Futures Basics

What Futures Trading Actually Is

Are you interested in Futures Trading?

If so, start by learning the basic definition of futures as shared by Investopedia:

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

While there are many types of futures, all of them share the following characteristics:

• Contracts that trade on an exchange
• Settlement by cash
• Backed by commodities or another type of asset

Now that you understand the basics of futures, let’s turn our attention to futures trading. Here are some related terms to help you get started:

• Contract size: This is the quantity behind a futures contract, such as ounces of gold for CME gold futures.
• Notional value: You can’t calculate the notional value of a futures contract until you know its size. From there, you can determine how much the contract is worth. This is as simple as multiplying the current price of the contract by its size.
• Tick: Futures contracts move in small increments known as ticks. These vary from one futures product to the next, so make sure you know the tick size before investing.
• Tick value: Many people are confused by tick value, as they assume that each tick is worth a penny, which is the case with stocks. The tick size for futures depends on the product, so the actual amount will vary.

Futures trading isn’t for everyone, and this definitely holds true of those who don’t understand the basics. However, as you learn more, you may come to find that this type of investment is exactly what you’ve been looking for.

Defining a Futures Contract

What is a Futures Contract?

Forward and futures contracts are financial instruments that allow market participants to offset or assume the risk of a price change of an asset over time.

A futures contract is distinct from a forward contract in two important ways: first, a futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Second, this transaction is facilitated through a futures exchange.

The fact that futures contracts are standardized and exchange-traded makes these instruments indispensable to commodity producers, consumers, traders, and investors.

A Standardized Contract

An exchange-traded futures contract specifies the quality, quantity, physical delivery time and location for the given product. This product can be an agricultural commodity, such as 5,000 bushels of corn to be delivered in the month of March, or it can be a financial asset, such as the U.S. dollar value of 62,500 pounds in the month of December.  

The specifications of the contract are identical for all participants. This characteristic of futures contracts allows the buyer or sellers to easily transfer contract ownership to another party by way of a trade. Given the standardization of the contract specifications, the only contract variable is price. Price is discovered by bidding and offering, also known as quotes, until a match, or trade, occurs.

Futures contracts are products created by regulated exchanges. Therefore, the exchange is responsible for standardizing the specifications of each contract.

Exchange-Traded

The exchange also guarantees that the contract will be honored, eliminating counterparty risk. Every exchange-traded futures contract is centrally cleared. This means that when a futures contract is bought or sold, the exchange becomes the buyer to every seller and the seller to every buyer. This greatly reduces the credit risk associated with the default of a single buyer or seller.

The exchange thereby eliminates counterparty risk and, unlike a forward contract market, provides anonymity to futures market participants.

By bringing confident buyers and sellers together on the same trading platform, the exchange enables participants to enter and exit the market with ease, makings futures markets highly liquid and optimal for price discovery.

Contract Specifications

Every futures contract has an underlying asset, the quantity of the asset, delivery location, and delivery date. 

For example, if the underlying asset is light sweet crude oil, the quantity is 1,000 barrels, the delivery location is the Henry Hub in Erath, Louisiana and the delivery date is December 2017.

When a party enters into a futures contract, they are agreeing to exchange an asset, or underlying, at a defined time in the future. This asset can be a physical commodity like crude oil, or a financial product like a foreign currency.

When the asset is a physical commodity, to ensure quality, the exchange stipulates the acceptable grades of the commodity.

For example, WTI Crude Oil contracts at CME Group is for 1,000 barrels of a grade of crude oil known as “light, sweet” which refers to the amount of hydrogen sulfide and carbon dioxide the crude oil contains.  

Futures contracts for financial products are understandably more straightforward: the U.S. dollar value of 100,000 Australian dollars is the U.S. dollar value of 100,000 Australian dollars.

Each futures contract specifies is the quantity of the product delivered for a single contract, also known as contract size. For example: 5,000 bushels of corn, 1,000 barrels of crude oil or Treasury bonds with a face value of $100,000 are all contract sizes as defined in the futures contract specification.  

