Futures Market Fundamentals
Written on Thursday, January 11, 2007 by Tazza Trader
A. Introduction
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities. Buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators.
Futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions.
B. How The Market Works
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically.
A future contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity; and the contract will state the price that will be paid and the date of delivery (but almost all futures contracts end without the actual physical delivery of the commodity).
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis.
C. The Players
The players in the futures market fall into two categories: hedgers and speculators.
· Hedgers
Hedgers are farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.
· Speculators
Speculators on the other hand, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. They aim to profit from the very price change that hedgers are protecting themselves against.
D. Characteristics
Given the nature of the futures market, the calculation of profit and loss will be slightly different than on a normal stock exchange.
· Margin
Margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.
When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract.
The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.
· Leverage
Leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay, meaning a small change in a futures price can translate into a huge gain or loss.
· Pricing and Limits
Contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on).
Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges. Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day.
E. Strategies
Essentially, futures contracts try to predict what the value of commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.
· Going Long
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.
· Going Short
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.
· Spreads
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short futures contracts.
F. How To Trade
It's important to note that futures trading is not for everyone. You can invest in the futures market in a number of different ways, but before taking the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader, you should have a solid understanding of how the market and contracts function. You'll also need to determine how much time, attention, and research you can dedicate to the investment.
The recommended way to participate in the market is by opening a managed account, similar to an equity account, with a licensed broker. Your broker would have the power to trade on your behalf, following conditions agreed upon when the account was opened. This method could lessen your financial risk because a professional would be making informed decisions on your behalf. However, you would still be responsible for any losses incurred as well as for margin calls. And you'd probably have to pay a management or profit sharing fee.
A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities. Buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also speculators.
Futures market is a major financial hub, providing an outlet for intense competition among buyers and sellers and, more importantly, providing a center to manage price risks. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions.
B. How The Market Works
The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically.
A future contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity - and a long position - the party who agrees to receive a commodity; and the contract will state the price that will be paid and the date of delivery (but almost all futures contracts end without the actual physical delivery of the commodity).
The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis.
C. The Players
The players in the futures market fall into two categories: hedgers and speculators.
· Hedgers
Hedgers are farmers, manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.
· Speculators
Speculators on the other hand, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. They aim to profit from the very price change that hedgers are protecting themselves against.
D. Characteristics
Given the nature of the futures market, the calculation of profit and loss will be slightly different than on a normal stock exchange.
· Margin
Margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses.
When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account. This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract.
The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished. For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount.
· Leverage
Leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay, meaning a small change in a futures price can translate into a huge gain or loss.
· Pricing and Limits
Contracts in the futures market are a result of competitive price discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit (gold ounces, bushels, barrels, index points, percentages and so on).
Prices on futures contracts, however, have a minimum amount that they can move. These minimums are established by the futures exchanges. Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day.
E. Strategies
Essentially, futures contracts try to predict what the value of commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads.
· Going Long
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase.
· Going Short
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator.
· Spreads
Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short futures contracts.
F. How To Trade
It's important to note that futures trading is not for everyone. You can invest in the futures market in a number of different ways, but before taking the plunge, you must be sure of the amount of risk you're willing to take. As a futures trader, you should have a solid understanding of how the market and contracts function. You'll also need to determine how much time, attention, and research you can dedicate to the investment.
The recommended way to participate in the market is by opening a managed account, similar to an equity account, with a licensed broker. Your broker would have the power to trade on your behalf, following conditions agreed upon when the account was opened. This method could lessen your financial risk because a professional would be making informed decisions on your behalf. However, you would still be responsible for any losses incurred as well as for margin calls. And you'd probably have to pay a management or profit sharing fee.
Note: The contents are extracted from Investopedia.
