Futures 101
Select individual sections by clicking on the questions below. You can return to the questions by clicking the "Return to Questions" button at the end of each lesson.
- What is a futures contract?
- What is a futures exchange?
- What contracts are traded?
- How does supply and demand effect prices?
- What is fundamental analysis?
- What is technical analysis?
- How do orders get processed in the pit?
- What is the trading pit?
- Who's who in an around the trading pit?
- What is Risk Management:
- What is the role of the speculators and hedgers?
- What are options on futures?
1. What is a futures contract?
A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price. All of the terms under which the commodity, service or financial instrument is to be transferred are established before active trading begins, no neither side is hampered by ambiguity. The price for a futures contract is what's determined in the trading pit of a futures exchange.
Take the Random Length Lumber futures contract, which trades at the Chicago Mercantile Exchange (CME) as an example. The contract quantity is already determined (80,000 board feet). So is the quality of the Lumber (grade stamped Construction or Standard, Standard or Better, or #1 or #2 2X4's of random lengths from 8 feet to 20 feet).
The delivery date of the contract is already decided too. That's when the contract matures. There are six different Lumber futures contracts traded each year, each with a specified delivery date -- February, March, May, July, September and November. So when you buy a March Lumber contract, you know the contract matures in March.
The delivery points for Random Length futures contracts are also known. That means if you make or take delivery of 1 Lumber contract (equivalent to 80,00. board feet of Lumber) when the delivery date arrives, you know exactly to which warehouses you can send your truck. (For many commodities, there's a cash settlement instead of delivery of the actual commodity.)
Here's an interesting point to remember. Most people who buy and sell Random Length Lumber futures don't deliver or pick up a load of Lumber when the contract matures. They usually offset the trade and get out of the market before that point. They don't really want the Lumber. They've traded that futures contract for other reasons such as protection against rising or falling lumber prices or simply earning a profit on the trade.
Return to Questions
2. What is the futures exchange?
Futures contracts are traded at a futures exchange and only at a futures exchange. Exchanges in the U.S. are nonprofit organizations that provide a place to trade, formulate rules for trading and supervise trading practices. There are currently nine futures exchanges in the U.S.
The Clearing Function
One of the most important functions of a futures exchange is to provide a clearing operation. This operation is called the Clearing House. The Clearing House is responsible for clearing trades and for the day-to-day settlement. What does that mean? Well, the Clearing House records all the trades happening in the trading pits each day. At the end of the trading sessions, it matches or reconciles contracts bought and sold.
The Clearing House also settles the traders' accounts to the market each day. When you buy or sell a futures contract, the exchange requires you to put up a performance bond. That's a cash deposit to cover any loss your investment may incur. Money is added to your performance bond balance if your position earned a profit that day. However, if your position lost money that day, money is subtracted from the balance and you may get a call to put more money into the account. The Clearing House figures that out.
Is trading at the exchanges regulated?
Yes, the federal government and the exchange both play a role in regulation trading. Federal law started regulating futures trading in 1923. The Trade Commission Act of 1974 created the Commodity Futures Trading Commission (CFTC), an independent federal body that oversees all futures trading. The National Futures Association (NFA) was created to regulate the activities of brokerage houses and their agents. These measure guarantee the integrity of the markets.
Return to Questions
3. What contracts are traded?
In 1874 the Chicago Produce Exchange, traded in butter, eggs, poultry and other farm products. Since then the commodities traded have changed. Many products have been added and others are no longer traded.
Agricultural Commodity Futures
The first type of futures contracts is made up of agricultural futures. A few examples of modern futures contracts are Feeder Cattle, Corn, Wheat, Lean Hogs and Cotton.
Financial Futures
A number of foreign currency futures are traded at the CME. Currency futures are quoted as U.S. Dollars against the currency. That tells you the number of dollars it takes to buy one unit of foreign currency. The CBOT and the CME trade interest rate futures such as the 30 Year Bond, Eurodollars, 3 Month T-bills and 10 Year Notes to name a few.