The exchange defines the contract size to meet the needs of market participants. For example, participants who wish to take a speculative or hedging position in the S&P 500 futures contract but cannot risk the exposure of that size contract ($250 x the S&P 500) can instead use the E-mini S&P 500 futures contract to gain that exposure ($50 x the S&P 500 Index).  

A futures contract also specifies where the asset will be delivered upon execution. Delivery is an important consideration for certain physical commodity markets entailing significant transportation costs. For example, the random-length lumber contract at CME Group specifies that delivery must occur in a specific state and in a certain type of boxcar.

Finally, every futures contract is referred to by its delivery month. Traders refer to the March Corn contract or the December WTI contract since this point in the future is germane to the value and execution of the contract position. Depending on the contract market, delivery can be anywhere from one month to several years in the future. The exchange specifies when delivery will occur within the month and when a given contract initiates and terminates trading. Typically, trading for a contract is halted a few days before the specified delivery date.

Contract Trading Codes

What are Trading Codes?

The display format of futures contract codes is fundamental to understanding pricing across multiple expirations.

Contract display codes are typically one- to three-letter codes identifying the product followed by additional characters indicating the month and year of expiration. The format of a contract code varies according to the asset class and trading platform. Many contract codes originated on the trading floor to convey maximum information with the fewest characters and migrated intact to the electronic environment.

For this exercise, let’s first look at the E-mini S&P 500 futures contract. The CME Globex contract code this product is ES, which is also the contract code used on CME ClearPort. Now let’s look at the Eurodollar futures contract. On CME Globex, this contract is identified by the code GE. On CME ClearPort, this product is identified by the code ED.  It is therefore important to be aware that contract codes can vary across platforms.

For contract expiration, additional characters added to the right of the contract code indicate month and year.

Each calendar month expiration is identified by a single letter as follows:

• January – F
• February - G
• March -H
• April -J
• May - K
• June - M
• July - N
• August - Q
• September -U
• October - V
• November -X
• December -Z

Available contract expiration months may vary by product, but the letter following the contract code always indicates expiration month.  The expiration year is indicated following the month as a numeric value.

Let’s construct the display code for the E-mini S&P 500 futures contract expiring January 2019. The first determining factor is trading platform and for this example we will use CME Globex. For CME Globex the E-mini S&P contract code is ES. Following ES, we add the expiration month, which for January is the letter F. Finally, we add a 9 for 2019. Therefore the display code for the E-mini S&P 500 futures contract expiring in January 2019 is: ESF9.

These general rules apply to the format of futures contract codes, but it is important to be aware that codes and available expirations can vary across platforms.

Contract Unit and Notional Value

Contract Unit

The contract unit is a standardized size unique to each futures contract and can be based on volume, weight, or a financial measurement, depending on the contract and the underlying product or market.

For example, a single COMEX Gold contract unit (GC) is 100 troy ounces, which is measured by weight.

A NYMEX WTI Crude Oil contract unit (CL) is 1,000 barrels of oil, measured by volume.

The E-mini S&P 500 contract unit (ES) is a financial calculation based on a fixed multiplier times the S&P 500 Index.

Contract Notional Value

Contract notional value, also known as contract value, is the financial expression of the contract unit and the current futures contract price.

Determining Notional Value

Assume a Gold futures contract is trading at price of $1,000. The notional value of the contract is calculated by multiplying the contract unit by the futures price.

Contract unit x contract price = notional value

100 (troy ounces) x $1,000 = $100,000

If WTI Crude Oil is trading at $50 dollars and the contract unit is 1000 barrels, the notional would be;

$50 x 1,000 = $50,000

Now assume E-mini S&P 500 futures are trading at 2120.00. The multiplier for this contract is $50.

