Futures Trading Essentials

Lesson 1:   What Is a Futures Contract?
Lesson 2:   Contract Specifications
Lesson 3:   Contract Trading Codes
Lesson 4:   Futures Expirations & Settlements
Lesson 5:   Understanding Tick Movements
Lesson 6:   Price Limits & Price Banding
Lesson 7:   Contract Notional Value
Lesson 8:   Meaning of Mark-to-Market
Lesson 9:   Margins – Know What’s Needed
Lesson 10:   Futures Expirations & Contract Roll
Lesson 11:   Price Discovery
Lesson 12:   Calculating Profit / Loss
Lesson 13:   The Role of Speculators
Lesson 14:   The Role of Hedgers
Lesson 15:   History of Futures Exchanges
Lesson 16:   Futures Contracts vs. Forwards
Lesson 17:   Trading Volume
Lesson 18:   Open Interest

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.

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.

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.

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 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.

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.

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 – 0.25 x $50.00 = $12.50

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 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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Today’s futures markets are technologically sophisticated global marketplaces, trading at high speeds on electronic platforms, around the globe, nearly 24 hours a day. But did you know that futures trading traces back to ancient Greek and Phoenician merchants, who transported their goods for sale around the known world, opening deep and lasting global interconnections based on trade?

Modern, electronic, globally traded futures markets have their origins in the Nineteenth-Century United States, as increasing agricultural production and consumption necessitated a central market for delivery, sale, and purchase, and eventually price discovery and payment and quality guarantees.

Futures contracts and forward contracts are agreements to buy or sell an asset at a specific price at a specified date in the future. These agreements allow buyers and sellers to lock in prices for physical transactions occurring at a specific future date to mitigate the risk of price movement for the given asset through the date of delivery.

Historically, a forward contract set the terms of delivery and payment for seasonal agricultural commodities, such as wheat and corn, between a single buyer and seller. Today, forward contracts can be for any commodity, in any amount, and delivered at any time. Due to the customization of these products they are traded over-the-counter (OTC) or off-exchange. 

Volume is reported for all futures contracts. It is calculated by counting the number of contracts that have been bought and sold over a given time. You can track volume using different time intervals like daily or intraday. When a futures contract is traded, whether bought or sold, it counts towards volume for that contract.

For example, a trader closes a short position in the E-mini S&P 500 (ES) futures contract by buying one contract in the ES, so volume will increase by 1. Traders often use and interpret the rise or decline of volume in a futures contract to help make trading decisions.

Open interest is the total number of futures contracts held by market participants at the end of the trading day. It is used as an indicator to determine market sentiment and the strength behind price trends.

Unlike the total issued shares of a company, which typically remain constant, the number of outstanding futures contracts varies from day to day. Open interest is calculated by adding all the contracts from opened trades and subtracting the contracts when a trade is closed.