Futures Trading Guide
The aim of this guide is to provide you with the prerequisite information that you will need before venturing into futures trading. this guide is not intended to encourage nor discourage you about futures trading. Any investment decision you make should only be done after you have consulted your broker or financial advisor with respect to your financial circumstances
History Of Futures
Playing an important role in the global financial system, futures exchanges can be traced back to the “Tulip Mania” in the early sixteen hundreds when tulip traders in The Netherlands signed contracts before a notary to purchase tulips at the end of the season. What remained after what some consider to be the first speculative bubble was the foundation for modern day futures exchanges with attributes including centralized trading, standardized contracts and regulation.
Then in the mid 1800’s as Chicago found itself at the center of railroad and telegraph lines and about the same time higher wheat production substantially increased due to the invention of the McCormick reaper, wheat sellers found themselves at the mercy of dealers after traveling with no storage facilities to speak of. This then brought about the standardization of futures contracts where farmers (sellers) and dealers (buyers) were able to exchange a specific commodity for cash at a said date in the future. Simply put, both the buyer and seller now knew exactly what they could expect to receive in advance.
Function Of The Exchange
One of the key functions of any futures exchange is to provide for the clearing and daily settlements of trades. The exchanges work with the FCM’s (your brokerage house) to ensure that all trades are reconciled correctly. Despite the changes that have occurred over time, the main purpose of the futures market is still to provide an effective and efficient system for the management of price risk. The purchase and selling of futures contracts provide a predetermined price for a future purchase or sale thus allowing businesses and individuals to protect themselves against adverse price changes.
Chicago has the largest futures exchange in the world, the CME (Chicago Mercantile Exchange), which operates with both the open outcry (traders standing in a pit calling out orders for execution) and electronic trading (through their Globex platform) methods. As a sign of the times, now at least 70% of the CME’s futures contracts are executed over Globex with over 1 million contracts traded or upwards of $50 billion in value.
What Are Futures?
Futures are standardized contracts that say how much of a specified commodity can be purchased or sold at a predetermined price and at a specified time in the future. These instruments are known as derivatives because the price is “derived” from its underlying asset.
Composition Of The Futures Contract
All the terms and conditions of a futures contract are predetermined by the exchange prior to trading, but they commonly include the expiration date, the exchange, the tick size and pricing unit, as well as the symbol.
Here is an example of the NYMEX Light Sweet Crude: Symbol: CL
Example: March (H) 2021
Venue (Exchange): CME Globex, CME ClearPort
Contract Unit: 1,000 barrels
Price Quotation (Unit): U.S. Dollars and Cents per barrel
Minimum Fluctuation (Tick Size): $.01 per barrel
When looking for a trade, you’ll need to look up the asset by its symbol.
Futures symbols consist of 3 items:
• Product Symbol
• Delivery Month
Of course, since there are hundreds of products to choose from we’ll give an example of Gold here which would be: “GC”.
This is self-explanatory, so let’s use the year 2021 as an example. In this case you would just denote the last 2 digits “21”. NOTE: The symbol for a Gold December 2021 contract would then be: GCZ21
Available Futures Asset Classes
There are several asset classes in futures:
Commodity Futures: such as crude oil, natural gas, corn, and wheat.
Stock Index Futures: such as the S&P 500 Index , Dow Jones Industrial Average.
Currency Futures: including those for the euro and the British pound.
Precious Metal Futures: such as gold, silver, copper, platinum, palladium.
U.S. Treasury Futures: such as bonds and other products.
The futures market space is made up of various trading participants, regulatory bodies, exchanges and execution methods, all playing an essential role for a liquid and functional market. Below is a list of each player and how they make up the futures marketplace.
FCM (Futures Commission Merchant)
A broker or brokerage firm that executes orders on behalf of traders (clients) as well as extends credit to them for margined transactions. They also hold client funds as well.
Hedgers are those who use the futures market to reduce the risk associated with price fluctuation for a commodity which is going to be bought or sold at a future date. By fixing the price for a commodity or product to be bought or sold in the future, hedgers can avoid the risk of future price fluctuation especially when they are unsure how the market will react.
Persons engaged in speculating on price movements. Speculators do not participate in the delivery process thus gain or lose money by offsetting futures and option instruments before contract expiry. Speculators buy and sell in the Futures markets hoping to profit from the very price changes which hedgers try to insure themselves against.
An exchange member who executes trades on the exchange floor typically for his or her own account. Also known as “locals”.
An employee of a member firm who executes trades on the exchange floor on behalf of the firm’s clients.
