Futures Trading Basics

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Futures Trading Basics

A futures contract is an obligation to buy or sell a commodity at or before a given date in the future, at a price agreed upon today. While the term “commodity” is usually used when referring to contracts like corn, or silver, it is also defined to include financial instruments and stock indexes. One of the benefits to the futures industry is that contracts are traded on an organized and regulated exchange to provide the facilities to buyers and sellers.

Exchange-traded futures provide several important economic benefits, but one of the most important is the ability to transfer or manage the price risk of commodities and financial instruments. A simple example would be a baker who is concerned with a price increase in wheat, could hedge his risk by buying a futures contract in wheat.

Not all futures contracts provide for physical delivery, some call for an eventual cash settlement. In most cases, the obligation to buy or sell is offset by liquidating the position. For example, if you buy 1 S&P500 e-mini contract, you would simply sell 1 S&P500 e-mini contract to offset the position. The profit or loss from the trade is the difference between the buy and sell price, less transaction costs. Gains and losses on futures contracts are calculated on a daily basis and reflected on the brokerage statement each night. This process is known as daily cash settlement.

US futures trading is regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). The CFTC is an independent federal agency based in Washington, DC that adopts and enforces regulations under the Commodity Exchange Act and monitors industry self-regulatory organizations. The NFA, whose principal office is in Chicago, is an industry-wide self-regulatory organization whose programs include registration of industry professionals, auditing of certain registrants, and arbitration.

If you are new to futures trading, be sure to check out our tips for futures traders & watch our FAQ video below. Get answers to common questions such as the role of commission in overall trading costs and learn how leverage can impact margin requirements.

For a free educational guide to “Trading Futures and Options on Futures”, provided by the National Futures Association (NFA), please click here.

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NinjaTrader Group, LLC Affiliates: NinjaTrader, LLC is a software development company which owns and supports all proprietary technology relating to and including the NinjaTrader trading platform. NinjaTrader Brokerage™ is an NFA registered introducing broker (NFA #0339976) providing brokerage services to traders of futures and foreign exchange products.

Futures, foreign currency and options trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing one’s financial security or lifestyle. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results. View Full Risk Disclosure.

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What are the basics of futures trading?

Not sure if futures trading is right for you? In this article, we’ll help you find out by taking a close look at what futures are and how they work.

What are futures?

To start, here’s a quick definition: Futures are contracts for the delivery, or cash settlement, of many things you may encounter every day, like materials, products, or even the stock market itself. But what does that really mean? Let’s break it down by exploring a few key traits that make futures unique.

All futures share the following three characteristics:

  1. Easy contract trading. Futures are contracts that trade on an exchange. That means if you buy or sell them, closing your trade is as easy as it would be for a stock. The futures market is relatively deep and liquid.
  2. Settlement by cash or physical delivery. Like stocks, most futures—including the CME E-mini S&P 500 and other equity index futures—settle in cash. There’s no exchange of physical goods or shares of stock. The only thing that changes hands is money.

However, some commodity futures, like corn and soybeans, are physically settled, meaning each party to the trade is expected to deliver or receive the actual commodity at expiration. But very few futures contracts are settled this way, and at E*TRADE, while you should be sure to close your positions on time, there are mechanisms in place to minimize this risk.

  • Backed by commodities or other assets. Futures contracts represent the pricing of essential things that affect our daily lives, including agricultural products (like wheat and cattle), energy products (like crude oil and gasoline), and financial products that facilitate international trade (e.g., those involving interest rates and currency exchange).
  • Equity index futures are one of the most popular, providing another way for investors to trade on price movement in the stock market. These include the CME E-mini S&P 500 mentioned above, plus the CME E-mini Nasdaq and CME E-mini Russell 2000.

    What are the basic terms used in futures trading?

    Now that we’ve seen what futures are, let’s explore how they work by defining and illustrating some essential futures terms.

