Futures Trading Explained

A brief history of the futures market

It is hard to be precise about the origins of the futures markets, which can in fact be traced all the way back to ancient Greece, before being adopted in medieval Europe and Japan, but there is no doubt that today’s modern markets were founded on the North American grain trade as it evolved during the 19th century. The location of these markets was of course largely driven by the patterns of grain transportation, resulting in the geographical location of many of the exchanges which have remained in place to this day.

Futures trading was ofcourse once regarded as a specialist market, and only used by speculators chasing large profits in market little understood by every day traders and investors. However, since the late 1970’s a variety of financial futures have been introduced, joining the more traditional agricultural and physical commodity markets, with interest rate futures, equities and foreign exchange products added in the last thirty years. As such, futures trading has now become an essential instrument for all traders and speculators, with the small retail trader able to compete equally with the institutional trader or investor. Indeed this has been further accelerated by the move away from the traditional open outcry method of buying and selling futures contracts, which operated on the floor of the exchange and during exchange hours only, to a market which is now dominated by electronic trading which occurs virtually twenty four hours a day.

The futures exchange

The futures exchange provides the framework for all futures trading, and generally has two distinct methods of matching buyers and sellers in the market. The first of these is the open outcry, where commodities futures traders buy and sell in the trading pit, using hand signals and gestures to confirm commodities quotes and prices.

These are the floor traders often depicted in Hollywood films, wearing brightly coloured jackets and yelling at each other in what appears to be a chaotic and angry mob. Despite this, floor trading in this way still continues, with the CME accounting for around 20% of all its business through the futures trading pit. The other 80% of business is of course conducted electronically, and with the CME this is through its Globex platform.

In the old days of course, trading hours were limited to those when the trading pit was open, and even until relatively recently, many futures exchanges were only open for a fixed number of hours per day, in much the same was as for equities. Some of the smaller futures exchanges around the world still operate with fixed hours.

However, many now trade virtually 24 hours a day, and the CME is no exception with the futures markets closed only for short periods each day for settlement and calculation of ongoing margin requirements to support open positions.

The role of the central exchange is not only to provide an orderly market, where commodity or futures trading is conducted in a highly regulated environment, it is also there to act as guarantor between the various parties, ensuring that all contracts are honored and met in full.

This is done through a clearing house which assumes responsibility and nets positions. As such the exchange ensures that all commodities futures trading is conducted in a transparent and regulated manner, as well as ensuring that market liquidity is always maintained, allowing buyers and sellers to be matched accordingly.

Futures trading is often referred to as a zero sum game, as any loss incurred by one party, becomes a gain for the other, with the exchange simply acting as a mechanism for this cash transfer to take place.Futures trading is therefore the purest of all forms of trading, as every seller is matched with a buyer, and for every buyer there is a seller.

What is a futures contract?

In simple terms a futures contract is just that – in other words it is a contract which binds you to an agreement to make or take delivery of the underlying goods specified in the contract at an agreed time and date in the future.

So the first, and most important thing we need to understand about a futures contract, is that it is just that, a contract, and as such places financial responsibilities and obligations on the parties involved. So, just as with any other form of contract, in agreeing to buy or sell a futures contract, the two parties are legally bound to deliver and receive the underlying asset which leads to our second important point.

The futures markets is a derivative market – in other words the futures contract is derived from an underlying asset class. Now in the case of a commodity future, the underlying asset is often a physical one such as oil, gold, sugar and corn, but for many other types of futures the underlying asset is often an intangible one, such as with an interest rate future,  a stock index future or perhaps a currency. So all futures contracts will have been derived from the underlying price in the cash or spot market. So for example, where we have the S & P 500 index in the cash market, the e mini S & P futures contract is derived from the underlying index, and will therefore track it relatively closely. Equally, a futures contract for the EUR/USD currency pair will follow the spot market price for the currency pair, whilst gold futures will track the spot gold market. There will always be a difference between the futures contract price and the underlying asset since there is always a cost of carrying the contract, up until the day the contract expires at which point the futures price and the underlying asset price will be equal, having converged over the life of the contract.

Prior to the actual delivery, a futures contract may trade at either a premium or a discount to the relative cash market or spot market value, and this is often referred to as the ‘basis’, and is in effect the cost of the carry. In other words this is the cost of carrying the underlying assets or instruments. As an example consider gold. A speculator may buy gold bullion and then sell gold futures with the intention of delivering the gold once the contract calls for delivery. Buying and holding the gold of course has a cost associated in the form of short term interest rates, and this would then be reflected in the ‘basis’ of the price differential. The further the futures contract is in advance, then the greater the basis will be, since the cost of financing the gold purchase increases.

One of the most important development over recent years, and again one which is partly responsible for the dramatic growth in the popularity of the futures market, has been the development of the so called ‘cash settlement’ mechanism, which was introduced by the CME and others in the early 1980’s. Prior to this futures contracts were largely settled by so called ‘physical delivery’ and again this was largely historical, since most exchanges were founded on the basis of grains, or livestock physically changing hands at the expiry of the contract.