$50 x 2120.00 = $106,000

The Importance of Contract Unit and Notional Value

Notional values can be used to calculate hedge ratios versus other futures contracts or another risk position in a related underlying market.

Hedge Ratio

How might a portfolio manager, with a $10M U.S. equity market exposure, use notional value of E-mini S&P 500 futures to determine a hedge ratio?

Hedge ratio = value at risk/notional value

We can determine the hedge ratio using our previous example of the E-mini S&P 500 futures with a value of $106,000.

Hedge ratio = 10,000,000/106,000

Hedge ratio= 94.33 (approximately 94 contracts)

If the portfolio manager sells 94 E-mini S&P 500 futures against her long equity cash position, she has effectively hedged her market risk.

Tick Movements

Minimum Price Fluctuation

All futures contracts have a minimum price fluctuation also known as a tick. Tick sizes are set by the exchange and vary by contract instrument.

E-min S&P 500 tick

For example, the tick size of an E-Mini S&P 500 Futures Contract is equal to one quarter of an index point. Since an index point is valued at $50 for the E-Mini S&P 500, a movement of one tick would be

                   .25 x $50 = $12.50

NYMEX WTI Crude Oil

The tick price of a NYMEX WTI Crude Oil contract is equal to one tenth of a point, and since a point is valued at $1000, the tick price is $10. The NYMEX WTI Crude Oil contract is quoted therefore in increments of .01.

Summary

Tick sizes are defined by the exchange and vary depending on the size of the financial instrument and requirements of the marketplace. Tick sizes are set to provide optimal liquidity and tight bid-ask spreads.

The minimum price fluctuation for any CME Group contract can be found on the product specification pages.

Price Limits and Price Banding

As a trader, you want to know that there are mechanisms in place to ensure an orderly market. A regulated marketplace like CME Group provides this order by setting price limits and price banding.

Price Limits

Price limits are the maximum price range permitted for a futures contract in each trading session. These price limits are measured in ticks and vary from product to product. When markets hit the price limit, different actions occur depending on the product being traded. Some markets may temporarily halt until price limits can be expanded or trading may be stopped for the day based on regulatory rules. Different futures contracts will have different price limit rules; i.e. Equity Index futures have different rules than Agricultural futures.

Example

Equity Indexes futures have a three level expansion: 7%, 13% and 20% to the downside, and a 5% limit up and down in overnight trading. Agricultural futures like Corn have a two level expansion: $0.25 then $0.40.

When price reaches any of those levels the market will go limit up or limit down.

Calculating Price Limits

Price limits are re-calculated daily and remain in effect for all trading days except in certain physically-deliverable markets, where price limits are lifted prior to expiration so that futures prices are not prevented from converging on prices for the underlying commodity.

Typically, Agricultural futures will go limit up or down most often compared to Equity Index futures which very rarely if ever go limit up or down. When trading a specific product, it is important to be aware of price limits and the mechanisms that occur when limits are hit. Traders also know that it is possible for limits to be reached for more than one session in a row, however the expansion of limit thresholds over the last few years have reduced this occurrence. 

Price Banding

Price banding is a similar mechanism which subjects all orders to price validation and rejects orders outside the given band to maintain orderly markets. Bands are calculated dynamically for each product based on the last price, plus or minus a fixed band value. Thus, if markets quickly move in one direction, the price bands dynamically adjust to accommodate new trading ranges. 

Conclusion

The rules for each market can be found on cmegroup.com.

It is important to note that traders can place trades outside the daily price limits. These trades will be executed when price limits and price bands move within the specified range. So, traders still have the ability to place good-til-canceled or good-til-date orders inside and outside daily price limits.

In the last few years there are fewer and fewer times that markets will actually go limit up or down, but it is important to be aware of these pricing rules when you trade.

Price Discovery

Price discovery refers to the act of determining a common price for an asset. It occurs every time a seller and buyer interact in a regulated exchange. Because of the efficiency of the futures markets and the ability for the instant dissemination of information, bid and ask prices are available to all participants and are instantly updated across the globe.

