What is Futures Trading

To understand the futures market, it helps to know why it was created. When food preservation, storage, and distribution were not what they are today, farmers and buyers struggled with chaotic price swings brought on by the impact of supply and demand. A group of businessmen in Chicago organized in 1848 to offer the first “forward contracts” guaranteeing farmers a particular price for their grain in the future. From these simple origins, the futures market stabilized price fluctuations over the natural cycle of growing seasons with its surpluses and shortages. This benefited farmers and livestock producers as well as consumers.

Today, the futures market stabilizes and manages price volatility in grain, livestock, and other food products, as well as diverse markets including energies, metals, even international currencies and financial instruments that can fluctuate in value. Futures are traded by buying or selling contracts that guarantee a future price on a commodity. Futures contracts are primarily used by those with a business interest in a particular market. Individuals may also use the traits of the futures market to do speculative trading on the fluctuations of futures contract prices.

A futures contract is based on the value of a commodity such a bushel of corn, an ounce of gold, or a barrel of crude oil. Market participants will trade futures contracts to set the prices they wish to buy or sell a commodity in the future. For example, a farmer planting corn in the spring will sell corn futures at the price he wishes to sell his crop by harvest time in the fall. Similarly, a transportation company will buy futures at the prices they wish to pay for oil and gas throughout the year. Profit and loss in futures trading will offset cash transactions for commercial market participants. Speculative futures trading is critical to maintain liquidity in the market. Without a business interest in the market, a speculator may trade on price action either up or down, using fundamental and technical analysis to identify trends.

Hedgers and speculators alike may open a futures trading account with a futures brokerage. The Internet has made it possible for hedgers and speculators to research futures brokerages that offer accounts to make trades in any commodity markets. The holder of a futures trading account may make his own trades or arrange with a broker for professional account management.

Trading Futures Basics

Money is made or lost trading futures using the conventional “buy low, sell high” approach. The primary difference between futures trading and trading stocks is that futures are traded to the downside just as easily as trading for upward price movement. Further, downward price changes in commodities are not necessarily indicative of “gloom and doom.” Commodity prices are moved by a range of fundamental factors that include natural seasonal cycles. Traders will follow the cycles that customarily impact individual markets and may also apply technical analysis for placing a speculative position.

Speculators trading the price action on commodities will research an individual market to study its particular traits. The agricultural markets illustrate basic strategies for trading futures. The fundamental concept of supply and demand indicates that prices will rise in times of commodity scarcity and drop when supplies are plentiful. Agricultural markets including corn, soybeans, wheat, and oats, will see price increases during planting and growing seasons. Weather events will be carefully studied along with USDA reports on crop progress and condition. As harvest season begins, prices may fluctuate with high volatility until the year’s yield is known. Prices will drop and stabilize as supplies rise. These basic cycles will return year after year, providing traders with benchmarks to follow. Traders in the financial commodities will also look to the market’s anticipated response to government reports and political events.

Futures traders often combine fundamental analysis with technical analysis, using charting strategies such as Fibonacci retracements, moving averages, Bollinger bands, pivot points, and support and resistance. Major fundamentals such as US government reports and serious weather events including flooding or extended draught have the power to influence significant market moves. Technical analysis may applied to the commodity markets to gauge the strength of trends, predict retracements and reversals, and to time position entry and exit while fundamentals provide a big picture to macro market moves.

Who Trades Futures?

Participants in the futures markets are hedgers and speculators. Hedgers have a business interest in managing price risk exposure. Speculators seek to profit on the price movement in the market, whether it is up or down, and provide necessary liquidity. Commodity markets will each have fundamental factors that influence price movement. Successful futures trading requires having an understanding of these factors combined with a knowledge of technical analysis.

The futures market was originally established to help farmers and grain merchants manage the price swings imposed by supply and demand through the seasonal cycles of planting, growing, and harvest. Today, futures market participants trading futures to hedge price risk exposure may include any commercial entity that produces or buys any of the commodities such as grains and livestock, the “softs” including cocoa, sugar, cotton, coffee, and orange juice; energies including crude oil, heating oil, gasoline, and natural gas; and metals such gold, silver, platinum, and copper. Futures contracts on interest rates and currencies allow money managers to hedge risk on the fluctuating values of institutional financial holdings.

A speculator may trade on price action, going long to profit from upward price movement or going short if the market is anticipated to drop. Speculators are essential to maintaining market volume, volatility, and liquidity. The futures market is open to any private individual who meets the basic financial requirements for opening a trading account. Money used for trading futures must be risk capital and a trader must be aware that it is possible to lose more money than the original account.

Internet-based electronic trading platforms make it possible for an individual to do his own futures trading. An investor may prefer to trade with the advice of a professional. A commodity trading advisor (CTA) is a professional who makes trades on behalf of investors in what is called a managed futures program. Performance of the program will be available for the investor to evaluate. The CTA generally receives a fee for trading advice and incentive fees when the program is profitable. Managed futures programs and the advice of CTAs are regulated by the National Futures Association.