Pit & Electronic Trading
Pit Trading refers to trades done by floor brokers and floor traders on a trading pit (floor) on an exchange. All trading and price discovery is done by humans in this environment (called open outcry) where there is a trading pit for a number of different commodities. Hand and verbal signals (known as Arb) are used to communicate orders in the pit.
Electronic Trading, referring to trading done through computerized trading markets, continues to replace pit trading due to its expanded trading sessions, lower costs and efficiency. Although more and more futures trades are conducted online, the trading pits of the US Futures Exchanges are still a hive of activity.
There is a long list of futures exchanges listed globally, however here are many of the major ones:
• CBOE – Chicago Board Options Exchange
• CME – Chicago Mercantile Exchange
• CBOT – Chicago Board of Trade
• ICE Futures – Part of Intercontinental Exchange
• KCBT – Kansas City Board of Trade
• MGEX – Minneapolis Grain Exchange
• NYMEX – New York Mercantile Exchange
• MX – Montreal Exchange
• LIFFE – London International Financial Futures and Options Exchange
• DBE – Dubai Mercantile Exchange
Since futures are exchange traded, those exchanges are then regulated by a government body. Here is a list of major regulators and their residing country:
• CFTC – Commodity Futures Trading Commission, United States
• CVM – Securities Commission of Brazil
• FSA – Financial Services Authority, United Kingdom
• MAS – Monetary Authority of Singapore, Singapore
• FSA – Financial Services Agency, Japan
• SFC – Securities and Futures Commission, Hong Kong
• ASIC – Australian Securities and Investments Commission, Australia
Futures trading is a leveraged product dealing with margin requirements, leverage and expiring contracts that may or may not need to be rolled over to a forward month. Below are details explaining these aspects of futures trading.
Margin & Leverage
As a leveraged product, futures would require margin (a performance bond) as collateral to control a much larger position. In the below example you can not only see how leverage is working, but the amount of funds you would need to control a position of this size, whereas:
Initial margin: $3,300 per contract
1 contract of EUR / USD controls 125,000 units
Trader position: Long 10 contracts
The margin required on this position is calculated then as follows: $3,300 x 10 = $33,000
With 1 contract controlling 125,000 Euros (contract size set by the exchange) and you having 10 contracts, you would then control 1.25 million Euro’s with only $33,000.
NOTE: Margin is set and adjusted by the exchange in accordance with volatility. typically higher volatility will bring increased margin requirements for an asset.
Since futures contracts expire, a trader needs to be prepared (if they are speculating and do not want to take delivery of the asset) to rollover the contract to another front-month (contract that has yet to expire). Rollover is then the act of transferring expiring contracts into new non-expired ones. Traders that wish to hold long term positions will have to rollover expiring contracts in order to remain in their desired position.
Rollover – soybeans Trader A has a long term bullish stance on soybeans. Let’s say he has built a large long position in contracts that will expire in 3 months. When the 3 months is up, he will have to make a rollover trade that will close out the expiring contracts and open new contracts with maturity further out.
NOTE: It is up to the trader how far out he wishes to go with the new contracts.
This is done as follows:
Position: Long 50 June Soybean Futures at the time of expiry.
Rollover order would be:
Sell 50 June Soybeans to no longer have a June position then,
Buy 50 December Soybeans contracts (as they have a forward non-expired front month).
With this, the trader has successfully rolled his long position to a longer maturity.
Physical & Cash Settlement
As referenced before, futures contracts can be of two forms, either a contract for the actual physical delivery of the asset in question or a call for cash settlement. In most cases, for contracts calling for the delivery of assets, actual physical transfer is hardly ever fulfilled. What usually happen is that an offsetting futures or options contract is procured prior to the fulfillment date as a means of profit taking. A cash settled instrument will then be closed at expiration closing the other side of the opening trade (buy or sell) using the settlement price at expiration.
Example: Physical Settlement – Gold Futures
In the most basic sense, a seller would deliver one contract of gold (100 oz) conforming to the standards set by the exchange and agreed on by the other party to a location also predetermined.
NOTE: Less than 5% of futures contracts in the US are delivered.
Example: Cash Settlement – Mini S&P 500
Position: Long 5 June 2021 contracts
Last Trade Date (expiration of contract): June 15, 2021
Settlement Price June 14: 1,333.00
Settlement Price June 15: 1,336.50
Since the final settlement of a cash-settled product follows the same procedures of the daily settlement, your account is either debited or credited the amount of change from the previous day.
In this case, the index was up 3.50 points (1,336.50 – 1,333.00) on the last trading day so we calculate your credit as follows: $50 (contract size) x 3.5 (change on last trade date) x 5 (contracts you own) = $875
NOTE: Many FCM’s and brokers dedicate personnel towards monitoring their client’s positions and communicating with them when they need to close or roll positions. Keep in mind that this is done on a best efforts basis and ultimately it is your responsibility to understand the contracts that you are trading.