Price discovery is the result of the interaction between sellers and buyers, or in other words, between supply and demand and occurs thousands of times per day in the futures markets.

This auction type environment means that a trader can find trades that they feel are fair and efficient. For example, a trader in Europe trading Corn futures (ZC) contract and a trader in Australia trading the same contract will see the same bid and ask quotes on their trading platforms at the same time, meaning that the transaction is transparent.

The bids and offers on the futures market constantly change with supply and demand, and with news from around the world. Since every piece of news could potentially impact the supply or demand of a specific asset, buyers and sellers adjust their prices to reflect these changing factors with every trade that is made in that market, hence why price is always fluctuating.

What does this all mean to a trader?

It means that you can rely on the quotes you are seeing on your screen, and trade with the knowledge that you are getting the best price, and the same price, as all others trading the same product at the same time. The one-lot order of a retail trader is treated the same as a 100-lot order from an institutional trader, and they will both pay or receive the same price for their contracts.

The open auction system means that all available information has been assimilated in to the current price of the product, increasing market efficiency and improving the reliability of price from one trade to the next.

The result is a global marketplace for the fair, efficient and transparent discovery of market price.

Margin: Know What's Needed

Understanding Margin

Securities margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond, or ETF. This practice is often referred to as buying on margin.

Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.

Futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.

Margins Move with the Markets

When markets are changing rapidly and daily price moves become more volatile, market conditions and the clearinghouses' margin methodology may result in higher margin requirements to account for increased risk.

When market conditions and the margin methodology warrant, margin requirements may be reduced.

Types of Futures Margin

Initial margin is the amount of funds required by CME Clearing to initiate a futures position. While CME Clearing sets the margin amount, your broker may be required to collect additional funds for deposit.

Maintenance margin is the minimum amount that must be maintained at any given time in your account.

If the funds in your account drop below the maintenance margin level, a few things can happen:

• You may receive a margin call where you will be required to add more funds immediately to bring the account back up to the initial margin level.
• If you do not or can not meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account.
• Your position may be liquidated automatically once it drops below the maintenance margin level.

Summary

Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment, and you do not own the underlying commodity.

The term margin is used across multiple financial markets. However, there is difference between securities margins and futures margins. Understanding these differences is essential, prior to trading futures contracts.

Mark-to-Market

What is Mark-to-Market?

One of the defining features of the futures markets is daily mark-to-market (MTM) prices on all contracts. The final daily settlement price for futures is the same for everyone.

MTM was a distinctive difference between futures and forwards until the regulatory reform enacted after the financial crises of 2007-2008. Prior to those reforms most OTC forwards and swaps did not have an official daily settlement price so clients never knew their daily variation except as described by a theoretical pricing model.

Futures markets have an official daily settlement price set by the exchange. While contracts may have slightly different closing and daily settlement formulas established by the exchange, the methodology is fully disclosed in the contract specifications and the exchange rulebook.

Example

Corn futures trade on CME Globex beginning the previous evening and officially settle for the day at 13:15 Central Time (CT). CME Group staff determine the daily settlement price of corn based on trading activity in the last minute of trading between 13:14:00 and 13:15:00.

E-mini S&P 500 futures trading on CME Globex begin trade the previous evening (CT) at 5:00 p.m. The final daily settlement price is determined by a volume-weighted average price (VWAP) of all trades executed in the full-sized, floor-traded (the Big) futures contract and the E-mini futures contract for the designated lead month contract between 15:14:30 and 15:15:00 CT. The combined VWAP for the designated lead month is then rounded to the nearest 0.10 index point. This contract then remains closed for fifteen minutes between 15:15:00 and 15:30:00 and then resumes trading until 16:00:00 (4:00 p.m. CT) when CME Globex shuts down for one hour.