Equity Index Futures
The third type of futures contracts is made up of equity Index futures. One example is the Standard & Poor's 500 Stock Index futures contract. The actual S&P Stock Index futures contract. The actual S&P Stock Index is based on 500 companies, about 80% of the value of all the stocks listed on the New York Stock Exchange. The CME's and CBOT's E-Mini S&P, Dow Futures and E-mini Nasdaq contracts have become very popular the last few years. People can use these indexes to trade for profit or to protect stock investments. These contracts are cash-settled and no
individual stocks are ever transferred.
As you can see from the great number and variety of contracts a lot has changed since 1874.
Return to Questions
4. How does supply and demand effect prices?
The price of agricultural commodities fluctuate, foreign exchange rates and change from minute to minute, interest rates and equity indexes rise and fall. Nothing stays the same.
Supply
Supply is defined as the quantity of a product that sellers are willing to provide to the market at a given price. When prices are high, sellers are willing to provide larger amounts of their products to the market. It's human nature. When prices are low, sellers are willing to provide smaller amounts to the market. This relationship between product supply and its price is called the law of supply.
Many economic factors can cause supply to increase or decrease, and that causes the supply curve to shift. But let's talk real life. When cattle prices are low, there's not much incentive for cattle producers to provide cattle to the market. If cattle prices rise, so does the incentive to provide more cattle. Other things can happen to affect supply. The price of fee may be low, encouraging more cattle production, or too high, causing producers to cut back on production. Each commodity has its own supply factors -- even currency, interest rate and equity
stock index products. Buy supply is only half the story.
Demand
Demand is defined as the quantity of a product that buyers are willing to purchase from the market at a give price. When prices are high, buyers are willing to buy less of the product. When prices are low, buyers are willing to buy greater quantities of the product. This relationship between product demand and its price is called the law of demand.
Many economic factors can cause demand for a product to increase or decrease, causing the demand curve to shift. You can imagine how the demand for beef can change depending on its supermarket price or how people feel about eating beef. And it's fairly easy to see how economic conditions could change the demand for credit or the demand for a foreign currency. Each commodity has its own demand factors.
And the market price"
The price of a product or a commodity depends on the relationship between supply and demand. If the supply and demand curves are placed on the same graph, the point where they intersect is the product's market price. Based on all the supply and demand factors, this is the price discovered as people buy and sell the commodity or trade futures.
Return to Questions
5. What is fundamental analysis?
Fundamental analysis is the study of the factors that effect supply and demand. The key to fundamental analysis is to gather and interpret this information and then to act before this information is incorporated into the futures prices. This lag time between an event and its resulting market response presents a trading opportunity for the fundamentalist.
Agricultural Fundamentals
For livestock, the fundamental trader studies both supply and demand. The U.S. Department of Agriculture releases several monthly and quarterly reports that supply statistics. Inflation, consumer tastes, consumption patterns and population numbers all affect the demand for meat. The fundamental trader puts all these factors into sophisticated models to try to determine where livestock prices are going.
Financial Fundamentals
As you would expect, trading financial futures calls for the study of entirely different supply and demand factors. The overall health of the economy is a key factor to watch. Economic reports such as the Leading Indicator Index, Consumer Price Index, Gross National Product and the Employment Situation are only a few of the reports providing information.
For example, changes in the economy's directions normally signals major interest rate turning points. This is obviously important to anyone trading interest rate futures such as U.S. Treasury Bonds. The demand for money rises during economic recessions, causing interest rates to fall. The fundamentalist can also study the relationship of long-term and short-term interest rates to predict the direction of interest rate movement.
Return to Questions
6. What is technical analysis?
This approach to price prediction is based on the premise that price movements follow consistent historical patterns. Those who engage in technical historical analysis study charts or statistics that measure price movements and try to find repetitive patterns. They start with the basic bar chart that plots high, low and closing prices of a futures contract over the life of the contract. Current activity is watched carefully for familiar patterns of price movement.
The up trend, downtrend and sideways patterns experienced in the past can alert a chartist to such a movement forming in the current market.