However, it is important to realize that within the commodities trading exchange, there will always be buyers looking to purchase physical stocks of raw commodities and to therefore take physical delivery at settlement of the contract, and these contracts will be clearly specified as such. For the novice trader this can be confusing, and I am not the only futures trader to have been caught holding a physical contract. In my case it was gold. Fortunately I was on the right side of the market at the time, and was alerted to the fact by my broker who only settles in cash, and therefore all I had to do was close the contract out prior to settlement the following day. Others have not been so lucky, having been forced to take delivery of cattle and other livestock. Yes it happens so be careful.

However, fortunately for us, most  future commodities contracts are cash settled, with the balance of cash transferring between the counter parties to the contract, and as such constitutes the bulk of futures contracts traded, as the largest group of market participants are of course the speculators, who are simply looking to profit from price movements in the futures contract.

Finally, as futures are derivatives, all futures trading takes place in a margin account, allowing for leveraged profits but also increasing the danger of equally dramatic losses, a fact that new futures traders seem to ignore time and time again. I will cover all these in more detail shortly and in particular the margin issue which has three very different components. For now though, lets look at the role of the exchange and how futures contracts are traded between the various parties.

The futures contract explained

In order for buyers and sellers to be able to trade futures contracts with one another, and to know what they are buying and selling, each contract traded on the exchange is tightly specified, and for every commodity will always include the following :

  • The quantity of the commodity
  • The quality of the commodity
  • The expiry month for the contract
  • The time of delivery of the contract.

The only item which is not specified is of course the price, which is agreed between the two parties when buying and selling the futures contract, and this is confirmed by virtue of the futures price, which we will look at shortly in an example. So in buying or selling a commodities futures contract, we will always be able to trade with other counter parties via the exchange, as each party knows the underlying specification of the contract.

In addition to providing the regulatory framework and consequent market liquidity for futures traders to buy and sell, the commodities exchange also fulfills one other crucial function, which is the creation of ‘price discovery’ for each commodity being traded, and it is often the futures data which is widely reported as the price of a particular commodity in the daily news. The ‘price discovery’ simply means that in trading futures contracts in a transparent and fair market, commodities ( and other asset classes) will trade at their fair market price, with the combined mix of market players all contributing to what is perceived to be the current market price for a commodity at any particular time.

Whether the holder of a futures contract is a supplier hedging a commodity risk, a bank or hedge fund speculating on the future price of a commodity, or a large industrial company looking to purchase basic commodities for onward supply or business use, the price of the commodity is reflected in the futures prices on the exchange.

So having looked at online futures trading and the role of the commodities exchange in regulating, controlling and providing liquidity for market participants, let’s look at some examples and see how online commodities trading actually works with some simple examples, which I hope will begin to explain some of the principles and mechanisms involved in a commodities futures contract.

In order to try to highlight how the futures markets are used by different players, let’s take two examples. The first is that of a producer who is hedging his risk, and the second is that of a speculator who is looking to profit from a price move in the futures market. So let’s take the first of these which is that of a farmer who is growing corn, and is therefore looking to hedge his risk by using corn futures in the commodity markets.

  • Corn futures – hedging risk
  • Corn futures contract from the CME commodities exchange

Suppose we have a farmer in the US corn belt, who is expecting a crop of 100,000 bushels of corn in September, and as such he wants to hedge his crop against changes in the future price of corn. It is March, and in 6 months time much could happen to the price of corn – it could increase, decrease or stay the same. The decision for the grower of course is not easy, as each has its own implication. The first option is to do nothing, take a chance, and hope that the price of corn either remains the same, or increases. The second option is to hedge against future price changes by agreeing a price now using a futures contract, which then secures this price in six months time, accepting of course, that if prices rise, then the farmer loses out on potential further profit. This is the decision that all producers face – take a risk and do nothing, with a consequent increase in profits, or loss, or guarantee a price now and accept in the future ( with hindsight) that this was a good or bad decision. The final element for a producer is that in guaranteeing the price with a futures contract, this allows for better budgeting control, as the price of the goods are now fixed whatever happens in the market.

In order to strike a balance between the potential risks of a fall in prices, against those of lost profits from a rise, our farmer decides to hedge only 50% of the crop, thus guaranteeing a price for 50,000 bushels, whilst allowing for any rise in corn prices to be reflected in the 50% of his crop which is not now protected with a futures contract, a strategy that is very common amongst producers in the commodities market. So, having decided to split his risk, the farmer decides to sell some futures contracts – what does he do next?

First he knows that each contract for corn futures has an underlying asset quantity of 5,000 bushels, so in order to protect 50% of his corn crop he needs to sell 10 contracts which is 50,000 bushels. Remember he is a producer and therefore looking to sell not buy! Now as I mentioned in my introduction, all futures contracts have an expiry date and time, so the farmer looks for a contract in September, 6 months ahead, and finds that at the CME futures exchange the current price being quoted for corn futures in September is $4.21 per bushel.