U.S. Treasury futures begin trading on CME Globex at 5:00 p.m. CT and will trade through the next day until 4:00 p.m. CT. However, the daily settlement price is established by CME Group staff based on trading activity on CME Globex between 13:59:30 and 14:00:00 CT.

In order to fully appreciate a futures contract’s final daily settlement price one needs to know the settlement procedures defined in the contract’s specifications.

Once a futures contract’s final daily settlement price is established the back-office functions of trade reporting, daily profit/loss, and, if required, margin adjustment is made. In the futures markets, losers pay winners every day. This means no account losses are carried forward but must be cleared up every day. The dollar difference from the previous day’s settlement price to today’s settlement price determines the profit or loss. If my daily loss results in my net equity falling below exchange established margin levels I will be required to provide additional financial resources to replenish the amount back to required levels or risk liquidation of my position.

Mark-to-market enforces the daily discipline of exchanges profit and loss between open futures positions eliminating any loss or profit carry forwards that might endanger the clearinghouse. Having one final daily settlement for all means every open position is treated equally. By publishing these daily settlement values the exchange provides a great service to commercial and speculative users of the futures markets and the underlying markets they derive their price from.

Calculating Profit or Loss

Market participants trade in the futures market to make a profit or hedge against losses. Each market calculates movement of price and size differently, and as such, traders need to be aware of how the market you are trading calculates profit and loss. To determine the profit and loss for each contract, you will need to be aware of the contract size, tick size, current trading price, and what you bought or sold the contract for. WTI Crude Oil futures, for example, represents the expected value of 1,000 barrels of oil. The price of a WTI futures contract is quoted in dollars per barrel. The minimum tick size is $0.01. 

Current Value

If the current price of WTI futures is $54, the current value of the contract is determined by multiplying the current price of a barrel of oil by the size of the contract. In this example, the current value would be $54 x 1000 = $54,000.

Value of a One-Tick Move

The dollar value of a one-tick move is calculated by multiplying the tick size by the size of the contract.

The dollar value of a one-tick move in WTI is $0.01 x 1000 = $10

Calculation Example

Calculating profit and loss on a trade is done by multiplying the dollar value of a one-tick move by the number of ticks the futures contract has moved since you purchased the contract. This calculation gives you profit or loss per contact, then you need to multiply this number by the number of contracts you own to get the total profit or loss for your position.

A trader buys one WTI contract at $53.60.

The price of WTI is now $54.

The profit-per-contract for the trader is $54.00-53.60 = $0.40

Therefore, the contract has moved $0.40 divided by $0.01 = 40 ticks

The total move in dollars is 40 ticks x $10 per tick = $400

The total profit would be $400 x the number of contracts the trader owns

Losses are calculated in the same manner as gains. 

The Value of Your Position 

The size of the contract can have a considerable multiplying effect on the profit and loss of a specific futures contract. Before entering a position in the futures market, it is critical that you understand how any price fluctuation or market volatility affects the value of your open trading position. Consider the average price move for the contract and the corresponding tick value to understand the size of typical moves and its value.

For example, the 14-day average true range is 15 for the ES and 0.32 for Silver futures (SI) .

The calculation is as follows:

The value of a typical daily move in dollars for the ES contract = 7.5 points x $50 per point = $375

Compared to the ES contract, the SI contract is a larger contract with larger moves.

The average true range or ATR for the SI contract  $0.16 = 160 ticks

The value of a typical daily move in dollars is 160 ticks x $5 per tick = $800

This example illustrates that on average the ES contract moves less than half the dollar value of the SI contract.

Some average moves in the larger valued futures contracts can be sizable, and traders should plan their risk and reward accordingly.

Expiration and Settlement

Overview of Expiration and Settlement

Expiration

All futures contracts have a specified date on which they expire. Prior to the expiration date, traders have a number of options to either close out or extend their open positions without holding the trade to expiration, but some traders will choose to hold the contract and go to settlement.