The chartist also watches daily volume numbers (the number of contracts traded each day) and open interest numbers (the number of contracts not yet offset). These numbers are used to assess the strength of a trend.
What patterns does a chartist look for?
As the days during the life of a futures contract pass, the chartist watches for price reversal patterns and price continuation patterns. That is, if prices are headed up, are they going to reverse themselves and head down? If prices are headed down, are they going to start moving up? Or will prices keep heading in the same direction?
Return to Questions
7. How do orders get processed in the pit?
A brokerage firm ("house") that is a member of one of the Futures Exchanges places orders to buy or sell futures or options contracts for companies or individuals and earns a commission on each transaction. Everyone who trades futures and options contracts must have an account with a brokerage house
Placing the Order
When you call in an order, you specify the futures contract you want to buy or sell, including the contract month. Each commodity has more than one contract, each one with a different maturity date. For example, there are four S&P 500 futures with maturity dates of March, June, September and December. So if you want June S&P's, you have to let the brokerage firm know that. You also have to say whether you're buying or selling and how many contracts you want bought or sold. Sometimes you even dictate the price.
The market order is one type of order. When you place a market order, you are asking that order to be filled at the best available price immediately after receipt of the order. You might say, "Buy 2 December Deutsche marks at the market." After the brokerage firm writes up this order, it's rushed to the floor broker in the pit who executes it right away.
If you place a limit order, you're asking the broker to fill the order at a specified price. If you say, "Buy 20 January Beans at $4.75/bu. even," the floor broker can fill the order at $4.75/bu. or any price lower, but not at a higher price. Likewise, if you say "Sell 10 January Beans at $5.35/bu. even," the floor broker can fill the order at $5.35/bu. or any price higher, but not at a lower price.
If the price you stat in your limit order isn't reached during the trading session, your order wouldn't be filled at all.
A spread trade is a specialized type of trade involving the simultaneous purchase and sale of two different but related futures contracts. The spread is the price difference between the two contracts.
Spread trading can include trading different delivery months of the same commodity or trading the same months of a different futures contracts.
Return to Questions
8. What is the trading pit?
Oh, yes. That's where it all happens. Futures contracts are traded in trading pits at Exchanges all over the world. That's where traders determine futures prices, which change from minute to minute as trading goes on.
What is trading?
In the futures industry, trading means buying and selling futures contracts. If you buy a futures contract at one price and sell it at a higher price, you make money. If you sell it at a lower price than what you paid for it, you lose money. Some people who trade futures are in it to make a profit by trading. Others are producers or users of commodities who are trading futures to protect a sale or purchase price.
The highest bid or lowest offer (the most competitive price) sets the true market value. A trader must "best" or beat that price in order to set a new "best" bid or offer. The seemingly frantic nature of the open outcry system is really about brokers and traders constantly bidding or offering prices that the market will perceive as the true value; and trades will then occur.
Hand signals, as well as vocal open outcry, relay quantity and price information between traders and brokers across the pit. As in any auction situation, a trader's action or word is a bond. With billions of dollars at stake, each action in the pits is actually a carefully recorded and executed trade agreement. Though seemingly chaotic, what you are witnessing in a futures trading pit are market professionals conducting business at lightning speed for either customer or for personal profit. In markets where prices move rapidly within short periods of time, the speed
of trade execution and timely delivery of orders to customers is essential.
Return to Questions
9. Who's who in and around the trading pit?
All the traders in the pits are members of the exchange. They may be private speculators who trade for their own profit. Or they may be floor brokers who act as agents for customers or brokerage firms.
Dividing the trading floors into sections are rows or workstations or desks. This is where orders are called into the brokerage firms from customers.
Different colored jackets help to identify all the people on the trading floor. Here's how the CME identifies who's who:
Red jackets are worn by members or brokers who trade in the pits. A floor broker refers to an Exchange member who executes orders for the accounts of one or more clearing member and their customers. A local or floor trader is a member who executes trades for his own account or for a clearing firm account.
