatives and bodies representing the interests of smaller companies.  For these traders, the value of futures trading is two-fold.

As sellers, they can assure themselves of a stable amount of income based on today’s prices, such that they will not suffer as badly from price drops.  As buyers, they can also make a profit, as the futures they buy today can become more valuable should demand outstrip supply and cause prices to rise.

For non-producers, the main interest is to make money off of the market movements.  When buying, you want to buy when it is cheap, and make a profit when the price rises and the contract reaches maturity.  For sellers, you will want to have sold the products at current market prices, avoiding price drops, and deliver them upon the maturation of the contract.

Individuals can enter commodities markets, but for the most part individuals tend towards the foreign exchange market.  Foreign exchange futures tend to be more accessible to the individual, since everyone has money.  The trading unit sizes are not too large – say USD 10,000 – making it a little more reachable for the individual trader.

The bond market is also quite popular, since the assurance of payment is slightly better.  As the opposite party in a bond exchange is usually a government, the individual can feel safer about whether or not he or she will get paid for the investment they put in.

Today philosophers and samurai are limited in number, or rather more so than they used to be.  So who use futures in our modern world?

Well, if you keep the two main reasons for futures in mind – securing cash flow and financial gambits – you can basically consider all businesses as potential users.  Usually though, it is the big businesses that go into these contracts.

For example, your company needs funds to start or continue the development of a new product.  You approach venture capitalist with deep pockets, and propose a futures contract.  In this case, the capitalist want physical items that he can then resell through his personal network, so the futures contract is of an ideal physical type.

The capitalist gives you money now, you complete research and development, produce batches to cover your obligations and more, and then hold up your end of the futures contract on time.  In this case, the contract is completed regardless of market forces.

Another example: Your company needs investors.  Because your performance has not exactly been stellar, investors are not flocking to you, so you decide to go out and get them.

You approach some of them, offering a futures contract – they purchase stocks now at the current market price, and you promise to improve the stocks’ price level with various business strategies.  At the final settlement time, you hold up your end by delivering the promised increased stock prices, the path to which could not have been taken without the money of your contracted investors.

On the other hand, it could also be buyers that propose the contract, so do not go about thinking that it is always sellers that instigate contact for a futures contract.