Settlement

Settlement is the fulfillment of the legal delivery obligations associated with the original contract. For some contracts, this delivery will take place in the form of physical delivery of the underlying commodity. For example, a food producer looking to acquire grain may be looking to take delivery of physical corn or wheat, and a farmer may be looking to deliver his grain to that producer. Although physical delivery is an important mechanism for certain energy, metals and agriculture products, only a small percent of all commodities futures contracts are physically delivered.

In most cases, delivery will take place in the form of cash settlement. When a contract is cash-settled, settlement takes place in the form of a credit or debit made for the value of the contract at the time of contract expiration. The most commonly cash-settled products are equity index and interest rate futures, although precious metals, foreign exchange, and some agricultural products may also be settled in cash.

For traders choosing to go to settlement, the form of delivery will be highly dependent on the needs of each trader, as well as the unique characteristics of the product being traded.

Contract Roll and Your Exit Options

The Lifespan of a Futures Contract

Futures contracts have a limited lifespan that will influence the outcome of your trades and exit strategy. The two most important expiration terms are expiration and rollover.

Contract Expiration Options

A contract’s expiration date is the last day you can trade that contract. This typically occurs on the third Friday of the expiration month, but varies by contract.

Prior to expiration, a futures trader has three options:

Offset the Position

Offsetting or liquidating a position is the simplest and most common method of exiting a trade. When offsetting a position, a trader is able to realize all profits or losses associated with that position without taking physical or cash delivery of the asset.

To offset a position, a trader must take out an opposite and equal transaction to neutralize the trade. For example, a trader who is short two WTI Crude Oil contracts expiring in September will need to buy two WTI Crude Oil contracts expiring on the same date. The difference in price between his initial position and offset position will represent the profit or loss on the trade.

Rollover

Rollover is when a trader moves his position from the front month contract to a another contract further in the future. Traders will determine when they need to move to the new contract by watching volume of both the expiring contract and next month contract. A trader who is going to roll their positions may choose to switch to the next month contract when volume has reached a certain level in that contract.

When rolling forward, a trader will simultaneously offset his current position and establish a new position in the next contract month. For example, a trader who is long four S&P 500 futures contracts expiring in September will simultaneously sell four Sept ES contracts and buy four Dec or further away ES contracts.

Settlement

If a trader has not offset or rolled his position prior to contract expiration, the contract will expire and the trader will go to settlement. At this point, a trader with a short position will be obligated to deliver the underlying asset under the terms of the original contract. This can be either physical delivery or cash settlement depending on the market.

You have choices when it comes to your futures positions at expiration. Knowing how you want to manage your trades around rollover and expiration is important as it will directly impact the outcome of the trades.

The Role of Speculators

What Are Speculators?

Speculators are primary participants in the futures market. A speculator is any individual or firm that accepts risk in order to make a profit. Speculators can achieve these profits by buying low and selling high. But in the case of the futures market, they could just as easily sell first and later buy at a lower price.

Obviously, this profit objective is easier said than done. Nonetheless, speculators aiming to profit in the futures market come in a variety of types. Speculators can be individual traders, proprietary trading firms, portfolio managers, hedge funds or market makers.

Individual Traders

For individuals trading their own funds, electronic trading has helped to level the playing field by improving access to price and trade information. The speed and ease of trade execution, combined with the application of modern risk management, gives the individual trader access to markets and strategies that were once reserved for institutions.

Proprietary Trading Firms

Proprietary trading firms, also known as prop shops, profit as a direct result of their traders’ activity in the marketplace. These firms supply their traders with the education and capital required to execute a large number of trades per day. By using the capital resources of the prop shop, traders gain access to more capital than they would if they were trading on their own account. They also may have access to the same type of research and strategies developed by larger institutions.

Portfolio or Investment Managers

A portfolio or investment manager is responsible for investing or hedging the assets of a mutual fund, exchange-traded fund or closed-end fund. The portfolio manager implements the fund’s investment strategy and manages the day-to-day trading. Futures markets are often used to increase or decrease the overall market exposure of a portfolio without disrupting the delicate balance of investments that may have taken a significant effort to build.