Runners and phone clerks wear gold jackets. They are employees of the brokerage firm members or individual members. A runner's responsibility is to get the customer's order to the appropriate broker in the correct pit as soon as possible. Filled orders need to also be returned to the firm's desk for confirmation to the customer. The runner's job is an important one because it provides the vital link between the customer and the execution of his order by the broker in the trading pit.
Out-trade clerks wear pale green jackets. They are employees of the brokerage firms and CME members. They're responsible for helping to resolve discrepancies in trades from the previous day each morning before the start of regular trading hours.
Market reporters wear light blue jackets. A market reporter is a trained pit observer employed by the exchange. They are responsible for reporting the prices of pit transactions and entering the information into the computerized price reporting system. This price information is then displayed on the price quotation boards on the trading floor and transmitted to investors and brokers around the world via wire services and quotation vendors.
Return to Questions
10. What is Risk Management?
The exchange provides and regulates a marketplace where futures and options on futures are traded. The Exchange clears, settles and guarantees all matched transactions in contracts occurring through its facilities. Furthermore, it establishes and monitors financial requirements for clearing members and sets minimum "performance bond" levels for all products. The financial integrity of the marketplace is foremost consideration of the Exchange's Board of Directors and management.
Risk management and financial surveillance are the two primary functions of the financial safeguard system. The system is designed to provide the highest level of safety and early detection of unsound financial practice on the part of any clearing member. The system is constantly being updated to reflect the most advanced risk management and financial surveillance techniques.
The Clearing House is an operating division of the Exchange, and all rights, obligations and/or liabilities of the Clearing House are rights, obligations and/or liabilities of the Exchange.
The Safeguards - The techniques employed by the exchanges are comprehensive and specifically designed to:
- Prevent accumulation of losses
- Ensure that sufficient resources are available to cover future obligations
- Result in the prompt detection of financial and operational weaknesses
- Allow swift and appropriate action to be taken to rectify any financial problems and protect the clearing system
Performance Bonds - The Exchange establishes minimum initial and maintenance performance bond levels for all products traded through its facilities. The Exchange bases these requirements on historical price volatilities, current and anticipated market conditions, and other relevant information. Levels vary by product and are adjusted to reflect change in price volatility and other factors. Both initial and maintenance performance bonds are good faith deposits to guarantee performance on futures and options contracts. Should performance bonds on deposit at the
customer level fall below the maintenance level, Exchange rules require that the account be re-margined at the required initial performance bond level.
Return to Questions
11. What is the role of the speculators and the hedgers?
Speculators are people who analyze and forecast futures price movement, trading contracts with the hope of making a profit. Speculators put their money at risk and must be prepared to accept outright losses in the futures market.
Are there different kinds of speculators?
Often times, speculators specialize in particular commodities. For example, a private speculator may specialize in Sugar and trade only in the Sugar pit day after day. Each speculator will trade according to his or her own style. Some traders are scalpers who buy and sell futures contracts quickly when prices move only a fraction of a cent. Others are day traders who will buy and sell throughout the day, closing their position before the session ends. Others are position traders who may hold their positions for days, weeks or months at a time.
Of course, speculators don't have to be Exchange members. There are thousands of individuals who trade speculatively through brokerage firms.
The role of the speculator
Speculators enter the futures market when they anticipate prices are going to change. While they put their money at risk, they won't do so without first trying to determine to the best of their ability whether prices are moving up or down.
Speculators enter the futures market when they anticipate prices are going to change. While they put their money at risk, they won't do so without first trying to determine to the best of their ability whether prices are moving up or down.
Speculators analyze the market and forecast futures price movement as best they can. They may engage in the study of the external events that affect price movement or apply historical price movement patterns to the current market. In any case, the smart speculator doesn't operate blind.
A speculator who anticipates upward price movement would want to take advantage by buying futures contracts.
If predictions are correct, then the contracts can be sold later at a profit. If it's expected that prices were going to move downward, the speculator would want to sell now and, if all goes as planned, buy back later at a lower price.
Hedger vs. Speculator
All people who trade futures contracts are not speculators. People who buy and sell the actual commodities can use the futures markets to protect themselves from commodity prices that move against them. They're called hedgers.
