Futures Trading 101: Getting to Know the Basics

This post will be talking about the futures market, which involves considerably more risk than traditional forms of investing. Before proceeding with futures trading, it’s important to know the basics of investing in the financial markets.

If you’ve never heard the term “futures” or “futures trading” before, don’t worry. The average retail trader is familiar with the stock market, but futures don’t come up much in those conversations. The basic definition of futures trading is buying or selling an asset (such as a commodity) at a specified price on a future date.

When I first heard about futures trading, I had only seen the stock and options markets. Despite knowing some basics of investing and trading, futures trading had never been on my radar.

It turns out that the futures market has existed for centuries and is one of the largest financial markets today. But instead of trading shares like those who trade on the stock market, futures traders are participating in the exchange of specialized contracts.

The price at which you enter into these contracts will be determined by the market value of the underlying asset at that time.

They can be used for speculative purposes (by predicting how much an asset will cost in the future), hedging purposes (to protect against price swings), or to help manage risk in other portfolios by offsetting losses elsewhere (for example, by using futures contracts to lower your exposure to stocks).

If none of that makes sense, that’s fine. We will revisit some of these ideas shortly. But first, let’s look at the basics of futures trading.

The Basics of Futures Trading

Futures trading is a form of speculation in which you bet on whether a specific price of an asset will go up or down. A futures contract denotes the price at which an asset can be delivered and taken ownership rather than bought and sold outright.

If you expect a particular commodity, such as Crude Oil, to rise in value, you would traditionally have to buy the actual barrels of oil. But with the futures market, you instead buy a contract that locks your position of oil at the current market price.

This way, if the underlying asset increases in value, you’ll profit from the difference between the original price and your contract’s sale price. If, on the other hand, you think that the commodity will drop in value, you can sell your contract. The flexibility offered by this arrangement allows retail investors to speculate on markets they otherwise would not be able to access as easily as institutional investors.

The idea behind futures trading is relatively simple to understand: by buying or selling contracts now, you’re betting on how high or low prices will go in the future.

To do so successfully requires extensive knowledge and understanding of market fluctuations and trends. But even with that knowledge, it can still be challenging to predict exactly how the market will move.

Before attempting to do any of that, let’s explain what takes place when two traders interact in the futures market.

What are Futures Contracts?

Futures contracts are financial contracts between two parties; they are traded in the futures market the same way shares of a company are traded in the stock market.

By trading one of these contracts, one party agrees to buy an asset at a future date at a specific price, and the other party consents to sell the asset at a specified price in the future.

These contracts are standardized, meaning they all follow similar rules and regulations. Most futures market have high liquidity, allowing rapid buying and selling of these securities by retail investors and large funds alike.

A Crude Example

Imagine you supply oil to a local gas station. You may consider buying 1000 barrels of oil regularly throughout the year. You know that the cost per barrel will fluctuate over time (it generally rises), but you don’t want to pay a premium when prices increase or take a loss if prices drop too low.

Instead of making this purchase now and paying whatever price is listed in the market today, you enter into a futures contract with someone who already owns 100 barrels of oil (or has access to them).

You agree with this person on a price that both parties consider fair: $50 per barrel today plus delivery charges when it’s time for delivery tomorrow, at a specified time like 6:00 PM PST. Both parties sign their names on their respective copies of this contract.

Then, when it’s 6:00 PM, one party delivers 1000 barrels worth of crude oil, fulfilling his part.

The other party receives them from him since he signed theirs earlier today in exchange for $50 per barrel plus costs associated with delivering those products from point A -point B without fail. If oil had suddenly risen to $60, it does not matter. The two parties share a contractual obligation to carry out their transaction, typically at the profit of one and the loss of another.

Because these futures contracts are standardized, the basics behind trading them become more straightforward.

Some investors buy futures to limit risk based on market movements. Others make bets on how specific assets will perform over time, based on macroeconomics. But ultimately, everyone in the futures market is speculating on the value of these contracts rising or falling on a daily basis.

