Futures Trading 101

An Introduction

Table of Contents

Future Contracts Overview

  • Definition: A futures contract is a legally binding agreement to buy or sell an asset at a predetermined price (futures price) on a specific date in the future (expiry date).

  • Market Participants:
    • Commodity Producers (e.g., farmers) use futures contracts to hedge against potential losses if prices decline.
    • Commodity Users (e.g., food manufacturers) buy futures contracts to protect against potential price increases.
    • Speculators trade futures to profit from price fluctuations.
  • Trading Conventions:
    • Futures prices are determined through bidding and asking on exchanges, where traders compete to buy or sell contracts.
    • All transactions incur exchange fees and require an initial margin deposit to ensure contract fulfillment.
    • The exchange acts as an intermediary, ensuring both parties meet their contractual obligations.
    • Most actively traded futures contracts are standardized by the exchange to ensure liquidity and uniformity.

Key Features of Futures Contracts

  • Obligation: Both parties in a futures contract are obligated to fulfill the contract at expiration.
  • Exchange Traded: Futures contracts are typically traded on organized exchanges, such as the CME Group, which provide a transparent and regulated marketplace.
  • Standardization: Futures contracts are standardized, meaning they have specific terms regarding the asset, quantity, quality, settlement type, expiry date, delivery location, and etc.
  • Hedging: Commodity users and producers use futures to hedge against price movement.
  • Leverage: Traders can control a large contract value with a relatively small initial investment (margin).

Types of Futures Contracts

Futures contracts come in various forms, but they generally fall into these key categories: Stock Index Futures, Agricultural Futures, Energy Futures, Metal Futures, Currency Futures. We introduce the first two as examples here.

Stock Index Futures

These futures allow traders to speculate on the movement of a stock market index. They do not involve the physical delivery of assets but are settled in cash.

  • Examples:
    • S&P 500 Futures (ES)
    • NASDAQ-100 Futures (NQ)
  • Trading Conventions:
    • Typically cash settled daily, no physical asset delivery.
    • Contracts represent a fixed multiplier of the index value.
    • Used for hedging stock portfolios and speculating on market trends.

Agricultural Commodity Futures

These futures involve contracts for the delivery of agricultural products at a future date.

  • Examples:
    • Corn Futures (ZC)
    • Wheat Futures (ZW)
    • Soybean Futures (ZS)
  • Trading Conventions:
    • Typically with actual delivery of the commodity.
    • Delivery occurs at designated warehouses if the contract is held until expiration.
    • The buyer of the contract is responsible for the warehouse storage fee and delivery cost.
    • Used by farmers, food producers, and speculators to hedge against price fluctuations.