Trading on margin involves a very high level of risk and as such may not be suitable to those investors who are adverse to risk. Any type of speculation that can yield an unusually high return on an investment is subject to unusually high risk of loss as well. In saying this, before deciding to trade Futures you should carefully consider your objectives, level of experience, and risk appetite. You should only use surplus funds for trading and anyone who does not have such funds should not participate in live trading. Here are common risks associated with trading margined Futures which include, but are not necessarily limited to the following:
Many traders find themselves trading because they love the excitement of it, and get sloppy with their rules and methodologies. Overtrading occurs usually because of boredom or an addiction to trading and must be watched closely.
Market Risk are risks associated with the price movement of the asset traded which can result from a change in economic, company, environmental, or political conditions.
Liquidity Risk results from decreased liquidity of an asset. This can be due to unanticipated changes in economic, environmental and/or political conditions, or just because there is a holiday. Decreases in liquidity can result in “Fast Market” conditions where the price of an asset moves sharply higher or lower, or in a volatile up/down pattern.
Leverage works for speculators when price action is favorable, but can work against the speculator as well if the market action is not favorable. As a result, it is possible that the amount of margin initially pledged against a trading position and the total amount of equity in the account can be completely depleted or even be negative because of excessive leverage used.
Technology Risk/Internet Trading Risks
There are risks which are associated with utilizing an Internet-based deal execution trading system. For example, the failure of hardware, software, and Internet connection can happen at any time.
5 Trading Tips
There are many ways to speculate which each trader can experiment with and decide what is best for them. Here though are a few tips that should work with any trading method that any good successful trader can use to build around.
No. 1 - Have Clearly Defined Goals
Before you enter a trade you need to know exactly what your goals are in terms of profit targets or percentage targets. You need to know this fully, and understand your reasoning for doing it in clear and well-defined terms so you can build on it as you progress as a trader.
No. 2 - Have A Strategy
Putting odds in your favor through simple Reward/Risk ratio’s, using scaling techniques to get in and out of trades, using specific indicators or chart patterns; all of these and more can be used as a strategy to enter and exit trades and can be quite useful. Make sure you know what your plan is, keep it well-defined and stick to it. This way you can learn from it understand if changes need to be made as you progress as a trader.
No. 3 - Be Disciplined
This is probably the hardest of all of them as it directly touches on the emotional side of trading. You will constantly be tested by greed or fear to change your strategy and/ or your goals. Do not do this as you set those up when you were rational before the trade was even placed. There are always exceptions to rules, but if even if “this time is different” you will open yourself up to believing the next time is different too and pretty soon you will not have any discipline at all. There is always another trade, stay disciplined and stick to your goals and strategies.
No. 4 - Keep A Journal
Many traders do not do this though it can be an invaluable teaching tool in showing them their rationale of entering a trade before it occurred. Not only does it help in showing the logic of a trade, but also details into the steps they took before they entered the trade and if it still applies for future trades, or if adjustments need to be made. Keeping a journal will give you great insight into aspects of your trading strategy, goals and disciplines few other methods can do.
No. 5 - Expect To Be Wrong
Your ego will kill you in this game, but if you expect to be wrong more often than right you will not be as affected by it. Knowing, and accepting, you will be wrong gives you some mental stability and allows you to then focus in on what to do in order to setup trades that gives you a good Reward to Risk ratio and protect your capital. Whether that is putting in better risk parameters before you trade, changing your trading goals, or staying patient and understanding there are limitless opportunities, understanding that being wrong is part of the game changes your mental framework for the better.
A financial instrument where the price is directly dependent upon (i.e., “derived from”) the value of another financial instrument(s). When trading derivatives, there is no transfer of property.
Taking offsetting positions usually in two different markets to minimize the risk of financial loss.
Limit (Up or Down)
Set by the exchange, Limit Up or Limit Down is a maximum price increase/decrease from the previous day’s settlement price within one trading session.
Usually due to adverse price movements against a trader, this is a request from a broker/ clearing firm to add more funds to cover their current position before their position is subject to liquidation.
A dealer who has an obligation to buy when there is an excess of sell orders and to sell when there is an excess of buy orders.
A daily cash flow system used for a futures contract to maintain a minimum level of margin equity that is calculated at the end of each trading day.
Also called a “ring”, this is an arena on the trading floor of some exchanges where trading is conducted.
The price at which a physical commodity for immediate delivery is selling at a given time and place.
The minimum change in price up or down.