1. Beginner's Guide To Trading Futures: Introduction
  2. Beginner's Guide To Trading Futures: The Basic Structure of the Futures Market
  3. Beginner's Guide To Trading Futures: Considerations Prior to Trading Futures
  4. Beginner's Guide To Trading Futures: Evaluating Futures
  5. Beginner's Guide To Trading Futures: A Real-World Example
  6. Beginner's Guide To Trading Futures: Conclusion

In this section, we’ll take a look at how the futures market works, how it differs from other markets and how the use of leverage impacts your investing.

How Futures Work

A derivative is simply any financial instrument that "derives" (hence the name) its value from the price movement of another instrument. In other words, the price of the derivative is not a function of any inherent value, but rather of changes in the value of whatever instrument the derivative tracks. For example, the value of a derivative linked to the S&P 500 is a function of price movements in the S&P 500. (For related reading, see Derivatives 101.) One type of derivative is a futures contract.

A futures contract is an agreement between two parties to buy or sell an asset at a specified future date and price. Each futures contract is specific to the underlying commodity or financial instrument and expiration date. Prices for each contract fluctuate throughout the trading session in response to economic events and market activity.

Some futures contracts call for physical delivery of the asset, while others are settled in cash. In general, most investors trade futures contracts to hedge risk and speculate, not to exchange physical commodities – that’s the primary activity of the cash/spot market. Nearly all futures contracts are cash settled and end without the actual physical delivery of any commodity.

All futures contracts have specific expiration dates. If you don’t exit your position before that date – and it’s a physically settled contract, like corn – you have to deliver the physical commodity (if you’re in a short position) or take delivery (if you’re long). The following image shows an example of the various monthly corn contracts available on the CME. Note that the nearer the contract expiration, the greater the trading volume – and the further out the contract, the higher the price.

The various contract months for corn (March, May, July, September and December).

Some contracts – such as those based on stock indexes – are always settled in cash because there would be nothing physical to deliver. It’s estimated that only 2% of all futures contracts are actually delivered. That’s because most traders don’t want to store, insure and deliver such a huge amount of a commodity (plus they’d have no use for it). Instead, most contracts are settled in cash – meaning, the position is closed at some point for expiration.

A contract month is the month during which a futures contract expires. Some contracts trade every month, while others trade only certain months of the year. Each contract month is represented by a single letter: 

Month

Code

 

Month

Code

January

F

July

N

February

G

August

Q

 March

H

September

U

April

J

October

V

May

K

November

X

June

M

December

Z

To avoid confusion, a contract name always includes the ticker symbol, followed by the contract month and two-digit year.  The complete contract name for the December 2017 corn futures contract, for example, would be “ZCZ17”:

Ticker Symbol

Contract Month

Year

ZC

Z

2017

ZCZ17

 

How Futures Differ from Other Financial Instruments

Futures differ in several ways from many other financial instruments. For starters, the value of a futures contract is determined by the movement of something else – the futures contract itself has no inherent value. Secondly, futures have a finite life. Unlike stocks, which can stay in existence forever (theoretically), a futures contract has a set expiration date, after which the contract ceases to exist. This means that when trading futures, market direction and timing are vitally important.

You’ll usually have some choices when choosing how long you want to make a wager for. For instance, there might be futures contracts on corn with expiration dates spaced every couple months for the next year and a half (i.e., December 2017, March 2018, May 2018, July 2018, September 2018 and December 2018). While it might be obvious that the longest contract gives you the most time for your opinion to be right, this extra time comes at a cost. Longer-dated futures contracts will usually be more expensive than shorter-dated contracts. Longer-dated contracts can sometimes be illiquid as well, further increasing your cost to buy and sell. 

A third difference is that in addition to making outright wagers on the direction of the market, many futures traders employ more sophisticated trades – such as spreads – the outcomes of which depend upon the relationship of different contracts (these will be explained later in this guide). Perhaps the most important difference, however, between futures and most other financial instruments available to individual investors involves the use of leverage. (For related reading, see Futures Fundamentals.)

Leverage

In general, futures trading is considered riskier than buying and selling stocks, primarily because of the leverage involved. Leverage allows you to enter a futures position that’s worth much more than you are required to pay upfront. Futures positions are highly leveraged because the initial margins (the required down payments on futures contracts) set by the exchanges are relatively small compared to the cash value of the contracts – which is part of the reason why the futures market is so popular. (For more, see Leveraged Investment Showdown.)

Leverage is always represented as a ratio; for example, if you have access to 20:1 leverage and you have $1,000 in your account, you could enter a position worth 20 times that amount, or $20,000. The smaller the margin requirement in relation to the value of the futures contract, the higher the leverage.

With leverage, if prices up or down even slightly, the changes to your gains and losses will be large in comparison to the initial margin. Say you buy an e-mini S&P 500 (ES) stock index futures contract that’s trading at 2,600, with a margin deposit of $5,000. The value of that contract is $50 times the S&P 500 Index, or $130,000 in this example – and for every point gain or loss, you stand to gain or lose $50.

Assume the ES rallies to 2,700 – for a gain of $5,000 (100 points X $50). Not bad for your initial $5,000 investment. But before you get too excited, consider what happens if the ES drops the same amount in the other direction – to 2,500. In that case, you would have lost $5,000 (your entire investment). Even a small downward shift in price can lead to big losses with this leverage.  

While leverage makes it possible to trade larger positions, it’s important to remember that leverage magnifies both profits and losses. You can limit your losses by using a protective stop-loss order. (For related reading, see The Stop-Loss Order: Make Sure You Use It.)


Beginner's Guide To Trading Futures: Considerations Prior to Trading Futures
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