Hedge Funds

A hedge fund is a managed portfolio of investments that uses advanced investment strategies to maximize returns, either in an absolute sense or relative to a specified market benchmark. The name hedge fund is mostly historical, as the first hedge funds tried to hedge against the risk of a bear market by shorting the market. Today, hedge funds use hundreds of different strategies in an effort to maximize returns. The diverse and highly liquid futures marketplace offer hedge funds the ability to execute large transactions and either increase or decrease the market exposure of their portfolio.

Market Makers

Market makers are trading firms that have contractually agreed to provide liquidity to the markets, continually providing both bids and offers, usually in exchange for a reduction in trading fees. Market makers are important to the trading ecosystem as they help facilitate the movement of large transactions without effecting a substantial change in price. Market makers often profit from capturing the spread, the small difference between the bid and offer prices over a large number of transactions, or by trading related futures markets that they view as being priced to provide opportunity.

Conclusion

All types of speculators bring liquidity to the market place. Providing liquidity is a crucial market function that enables individuals to easily enter or exit the market. Though speculative trading activity generates considerable liquidity, all market players benefit. In contrast to speculators who aim to profit by assuming market risk, some buyers and sellers have a vested interest in the underlying asset of each contact. These market participants aim to offset or eliminate risk and are referred to as hedgers.

The Role of Hedgers

What is a Hedger?

Hedgers are primary participants in the futures markets.  A hedger is any individual or firm that buys or sells the actual physical commodity.  Many hedgers are producers, wholesalers, retailers or manufacturers and they are affected by changes in commodity prices, exchange rates, and interest rates. Changes to any of these variables can impact a firm’s bottom line when they bring goods to the market. To minimize the effects of these changes hedgers will utilize futures contracts. Unlike speculators who assume market risk for profit, hedgers use the futures markets to manage and offset risk. 

Corn Hedger Example

Let’s look at an example of a corn farmer. In the spring, the farmer is concerned about the price for his crops when he sells in the fall.  If prices drop at harvest, the farmer will have to sell the crop at a lower price.

One way the farmer could hedge his exposure would be to sell a corn futures contract. When harvest rolls around and the price of corn drops, he will see a loss in price when he sells his crop in the local market, however that lose would be offset by a trading gain the futures market.  If prices rallied at harvest, the farmer would have a trading loss in the futures market but his crop would be sold at a higher price in the local market. 

In either scenario, the hedged farmer has added protection against adverse price movements. The use of futures enabled him to establish a price level well before the he sells the crop in his local market.  

Types of Hedgers

There are several types of hedgers in the commodities markets:

• Buy-side Hedgers: Concerned about rising commodity prices
• Sell-side Hedgers: Concerned about falling commodity prices
• Merchandisers: They both buy and sell commodities. Their risk is different than the directional risk of a traditional buying and selling hedger. Their risk is the spread or difference between the purchase and selling prices that determines their profitability.

Summary

Many industries now use the risk management potential of futures contracts for a variety of assets.  The profitability of a construction company partially depends on the cost of building materials.  By purchasing a steel futures contract, the firm is able to secure a price at which it acquires steel.   Conversely, steel mills worried about a decline in building demand and the drop in steel prices can sell steel futures contracts to protect against that price movement. 

Airlines now hedge against rising fuel costs through the use of crude oil futures. And jewelry manufacturers can hedge against gold and silver price movement by utilizing precious metals futures contracts.

When it comes to hedging, there are a variety of market participants who buy and sell physical commodities, and they may benefit from the added price protection offered by futures and options contracts.

Trading Venues: Pit vs. Online

Understanding Trading Venues

The futures market is a dynamic marketplace that currently conducts business via the trading floor or electronic trading. While trading has shifted to mostly electronic transactions, the trading pit still exists and maintains relevance in today’s marketplace. 