What types of futures exist?

1. Equity stock futures

Equity stock futures are a type of financial futures contract that allows investors to speculate on the price of particular equity stock. They are traded on an exchange, like any other stock or option. The investor pays the seller when purchasing the contract and receives payments from the seller when they buy back their position. Equity stock futures are settled in cash, unlike commodity futures which require physical delivery of assets like gold or oil. With equity stock futures, you won’t receive an unexpected delivery of goods.

2. Currency Futures

Currency futures allow investors to hedge against currency risk. For example, a company that operates in more than one country might have foreign currency exposure. To protect themselves from fluctuations in exchange rates, they can enter into a trade where they either sell or buy the currency they have exposure to at some point in the future. This practice is hedging, a common way of managing risk.

3. Commodity Futures

Commodity futures contracts are based on the price of a single commodity, such as oil or gold. They are traded on an exchange and in units of specific quantity.

For example, if you buy a commodity future for $10/barrel of oil, you agree to pay $10 per barrel at a specified date. That’s a contract that requires you to buy one standard unit (1,000 barrels) of crude oil from your counterparty at some point in time after entering into this agreement with them.

4. Interest rate futures

Interest rate futures are used to speculate on the future value of interest rates. They are based on a benchmark interest rate, such as the federal funds rate.

Interest rate futures trade on exchanges, and ultimately settle in cash.

5. VIX Futures

VIX Futures are used to hedge against volatility in the stock market.

Because they have a lower level of liquidity than other futures contracts, it can be challenging to find an active market for VIX Futures at any given time.

To see a full list of the products available on the Chicago Mercantile Exchange (CME), visit this link. Each of these symbols represents a separate futures contract and market.

Futures Contracts and Pricing

Futures contracts are priced using the spot price of an underlying asset, adjusted for interest, time, and paid out dividends.

Don’t worry, you don’t have to calculate any of this yourself. But this is the reason that futures contracts from different months have distinct prices. Take a look at the differences between the Gold Futures contracts at the time of writing this article:

Symbol	Days (til expiration)	Exp	Bid	Volume
/GCV22	5	Oct 22	1631.60	16,693
/GCX22	36	Nov 22	1640.00	1,364
/GCZ22	65	Dec 22	1651.60	237,202
/GCG23	128	Feb 23	1665.00	3,411

As you can see, the price varies based on the time left on the contract, as speculators in the market try to gauge where the underlying asset’s value will be in the future. At the time of writing this, gold price is $1643 per troy oz. Going by the bid prices above, the market judges that gold will continue to fall through October, but perhaps recover by the end of November.

Futures Trading Terminology

Margins, leverage, and ticks are some more basics that must be understood well before beginning any real futures trading. Ensure that before you take any trades of your own, you are well-acquainted with the math behind any transaction with futures contracts.

Margins

Margins are the minimum deposit you must have in your account before trading a futures contract. The higher the margin requirement is, the more money you need to pay for your futures trades.

A lower margin implies needing less money to trade, but it also means a greater chance of wiping out your entire position in one move.

The most common margin requirement is 50%. If you buy $100,000 worth of contracts, you will need $50,000 in your account. A 2x leverage is also typical for trading stocks and other instruments on margin.

Leverage

The word “leverage” can mean different things in different contexts. Still, when you’re trading futures, leverage has a relatively simple definition. Leverage is a tool for borrowing funds to increase the size of one’s position, beyond what would be possible through capital alone.

With leverage, your profit potential is multiplied by a factor depending on the funds you borrow from your broker to make the trade. At the same time, your loss potential will be multiplied by the same amount.

Regarding futures trading, leverage can be a blessing or a curse. Leverage is excellent when price moves in the trader’s favor, because the profits can be extraordinary compared to traditional investments. But when it doesn’t go as planned, losses can be disastrous. In many cases, traders have lost much more than 100% of the invested capital.