    • Tick . Futures contract prices move in minimum increments called “ticks.” These are different for each futures product and can usually be found by checking the futures page. As an example, the CME E-mini S&P 500 has a tick size of a quarter of an index point.
    • Tick value. Unlike stocks (where each tick is worth a penny), tick size for futures is product-dependent, and as a result, the dollar value will vary. The tick value of the CME E-mini S&P 500 is $12.50, so if you buy a contract and end up selling it, say, two ticks higher, you’d make $25.00, assuming no commissions or fees.
    • Contract size. The specified quantity behind each futures contract (i.e., how much of a commodity or financial instrument is backing that contract) is called its contract size. For example, the CME gold futures contract represents 100 troy ounces of gold.
    • Notional value. Knowing the size of a futures contract enables you to determine its notional value—i.e., how much each contract is worth. You can figure this out by multiplying the contract size by the current price of the futures contract.

    Consider gold: If gold futures are trading at $1,300 per ounce and the size of the CME gold futures contract is 100 ounces, the contract’s notional value would be $130,000 ($1,300 x 100). In dollar terms, that’s how much one gold contract is worth.

    If a contract’s notional value ever seems too big for your wallet, check to see if there’s a contract with a smaller size. With gold, there is. It’s the CME E-micro gold, which has a contract size of 10 ounces—and a notional value of $13,000 ($1,300 x 10). That’s one-tenth the size of the bigger contract.

    NEW – CME MICRO-FUTURES are here !!

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    • Futures Trading Basics

    Futures trading has become an increasingly popular instrument for investors in recent years, particularly off the back of a wider media profile for derivatives trading in general. As traders increasingly turn their attention to high-risk, high-reward, leveraged instruments, futures are steadily becoming a staple of the investment portfolio mix.

    Even the most successful futures traders were once beginners. If you are new to commodities, it’s important to start with the basics and learn the ins and outs of the market.

    What is a futures contract?

    A futures contract is a legally binding agreement between a buyer and seller to receive (in the case of a LONG position) or deliver (in the case of a SHORT position) a commodity or financial instrument sometime in the future, but at a price that’s agreed upon today. These contracts mature at a particular point in the future and are identified by reference to that date – for instance, a July Corn futures contract or a December S&P 500 stock index futures contract. The ability to make or take delivery of the underlying commodity at expiration creates a strong tendency for cash and futures prices to react to the same economic factors and move in the same direction by roughly equal amounts.

    The process of futures trading

    Futures trading takes place at centralized exchanges, mostly on electronic trade-matching platforms – such as the CME Group’s Globex system – but also, to a lesser extent, in open-outcry, auction-style trading pits. In every transaction, the exchange clearinghouse is substituted as the buyer to the seller and the seller to the buyer, thereby guaranteeing performance and eliminating counterparty risk.

    Customers who trade futures are required to post margin deposits with an exchange member firm which, in turn, must deposit margin with the exchange. Margins are not payment against the market value of the commodity represented by the futures contract, but rather are performance bonds – good-faith deposits – to ensure the ability of market participants to honor their financial commitments and cover any obligations which might arise out of their trading activities.

    Buying a futures contract is called taking a LONG position, while selling a futures contract is referred to as taking a SHORT position. A long futures position profits when the futures price goes up, and a short futures position profits when the futures price goes down.

    Maturing futures contracts expire on specific dates, usually during the contract month. At any time before the contract matures, the trader may offset, or close out, his or her obligation by selling what was previously bought or buying what was previously sold. By offsetting an open futures contract, a trader is relieved of any obligation to make or take delivery of the underlying commodity or financial instrument. This is made possible by the fact that futures contracts have standardized terms and trade on centralized exchanges. The vast majority of futures contracts, in fact, are closed out by offsetting market transactions prior to their maturity, rather than through the delivery process.

    Futures exchanges, clearinghouses and market professionals

    U.S. futures exchanges typically have operated with a trading floor where traders and brokers compete on equal footing in an auction-style, open-outcry market and where they communicate by voice and hand signals with others in the pit. Customer orders coming into the futures pit were delivered to floor brokers who executed them with other floor brokers representing other public customers or with floor traders (known as locals) trading for their own accounts.

