The desire to foresee events in the future, or to forecast what is "likely" to happen, is one characteristic of human behaviour that dates back to the origin of mankind. At its core, the trading of a futures contract is no different than prognosticating on any subject; a hypothesis is formed and tested, and a result is observed.
What Is A Futures Contract?
In its simplest form, a futures contract is an agreement between a buyer and seller to trade an underlying asset at an agreed upon price on a specified date. There are four basic components to a futures contract: the underlying asset, expiration date, pricing and leverage.
The underlying asset of a futures contract provides the "hard value" to the transaction. Assets come in various types, ranging from traditional to exotic. Agricultural commodities, precious metals, foreign currencies, energy products and interest rates are the categories of traditional futures products. Exotic futures contracts such as region-specific snowfall, temperature indexes, hurricanes, and even box office receipts for a motion picture release are examples of unconventional contracts.
Each futures contract is given a code for identification. The code includes information regarding the underlying asset along with contract month and year. For instance, the June 2016 Western Texas Intermediate (WTI) Crude Oil contract is expressed as "CLM6." The "CL" represents the underlying asset of crude oil, the "M" notes June as the contract month, and "6" stands for the contract year, 2016.
The period of time during which a futures contract can be actively traded varies depending on the contract's specifications. Upon becoming available for trade, each contract is supplied with an "expiration date." The expiration date is defined as being the date at which open trading of the contract is closed, and a final settlement price is determined.
On expiration day, cash accounts are squared using the final settlement price as the basis for valuation, and buyers of the actual physical asset (if there is one present) may begin arrangements to take delivery.
It is important to remember that a current futures contract addresses the potential value of an underlying asset at a future date. "Front month" contracts are the most liquid, and represent the month closest to the contract expiration date. For instance, a contract offered on a monthly basis, such as crude oil, commonly has a front month contract one month removed from expiration; the front month contract for active trading in May is dated June, for June is dated July, etc.
However, it is possible that the front month contract is several months away. In the case of index futures, such as the S&P Eminis, new contracts are offered quarterly, with the front month often being multiple months from expiration.
The price of a futures contract is the current amount of money needed for an individual to buy or sell the underlying asset ahead of expiration day.
Similar to trading a currency pairing on the forex, a futures contract's price is based upon the value of a specified amount of the underlying asset. For instance, one contract of WTI Crude Oil is priced according to the total value of 1,000 barrels of oil. Essentially, the aggregate value of one contract of WTI Crude Oil is 1,000 times the current market price per barrel. Due to the fact that futures contracts are traded on margin, a move in price of US$.01 per barrel is equal to pledged trading capital of US$10.
The current price of the futures contract is based upon its projected value at expiration. For instance, if a barrel of front month WTI Crude Oil is currently priced at US$50, the market's projection is that upon expiration the contract will be worth US$50. As market participants change and unknown future events transpire, the pricing of $50 may become obsolete and fluctuate radically.
Leverage is a double-edged sword as it can significantly increase profits as well as losses.
One of the key principles of futures trading is the employment of leverage upon the marketplace. Futures contracts can be traded in multiple quantities, commonly referred to as "lots." A "lot" is akin to one contract and is the smallest increment by which futures can be bought or sold.
Using the WTI Crude Oil example, buying one lot of crude employs leverage based upon the value of 1000 barrels and in turn of US$10 per US$.01 of current market value. In the event that the trader wants to add to the position and purchase another lot, the exposure is increased to US$20 per US$.01 of current market value, and so on.
Margin requirements are set forth by the trader's brokerage firm in order to govern the maximum number of lots traded at one time. There are two types of margin requirements: intraday and overnight.
- An intraday margin requirement is the amount of capital needed to trade a futures contract given that the position will be closed at session's end.
- The overnight margin is the amount of capital reserves to be present in the trading account in order to hold a position through the session close and into next session's open.
Margin requirements vary greatly depending on position size, brokerage firm, client account size and futures product being traded.
The trading of futures contracts in the modern electronic marketplace is a fast-paced endeavour, with an abundance of liquidity and volatility. Regulatory bodies, exchanges, brokerage firms and individual traders all play separate roles in the trading of futures.
Classifications Of Futures Traders
The characteristics of a futures contract afford the individual an opportunity to limit risk through proper investment, or to capitalise on a prediction of coming events. Two types of individuals participate in the buying and selling of futures contracts:
- Hedgers: A hedger participates in a futures market with the goal of wealth preservation, through eliminating unknown risk. Farmers, bankers and producers are examples of hedgers.