Futures Exchanges

In 1848, a group of Chicago businessmen set out to calm the chaos of grain trading in the Midwest, organizing what would grow into the Chicago Board of Trade (CBOT). Left unchecked, price swings were so severe farmers would burn their grain as fuel when supplies drove prices too low to cover the cost of transporting it to be sold. Initially offering basic “forward contracts” to guarantee future prices to buyers and sellers, the first futures contracts were introduced by the CBOT about two decades later and included formal specifications for grain quality, and quantity, and delivery. As futures trading became adopted as a standard practice, millions of bushels of grain passed through Chicago, establishing the city as a major transportation and shipping hub and giving birth to a second futures exchange, the Chicago Mercantile Exchange (CME). The needs of dairy merchants in Manhattan gave rise to the New York Mercantile Exchange (NYMEX) at the turn of the century.

The 1960s launched an era of dynamic expansion by the Chicago Board of Trade with the introduction of futures trading in livestock, metals, and lumber. Futures contracts in currencies, indices, interest rates, and energies followed. The 1970s saw the creation of listed options when the Chicago Board Options Exchange opened its doors across the street from the CBOT. The NYMEX evolved into the primary center for futures trading in energies and metals.

The new millennium saw a major development in the futures industry when the Chicago Board of Trade merged with the Chicago Mercantile to form the CME Group. With the addition of the New York Mercantile, the newly-formed entity became the world's largest and most expansive exchange for futures. The ICE is the newest US exchange for futures trading. Established in 2000 to offer an electronic energy market, the ICE later acquired the New York Board of Trade to become the primary center for trading the softs commodities including coffee, cocoa, sugar, and orange juice.

What is a futures contract?

A futures contract is appropriately named. It is a contract on what you can do in the future. Futures contracts, or simply “futures,” were created to help producers and buyers of commodities manage their price risk over time. A futures contract is a financial instrument on the value of a commodity such as corn, crude oil, gold, or coffee. The futures contract describes quality and quantity specifications for the commodity and guarantees a future price to the holder by a specified date. As the value of the commodity fluctuates, the value of the contract will change with the holder’s ability to make a profit on the price change.

Futures are traded on exchanges similar to stock exchanges. The basic trading concept of “buy low, sell high” applies for futures trading. Most participants in the futures market have a business interest in the commodities they trade but speculators are also necessary for the market to maintain liquidity.

Let’s look at a simple example of how a hedger and a speculator might use the futures market. A jewelry designer will need to purchase gold to replenish the current supply by the end of the year, several months out. He is concerned that the price of gold may rise above his company’s budget for raw materials. He will do in futures what he plans to do in the future: He opens a contract in the market to buy gold futures at his target price for the month he plans to make his purchase. A speculator follows the value of currencies and sees the US dollar index strengthening. A rising US dollar tends to pressure the price of gold downward so the speculator sells gold futures to potentially profit from downward price movement.

As a hedger, the jeweler will ultimately buy gold for cash from an industry supplier. If the futures are above the current cash prices at the time of his gold purchase, he will make a profit on his futures trade, offsetting the higher price he has to pay for gold from his supplier. If gold futures are trading below cash prices, he will take a loss on the futures trade and average out his costs when he buys actual gold for a low cash price. With no business interest in the price, the speculator will take a profit or loss purely on the basis of market price action against his futures position in gold. The speculator’s short position would profit if gold futures drop and the speculator closes his futures position at a lower price than where he entered the trade. He will lose money on the futures trade if gold prices rise.

Trade Options on Futures

Options provide a futures trader with unique strategies for managing the risk of a futures position. Options can be used in combinations called “spreads” to establish a position in the market with the potential to profit across a range of futures prices.

Like futures, options are in the class of financial instruments called derivatives. They derive their value from the value of an underlying asset or another financial instrument including futures contracts.

The value of an option will fluctuate with the value of the underlying futures contract, allowing options to be bought and sold on an exchange and traded in the same manner as futures. Option contract terms will extend a right or require an obligation with respect to the future value of the futures contract.

The buyer of an option will acquire the right to be long or short a futures position at a particular price called the strike price, by a specific date which is the expiration date. There are two types of options. A call is an option on a long futures position. A put is an option on a short futures position. If the strike price of the option becomes profitable relative to the underlying futures price by the expiration date, the option holder may exercise the option, meaning he may assume the futures position, long if he held a call option or short if he traded a put option.

The price quote for an option is called the premium. The buyer of an option pays the premium to open a position. The option buyer’s maximum potential risk on the trade is the amount of premium paid. An option seller collects the premium amount and it is credited to his options trading account. The option seller is paid upfront to assume the potential risk of the position. If an option buyer’s position becomes profitable and he is able to exercise his option, the option seller will be required to take the opposite position which will be a loss at the time it is opened. The potential for loss to the option seller may be unlimited. The option seller profits on a trade if the option does not reach the strike price and the buyer is unable to exercise the option. If the option trade is not profitable to the buyer, the option seller will retain the amount of premium he collected when he opened the trade.

It is important to note that options and futures markets are separate and distinct and do not necessarily respond in the same way to similar market conditions.

Option prices do not move in lockstep with changes in the underlying futures market price.