    However, trading by means of electronic order matching has grown dramatically in recent years, as more and more market participants have expressed a preference for the speed, convenience, and extended hours of electronic trading. Some markets have abandoned open-outcry altogether in favor of screen trading.

    The clearinghouse system is an important aspect of the financial integrity of the futures market. Traditionally, each U.S. futures exchange has had its own clearinghouse to act as the master bookkeeper and settlement agent. In every matched transaction executed through the exchange, the clearinghouse is substituted as the buyer to every seller and the seller to every buyer. The clearinghouse deals exclusively with clearing members and holds each clearing member responsible for every position it carries on its books, regardless of whether the position is being carried for the account of a non-member public customer or for the clearing member’s own account. The clearinghouse does not look to public customers for performance or attempt to evaluate their credit worthiness or market qualifications. Instead, the clearinghouse looks solely to the clearing member carrying and guaranteeing an account to secure all margin requirements and payments.

    A futures brokerage firm – known in the U.S. as a futures commission merchant (FCM) – is the intermediary between public customers and an exchange. Some FCMs are part of national or regional brokerage companies that also offer securities and other financial services, while other FCMs offer only futures and futures options. An FCM must maintain records of each customer’s open futures and futures options positions, margin deposits, money balances and completed transactions. In return for providing these services and for guaranteeing the accounts carried on its books to the exchange clearinghouse – an FCM earns commissions. By U.S. law, an FCM is the only entity outside a futures clearinghouse that can hold the funds of futures customers.

    Federal law also requires an FCM to segregate customer funds from the firm’s own funds at all times. The funds in segregation must be sufficient to meet the firm’s obligations to customers, and the FCM may not use those funds to satisfy any of its own obligations to creditors. Furthermore, an FCM must deposit its own funds to cover any customer-account deficits until the customer remits sufficient funds. Segregation of funds is designed to protect customer funds and make it possible to identify such funds in the event of an FCM’s default or bankruptcy.

    Futures market participants: Hedgers and speculators

    Futures market participants can be divided into two broad categories: Hedgers, who actually deal in the underlying commodity or financial instrument and seek to protect themselves against adverse price fluctuations, and speculators (including professional floor traders), who seek to profit from price swings.

    The futures markets exist to facilitate the management of risk and are thus used extensively by hedgers – individuals or businesses who have exposure to the price of an agricultural commodity, currency, or interest rate, for instance, and take futures positions designed to mitigate their risks. This requires the hedger to take a futures position opposite that of his or her position in the actual commodity or financial instrument. For example, a soybean farmer is at risk should the price of the commodity fall before he harvests and sells his crop. A short position in the futures market will return a profit when the price of soybeans declines, and the hedger’s profit on the short futures position compensates to some extent for the loss on the physical commodity. Speculators are attracted to futures trading purely and simply because they see the opportunity to profit from price swings in commodities and financial instruments. Speculators take advantage of the fact that the futures markets offer them access to price movements; the ability to offset their obligations prior to delivery; high leverage (low margin requirements); low transaction costs; and ease of assuming short as well as long positions (short futures positions are not subject to any uptick rule or broker/dealer interest charges). In pursuit of trading profits, speculators willingly take risks that hedgers wish to transfer. In this process, speculators provide the liquidity that assures low transaction costs and reliable price discovery – market characteristics which, in turn, make futures markets attractive to hedgers.

    Regulation of the futures markets

    The Commodity Futures Trading Commission (CFTC) is the federal agency that regulates the futures markets. The mission of the CFTC, which was created by Congress in 1974, is to protect futures market participants against manipulation, abusive trade practices and fraud; to guarantee the integrity of futures market pricing; and to assure the financial solvency of futures brokerage firms, exchanges, and clearinghouses. The CFTC’s oversight and regulation help ensure that futures markets provide effective price discovery and risk-transfer opportunities.

    CFTC regulations designed to protect customer trading funds are impressive. The single most significant safeguard is that no brokerage company is permitted to hold customer funds in any of its corporate bank accounts. Rather, futures brokerage companies are required to maintain customer funds in bank account that are totally separate from their own bank accounts.

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