The Hedgers
There's a futures contract for a commodity or financial product because there are people who conduct an active business in that commodity. For example, there's a Lumber futures contract because there are lumber producers who sell lumber and companies that buy lumber. The hedger plans to buy (sell) a commodity, such as lumber or live cattle, and buys (sells) a futures contract to lock in a price and protect against rising (falling) prices.
Hedging
The producers and users of commodities who use the futures market are called hedgers. Buying and selling futures as a risk management toll is called hedging.
Commodity prices in the cash markets have a fundamental relationship to the futures prices. When the forces of supply and demand shift and drive prices up and down in the cash markets, futures prices tend to rise and fall in parallel fashion. So, for example, if soybean prices in the cash markets started to rise, the soybean futures would start to rise in roughly the same way. But not exactly. They don't tend to move in exact amounts. Hedgers take advantages of this relationship between cash and futures prices.
Hedging in buying and selling futures contracts as a temporary substitute for buying or selling the commodity at a later date in the cash market. We'll show how that works.
Here's how hedging works. Let's take a look at the meat packer. Suppose a meat packer needs to buy cattle in October. Today's cash price is okay, but what if prices rise? The meat packer can lock in a price on the cattle today, just in case the cash prices do go up between now and October. Protecting an October purchase price can be done by buying October Live Cattle futures contracts. This is called a long hedge.
Who are hedgers?
Well, you know about meat packers. Others are commercial firms or individuals whose businesses concern the same or similar commodities that are traded on the futures markets. They're both U.S. and international firms, including banks, corporations, pension funds, exporters and importers who need to protect against foreign currency fluctuation, food processors and a great variety of other businesses.
Return to Questions
12. What are options on futures?
Options on futures were introduced in the 1980s. An option contract allows you the rights, but not the obligation, to buy or sell an underlying futures contract at a particular price.
Say that again!
An option is the right, but not the obligation, to buy or sell an underlying futures contract at a specified price. For example, you could purchase an option to buy a November Swiss franc futures contract at $0.88 per Swiss Franc (an option to buy is a call option).
What do you do once you buy the Swiss franc option? You watch price movement. Suppose that November Swiss Franc futures price rises above $0.88. You could exercise the option and assume a long November Swiss Franc futures contract. You would have bought a futures contract at $0.88 that you could sell immediately at the higher price (buy low, sell high). But you don't have to. With prices above $0.88, your option would have increased in value, so you could choose to offset it by selling back the same option at a profit. If the futures price falls
below $0.88, the option would have decreased in value. Then you can simply forget about it and let it expire, losing the money you paid for it.
Puts and calls: There are special names for options depending on whether the option is for the right to buy or sell a futures contract. A put option is the right, but not the obligation, to sell a futures contract at a particular price. A call option is the right, but not the obligation, to buy a futures contract at a particular price. These terms originated from the concept of putting a commodity on the market (selling) and calling a commodity from the market (buying).
Options Trading
In options trading, the buyer has the right, the seller has the obligation. An option buyer purchases the right, but not the obligation, to buy or sell the underlying futures contract at a specified price. For every option bought someone has to sell that option.
Options on futures contracts were first traded in October of 1982 when the Chicago Board of Trade (CBOT) began trading options on T-bond futures. Soon after, the Chicago Mercantile Exchange (CME) opened its Index and Options Market (IOM) division, which offered options on stock index futures, Eurodollar futures, and T-bill futures.
What options are traded?
Today at the U.S. exchanges, options are available on a great variety of futures contracts. These include the following commodity groups: Agricultural commodities, foreign currencies, interest rate products, equity indices, energy products, and metals. More options are traded on interest rate futures than any other category.
Chicago's Role
As with futures trading, most of the options on futures contracts traded in the U.S. occur on the Chicago futures exchanges. The CBOT and CME trade over 80% of all options traded in the country. Almost 15% are traded at New York exchanges.
Return to Questions
*Past performance is not necessarily indicative of future results. Trading futures and options involves substantial risk of loss and is not suitable for all investors.
|