Futures Trading 101

Archive for the ‘Futures Trading Basics’ Category

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.

Currency futures are also referred to as a transferrable currency futures contract.  This contract specifies a price at which you can buy or sell a particular currency at a future date.

Futures trading and forex trading

Just imagine.  Approximately 350 billion dollars are traded daily.  Large banks, multinational companies and investments known as hedge funds populate the majority of currency futures trading that happens on the floor.

To hedge is to make an investment which is more secure.  With the help of a futures contract, you can choose to sell your stock already at a set price.  Hedging reduces the risk of loss especially when the market fluctuates and price movements are likely to go adverse.  The next chapter will tell you all about the benefits on hedging on pricing.

A basic idea on how forex trading works would be to your advantage.  Similar to forex trading but uniquely apart, currency futures trading is a little more complicated as a foreign exchange market.  With forex futures trading, the currencies of different countries are traded against the dollar.

Some of the most liquid foreign currencies are those of the G7.  In particular, the British pound, the Japanese yen, and the Swiss franc are very liquid and trendy.

How currency futures began

An industry which began in the 70’s, currency futures trading ended the gold standard.  For every U. S. dollar printed, there should be enough gold reserves in the treasury.

Without this standard, the dollar and its actual value now fluctuate.  The numbers can’t help but change daily.    Liquid and trendy as this futures trade can be, any trader can speculate as to what the dollar’s value would be as against any currency on any given day.

The future of the dollar

Are we to assume, therefore, that the value of the U.S. dollar will keep waning?  When confidence in the dollar fades, the popularity of gold correspondingly rises.

People are beginning to realize that solid gold and silver are safer, more valuable investments than paper bills.

An increase in gold reserves

The latest news reveals that most banks now hesitate in selling their gold holdings.  Along with this reluctance, many countries like China are now eyeing an increase in their gold reserves.

This gold rush could make gold prices plummet and dollar prices plunge.

Because of this serious possibility, it becomes even more important to be good at predicting currency futures.  If you exercise good judgment in your futures trading, you could still make trades that buy low and sell high on currencies.

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.

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.

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.

A futures contract is contract, or a written legally-binding agreement, between two parties to buy or sell a specified asset of standardized quantity and quality at a specific time in the future, at a price to be agreed upon at the time of signing.

What is a Futures Contract in English

Breaking it down, it goes like this: One party agrees to sell to another party who in turn agrees to buy – it is legally-binding, so there’s no backing out on either side.  The item to be exchanged is something of reasonable quantity and quality, so the buyer does not feel cheated of the money they paid.  The price is agreed upon today, and the sale is also made upon the signing of the contract.  The buyer pays the seller the money today, but will not get the goods until later on, at a time specified in the contract.

Think of it this way: Customer wants to buy pots from Potter today, but the pots have not been made.  Since they are in legally-binding agreement, Customer must pay at the specified time (usually now), and Potter must deliver the pots at the date they agreed upon.  The price is set today, so changes in the market will not affect the amount that is transferred between the two parties.

On your part, you are basically buying things that have yet to exist, yet can be reasonably expected to come into being.  It is kind of like ordering something online, knowing that your order has to be made first before being shipped to you, and that both parties are obliged to hold up their end of the agreement.

The two basic types of futures contracts are differentiated by the item to be exchanged.  The “physical” type involves physical delivery of assets at the specified time.  In practice though, actual physical delivery is quite rare.  Instead, when the final settlement date rolls around, the seller (who is obliged to deliver something) will buy a contract or sell a contract to cover his position.

The other type is called “cash-settled”, because the obligations are settled at the end of the period using money.  This is good for those sales and purchases that involve non-physical items.  Such items would be things like a certain index level in the stock market, or interest rates, and so on.

These contracts are very specific, since they will allow little wiggle room for either party, as a means of securing the interests of the opposing parties.  Everything down to the currency and quality grade of the underlying asset is specified in detail, and both parties are bound by law to follow the terms of the contract.

It is not too complicated actually, but you might be thinking “Who actually does this kind of thing?”  You would be surprised – lots of big businesses use it.  The influence that these contracts have extends far beyond the signing tables and trading markets, and even the very snacks meals you eat and energy you use are in some way affected by futures contracts.

Let us make this clear now: trading futures is not the same as trading stocks.  Though they share many similarities, especially from the layman’s point of view, they are quite different in foundation and at times practice.  To get a better idea of just what sets these two apart, you will need to understand what a futures contract is.  Hopefully by the end of this chapter you will understand just what trading futures is about, even if it is just enough to get you on your feet.