Corn futures CME contract

As you will see in the screenshot, this is the appropriate contract for corn futures from the CME, which specifies all the underlying elements of the contract. The contract size is 5,000 bushels, and the pricing unit for the contract is cents per bushel, so if we see a quote of 413 on the exchange, then this means the price per bushel is $4.13. Above this is specified the grade of the corn to be delivered under the contract, and importantly at the bottom of the contract is the settlement procedure, which in this case is physical delivery. Finally, the contract also specifies the periods over which the futures contracts will be offered, and for corn futures these are quoted for March, May, July, September and December, along with details of the expiry date and time. So having found a suitable contract in September at $4.21 per bushel, our farmer sells 10 corn futures contracts at a strike price of $4.21. What happens next? Let’s assume that corn prices fall in the next few months, and by September these are now trading at $3.90 per bushel. Let’s look at the maths as follows :

  • Farmer sells 10 corn futures contracts ( September expiry) in March at $4.21 – Total : 10 x 5000 x $4.21 =$210,500
  • Farmer buys 10 corn futures contracts ( expired) in September at $3.90 – Total: 10 x 5000 x $3.90 = $195,000
  • The 10 futures contracts have generated a profit of : $210,500 – $195,000 = $15,500
  • He sells his 50,000 bushels at $3.90 per bushel for : $195,000
  • He sells the second half of his crop at $3.90 per bushel for: $195,000

The net result is that by hedging part of his crop, he has managed to generate an additional $15,500 from the sale, which would otherwise have been lost, had he simply waited until the crop was ready for sale.

The converse of this of course is that had corn prices risen, then on the hedged futures element of his crop he would have lost out on a potential profit. The other key point to note from the above example is that in this case the commodity future is ‘covered’, with the seller holding the underlying asset, a common occurrence in soft commodities. However in certain parts of the world some commodities exchanges ban the selling of ‘so called’ naked futures, where the underlying asset is not held, which is generally a speculative activity, in an attempt to try to control market prices. So let’s now look at a second example, and this time from the speculators perspective of simply making money from a move in the commodities markets.

Let’s stay with our corn futures, but this time we are going to enter a commodity trade for pure speculation. Having opened our account with our commodities broker, we check the corn futures prices and see that March corn is trading at $4.21. It is early in the month and the futures contract is not due to expire for two weeks. We are bullish on corn, and feel that it is set to rise in the next few days, due to a poor long range weather forecast, and a general lack of stock, coupled with increasing demand and a weak US dollar.

We therefore buy one corn futures contract at $4.21, and in the next few days corn prices begin to edge higher, with the futures contract now trading at $4.29, and we therefore decide to close our position by selling a March corn futures contract, thereby netting off our positions, and closing our exposure to the market. So let’s look at the maths for this example, and as we can see from the above contract specification, a 1 cent move in the corn price is equivalent to a $50 ( 5000/100) move in the value of the contract.

  • We bought 1 corn futures contract at $4.21 and sold 1 corn futures contract a few days later at $4.29
  • The contract increased in value by $4.29 – $4.21 = 8 cents
  • The total gain in the value of the contract was therefore 8 cents x $50 = $400

As we can see from the above example, a small move in the price of the underlying commodity, has resulted in a large profit on the futures contract, such is the power of leverage.

Expiry of a futures contract

All futures contracts, ultimately expire, and the dates and times for expiry are always clearly specified in the terms of the futures contract. Generally most futures contracts will be based on either a monthly or quarterly cycle, and in the US markets the most popular day for expiry is the third Friday of the trading month and on these days the ‘front’ contract expires to be replaced with the next available contract. So for example if we are trading on the third Friday in December and on a quarterly cycle, then the December contract expires and is replaced with the March contract.

These are key days in the futures markets, as this is the day that the underlying cash or spot prices, should converge with the futures price, and is the day when arbitrage desks will be at their busiest, making money from any divergence in the spread between the two market prices. This is why prices can be extremely volatile, particularly in the last thirty minutes as the futures prices close. This volatile price action is further increased when this coincides with options expiry, often referred to as triple or quadruple witching.

Futures codes and contracts

Most futures contracts consist of four letters or numbers, which define the underlying asset being traded, the contract month, and the year. In general terms these are as follows:

January : F
February : G
March : H
April: J
May: K
June: M
July : N
August: Q
September: U
October : V
November : X
December: Z

As an example, if we were trading a corn future for March 2012, then this would be designated on the futures market as follows :

ZC is for corn

H is for the March contract

2 is for 2012 ( the last digit of the year )

The futures contract to trade would be ZCH2. This then defines that contract and the underlying asset, but as always we have to remember that futures contracts ultimately expire, and roll over into the following month or quarter, something which is easy to forget when trading!