Trading Floor

Historically, all futures business was transacted on the trading floor. The trading floor was organized into segmented areas, called pits, where traders and floor brokers met face-to-face to buy and sell futures contracts. 

Every one of those participants was a member, or associated with a member, of a specific exchange where they paid for the right to transact business on the floor. People who wanted to participate in the futures market, but were not a member of the respective commodity exchange, had to call a broker who would then place and order on their behalf. 

The floor was a visually dynamic marketplace and the image of traders in colorful jackets shouting orders to each other accompanied by specific hand signals remains the image of futures trading.  However, during the 1990’s, new technology allowed futures trading to transition to an electronic platform and online brokerages.

Electronic Trading

Access to trading platforms, lower commissions rates and sophisticated high-speed trade routing followed suit. The reduced costs of trading meant that more participants were drawn to the futures market, which in turn had a positive effect on the liquidity of each contract. Today any trader can transact with any other market participant. 

Trading Hours

Hours of operation for a pit trader versus a retail online trader are different. For example, the market hours for ES, which is traded online, is Sunday through Friday 5 p.m. to 4 p.m. Central Time (CT) while the SP pit session is Monday through Friday 8:30 a.m. to 3:15 p.m. CT.

The transaction of trades may have changed over the years but the core purpose of the futures market has remained the same. Whether on the trading floor or through the modern electronic markets, futures remain an excellent contract to trade and manage risk.

Micro Bitcoin Futures

Contract Specifications

Past performance is not necessarily indicative of future performance.

Best Books on Futures Trading

There are many benefits of futures trading, but it’s not something you should dive into without a high level of knowledge and understanding of the markets.

While there’s no shortage of websites, blogs, and online resources, don’t rely solely on the internet to guide your investing decisions. Instead, you should also read as many books on futures trading as you can find.

Below, we outline a handful of the best futures trading books, all of which provide in-depth knowledge and guidance for beginners and advanced traders alike.

1. Futures 101, Richard E. Waldron

It’s one of the oldest books on futures trading, but also one of the most popular.

Geared toward beginners, it doesn’t dive too far into the technical details of trading. Furthermore, it’s neutral in regards to whether or not you should give it a try.

As a book about the basics, it’s best suited for beginners who are wondering if this is an investment strategy for them.

2. Starting Out in Futures Trading, Mark Powers

Despite the name, this book is more advanced than Futures 101. Written by Mark Powers – former chief economist for the Commodity Futures Trading Commission – you can be rest assured that the information is accurate.

Over the years, many editions of Starting Out in Futures Trading have been published, so make sure you read the most recent version.

From choosing a broker to the many different order types, there’s no shortage of information in this book.

3. Fundamentals of the Futures Market, Donna Kline

You won’t feel comfortable with futures trading unless you have a firm grasp of the fundamentals. So, it only makes sense to read the Fundamentals of the Futures Market.

With its interactive approach – which includes checklists and quizzes – you gain all the knowledge you need to dive into futures trading with confidence.

4. One Good Trade: Inside the Highly Competitive World of Proprietary Trading, Mike Bellafiore

Not only does this book have killer reviews, but it’s approach is different than every other one on this list.

Here’s how: One Good Trade focuses heavily on getting into the trading frame of mind, as opposed to the fundamentals. Of course, there’s plenty of guidance throughout, so you’re sure to pick up some tips on how to get started.

5. Technical Analysis of the Futures Markets: A Comprehensive Guide to Trading Methods and Applications, John J. Murphy

Yes, it’s true that this book was published in 1986, but don’t let that scare you away. When it comes to technical analysis of the futures market, John J. Murphy is a leading authority.

There’s more to technical analysis than meets the eye. While it takes firsthand experience to devise a strategy, this book outlines a variety of techniques and patterns for helping you make the best trades.

You only have so much time in your day for reading, but when you do it makes sense to start with one of these five books. For anyone interested in futures trading, all of these offer something of great value.