Ticks

A tick is the smallest price change allowed for any given commodity or financial product. For example, in S&P 500 E-mini futures, each price increment is one quarter of a point. It may seem insignificant, but the value of a single tick can vary greatly depending on the underlying asset.

In some cases, the value of a single tick can be as small as $0.01. When it comes to the S&P 500 E-Minis, one tick is $12.50. Considering the market moves several points in minutes at times, it’s easy to see how a careless trader can earn an expensive lesson.

If our trader is trading crude oil or natural gas, trades will be based on an underlying commodity with smaller increments than stocks and bonds. Share traders and option traders often deal in positions of 100 shares at a time. In futures, with assets such as oil and gold, traders are more often only taking one contract positions. While one contract represents dozens to a thousand units of a particular instrument (a Crude Oil controls 1000 barrels), it’s important to know the math and true size of any position before trading.

Note: Accidentally buying 10 contracts of Crude Oil Futures during a volatile trend may cause a panic attack.

Why trade or invest in futures?

So we know a little bit about the basics of trading futures: contracts, pricing, and leverage. They may seem complicated and scary still. Considering the high risk of speculating with leverage, why invest in futures at all?

1) Futures can be used to hedge physical assets in storage.

You can use futures to hedge physical assets that are in storage.

For example, if you have a large number of soybeans stored in a warehouse, and you’re concerned that their price will rise before they’re used or sold, you could hedge them by investing in futures contracts.

2) Futures provide flexibility.

You can buy or sell at any time during the contract. You are not required to hold the position until it expires, so you can take your profits or cut losses early.

3) Futures allow you to leverage your money.

The leverage itself becomes an asset once investors utilize it correctly.

If you have a volatile investment, futures will let you lock in a price for your future purchase. This guarantees that you’re at least getting the asset’s cost at the time of your purchase.

Futures contracts also allow you to short-sell, so that if the value drops, you’ll be able to make up the difference with the money from selling it short, and vice versa if the value rises. The best part is that futures are highly liquid, making it easy to hedge and enter or exit positions.

4) Futures Stabilize the Market

One reason for trading futures escapes even most futures traders. By allowing speculation on these assets, they actually help increase the efficiency of that market. For example, if someone wants to invest in the S&P 500 Index, but is unaware of what to expect, futures help to offset any extraordinary changes that may occur, especially in the short term.

In addition, not everyone can afford the staggering costs of investing in some of these assets directly, especially with the size required to earn any reasonable profit. Rather than trying to invest in every company that is on the S&P 500, going long on a futures contract is a viable option.

5) Futures offer unique opportunities for growing capital quickly.

At the end of the day, we’re here to make money. But not everyone has enough for a sizeable futures account.

If you’re not an amateur, and just don’t have the capital, trading stocks can be quite limiting. A good day on one stock might earn a day trader 3 or 4%. For a capable trader who has significantly less than $100,000 to use, these returns are hardly worth replacing a decent day job. But in futures, especially with limited capital, gains of over 100% are not unordinary.

It helps that there are opportunities now for traders to earn funded accounts by participating in combines via prop firms. These opportunities exist for stocks in some cases, but the experienced trader will naturally gravitate toward better leverage and profit percentages. Knowing that these markets exist for traders in that situation is a comfort that some of us know well and appreciate.

Conclusion

This wraps up our first mini lesson on speculation in the futures market. While this article covers the basics of futures trading, it is by no means a complete blueprint for making consistent money as a trader in these markets.

Keep in mind that futures trading is ultimately a separate category from stock trading. There is always a risk of losing more than the capital invested on any particular trade. But learn the basics, develop a sound strategy with good trading habits, and the futures markets can reward you graciously.

I hope this helps you understand a little more about what goes on in the derivatives market. Head over to lesson #2 to learn more about the world of futures trading.