Learn About Futures

1. What is a Future?
2. Elements of a Futures Contract
3. Participants in the Futures Market
4. The Hedger
5. The Speculator

What is a Futures Contract?

A futures contract is a legally binding agreement to deliver or receive a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future.

Where are Futures Contracts Traded?

All Futures are traded on an exchange in a controlled, regulated environment where the underlying facts related to the trades, called the Contract Specifications, are set.

The buyers and sellers of the commodities meet through the exchange to try and determine the price and location where the buying and selling of the product will take place. With the increase in popularity of online trading, more and more futures transactions take place through electronic trading environments, in addition to the more traditional trading floor arena.

Types of Goods Sold

A futures contract can be any physical commodity, such as corn, wheat or meat products. It can also be a financial instrument, such as government and treasury bonds, equity indices and currencies. There are also futures contracts based on energies, such as oil, natural gas and heating oil.

As mentioned in the previous article, the elements of a futures contract are determined by the exchange on which the future is traded. As seen in the example below, the futures contract specifies the size, exchange, trading hours, etc. Here is a sample contract specification for a S&P E-mini contract (ES).

Contract Size: The size of one S&P E-mini contract is 1/5 the size of the standard S&P index.

Value of 1.0 point: Each point in the contract is worth USD 50, meaning that a S&P E-mini contract with a Bid price of 1,281.25 is actually worth USD 64,062.50 (64,075.00).

Tick Size/Value: A tick is the smallest allowable increment by which a futures contract can move or, in this instance, in increments of .25. Given the fact that 1 point is equal to USD 50, the value of 1 tick (.25 of a point) would be USD 12.50.

Margin: Futures contract margins are set by the exchange on which the contract is traded. Exchanges use a system called SPAN (Standard Portfolio Analysis of Risk) to determine the margin level for each contract. SPAN is a computer model that calculates the range of possible changes in price for a particular contract. The "worst case scenario," i.e. the most adverse change in price with the position a trader holds, is then used to calculate the initial margin. For this S&P E-mini contract, the initial margin is USD 4,000/contract.

Futures contracts also have what is called a maintenance margin, i.e. the amount required to hold the open Futures position. For the S&P E-mini contract, the maintenance margin is USD 3,150. If the margin on the trader's account falls below the maintenance margin, additional funds must be transferred or the number of open contracts on the account must be reduced. The margin associated with a particular contract is subject to change.

Exchange: The S&P E-mini is traded on the Chicago Mercantile Exchange.

Trading Hours: S&P E-mini contracts can be traded between these hours.

ESU6, ZGZ6, YMM7 – What's It All Mean?

Futures contracts are named according to the type of contract that is traded, plus the month and year in which the contract will be delivered. For example, in the contract name ESU6, ES stands for E-mini S&P 500. U is for September and 6 stands for the year 2006. Each month has a specific letter of the alphabet assigned to it, as follows:

In the next article we will discuss the specific participants in the futures markets.

Who Trades Futures?

There are two types of futures investors, the speculator and the hedger. The speculator looks to take advantage of price movements in the market. The speculative investor is typically risk-willing, taking positions in which there is a potential for large gains but that also carry the risk of large losses.

The hedger trades futures to neutralize the risk associated with other investments, and takes positions to reduce or avoid market exposure and vulnerability to future price movements in the underlying assets.

Why Trade Futures?

For the investor looking to diversify his/her portfolio, futures offer an exciting option, giving the opportunity-seeking investor access to a variety of alternative markets. Futures are highly liquid financial instruments, meaning that you can trade on tight spreads. The transaction costs for trading futures are generally low, the pricing is very transparent due the level of specificity found in the futures contract and the regulations imposed by the various exchanges. Online trading of futures offers swift order and trade execution and no counterparty risk as all transactions are handled through the exchange and the clearinghouses have a daily responsibility to ensure that all transactions and margins are conducted in an orderly manner.

Using Futures to Hedge

Hedging is a way of protecting your investments from risks associated with adverse turns in the market. Hedging normally involves taking a position in a related instrument that will help offset any adverse changes in your investment?s price. In the Futures market, hedgers seek to lock in a particular price level weeks or months in advance for the products that they want to buy or sell on the market. Their futures position helps to protect their tangible investment (the product itself) from adverse price changes before the physical sale occurs.

Hedging Example

Mr. Olsen is a jeweler who is currently in possession of 100 ounces of physical Gold (around 3,2 kg). He is concerned about the possibility of declining world prices on gold and wants to protect his asset from a possible decline in value. He knows that 1 contract of Gold at CBOT exchange in Chicago exactly matches his own quantity and therefore sells 1 ZGM6 contract at USD 665.00/ounce.

Market Scenarios

The market can move in one of two ways:

1. Price on the world market goes up, e.g. to USD 670/oz. Result: His short Futures contract will be a losing position of USD 500, but his physical Gold will increase by approximately the same amount (USD 500). Risk = 0
2. World market price will decline, e.g. to USD 660/oz. Result: Mr. Olsen's physical Gold will decline in value with USD 500 but he will gain about the same amount (USD 500) on his short Future contract. Risk = 0

The Hedger's Trade-off

The benefit of hedging is that the hedger is able to protect his/her investment from adverse changes in the market price level. The downside is that the hedger is not able to benefit from any favourable changes in the market.

In the next article we will look at the other major type of Futures trader, the Speculator.

Speculating

Speculators seek to take profit from the price movements in a particular market. They speculate about how they fill a price will perform over a given period of time and then take an investment position that will allow them to benefit from that movement if it occurs.

Sample Trade

Mr. Olsen is a speculator and believes that the U.S. Stock market is going to rally and would like to take advantage of the upward move. Since he thinks that the S&P mini contracts are a good reflection of the Stock market, he decides to buy an S&P E-mini future. Mr. Olsen selects the contract in his SMPTrader (ESM6) where the market is currently trading at 1284,75 / 1285,00 (Bid / Offer).

Mr. Olsen knows that the margin for a S&P E-mini is USD 4,000 per contract. He has USD 23,000 cash in his account so that would be sufficient for 5 contracts (5 x USD 4,000 = USD 20,000).

Mr. Olsen places an order to buy 5 contracts at 1285,00 and receives his Order and Trade confirmation tickets.

Two hours later the market rallies to 1302,25/1302,50 and he decides to sell his 5 contracts back, thus closing his position.

The Balance Sheet

The results of futures trades are outlined in your Account Summary, but let's take a closer look at the profit and loss calculations for Mr. Olsen's trade:

Mr. Olsen bought 5 S&P E-mini contracts at 1285.00 and sold 5 contracts at 1302.25.

Role of Speculating in the Futures Market

While historically speaking investors entered the Futures markets looking for ways to protect their tangible assets from adverse market conditions, i.e. hedging, more and more traders enter the futures markets to profit from the rise and fall in market prices, i.e. speculating. This development is aided by the rise in popularity of online trading, thus making it easier for speculators to participate in the futures markets. Speculators now play a valuable role in the futures market, ensuring the continual liquidity necessary for the Futures market to function effectively.