- Speculators: A speculator looks to gain financial reward from capitalising on pricing volatility. Investors and traders are examples of speculators.
No matter which type of market participant one is, the bottom line of futures trading is profit and loss. Where there is uncertainty, there is opportunity; and where there is opportunity, there are always individuals looking to prosper.
Global Futures Exchanges And Regulatory Bodies
Numerous futures exchanges exist around the globe providing speculators and hedgers alike the opportunity to actively trade futures contracts based on a number of asset classes. If one is interested in conducting trading operations involving futures, then one of the following exchanges is likely facilitating the trade. For the year end 2014, listed below are the top-five futures exchanges in the world, according to total volume of contracts traded:
- CME Group
- Intercontinental Exchange (ICE)
- National Stock Exchange of India
- BM&F Bovespa
Each exchange has a specific country in which it is based, but due to the global nature of futures trading, most operate separate branch offices around the world. Although futures trading was once exclusive to the open outcry trading system, modern trading practices have evolved into a largely digital marketplace.
Regulation of a futures exchange exists as "self-regulation" coupled with oversight from a jurisdictional authority. For instance, in the United States, the CME Group functions as a self-regulatory body. In addition to the CME Group, the Commodities Futures Trading Commission oversees the entire futures trading industry in the United States. Conducting trading operations according to adopted fair-trade policies is crucial to the transparency and authenticity of marketplace activities.
Trade Execution: Top To Bottom
The process of placing a trade is standard no matter which exchange or type of futures contract is involved in the transaction. Currently, the active trading of futures is a digital, exchange-based endeavour with trading operations being conducted by the trader online via internet connection with the exchange.
For example, a trader decides to buy one lot of May 2016 WTI Crude Oil at a price of US$50. Upon the order's placement by the trader, several actions are carried out:
- The buy order for one CLK6 is sent from the trader's platform to the brokerage firm.
- Upon arrival at the brokerage firm, the order undergoes liquidity tests to ensure that margin requirements are met. If so, the brokerage firm relays the order to the exchange.
- The exchange receives the order and acts as a clearinghouse. The order is accepted, filled and a confirmation including the details of the transaction is returned to the brokerage firm.
- The brokerage firm forwards confirmation to the trader.
Upon completion of the buy order for one CLK6 at US$50, the trader is "long" one lot of WTI Crude Oil. As price moves for and against entry, a running tally of profit or loss is kept, and the trader's account is instantly debited or credited the move.
As the trader closes the position, an offsetting order is processed, and a profit or loss is realised. In this case, if the trader closes the long position at US$50.10, then a profit of 10 ticks, or US$100, is realised. If price moves against entry to US$49.90, and the position is closed, a loss of 10 ticks or US$100 is realised.
Trading futures is not like investing in real estate, precious metals or a retirement account. In futures, asset values fluctuate rapidly, nearly 24 hours a day, five and a half days a week. To successfully navigate the sometimes-turbulent waters any futures market can bring, one must define and mitigate as many elements of risk as possible.
Key risk factors present in the trading of futures are as follows:
- Volatility: Depending on the product and contract, periods of extreme pricing fluctuation are likely to occur every trading session. Unexpected news, geopolitical issues and economic data releases are a few occurrences that can send a futures market into chaos.
- Leverage: By nature, a futures contract is a leveraged financial product. The ability for an individual to engage in a trade with disproportionate risk is easy. A simple click of the mouse and an increase in the number of "lots" being traded can boost exposure quickly and dramatically.
- Slippage: The digital marketplace has increased the amount of volume in the world's futures markets exponentially. Often, large moves in price occur at near light speeds. Without adequate equipment and proper trade strategy, entering and exiting the market can be costly. At no fault to the trader, an order price may be filled with a vastly different price than desired. Large losses can be sustained when participating in an irrational market.
Risk management must always be in the futures trader's mind. The use of proper money management techniques, stop-loss orders and adequate trading equipment are all necessities when trading futures. It is imperative that proper risk management techniques are employed to ensure the relative safety of an individual's investment capital.
The active trading of a futures contract provides the individual many unique financial opportunities, while also presenting the potential for financial hazard. Hedging practices and short-term speculative endeavours can be wealth preserving and profitable ventures. However, the volatility and financial leverage present in the modern futures marketplace is capable of producing severe drawdowns of capital in relatively short periods of time.
As in any trading activity, one must possess an understanding of the basic tenets governing money management and the mechanics of trade applicable. If approached from an educated and financially responsible standpoint, an excursion into the arena of futures trading can become a rewarding experience.
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