What is Futures Trading?
Futures Trading is a form of investment which involves speculating on the price of a
commodity going up or down in the future.
What is a commodity? Most commodities you see and use every day of your life:
the corn in your morning cereal which you have for breakfast,
the lumber that makes your breakfast-table and chairs
the gold on your watch and jewelry,
the cotton that makes your clothes,
the steel which makes your motor car and the crude oil which runs it and takes
you to work,
the wheat that makes the bread in your lunchtime sandwiches
the beef and potatoes you eat for lunch,
the currency you use to buy all these things…
… All these commodities (and dozens more) are traded between hundreds-of-thousands of
investors, every day, all over the world. They are all trying to make a profit by buying a
commodity at a low price and selling at a higher price.
Futures trading is mainly speculative ‘paper’ investing, i.e. it is rare for the investors to
actually hold the physical commodity, just a piece of paper known as a futures
What is a Futures Contract?
To the uninitiated, the term contract can be a little off-putting but it is mainly used
because, like a contract, a futures investment has an expiration date. You don’t have to
hold the contract until it expires. You can cancel it anytime you like. In fact, many
short-term traders only hold their contracts for a few hours – or even minutes!
The expiration dates vary between commodities, and you have to choose which contract
fits your market objective.
For example, today is June 30th and you think Gold will rise in price until mid-August. The
Gold contracts available are February, April, June, August, October and December. As it is
the end of June and this contract has already expired, you would probably choose the
August or October Gold contract.
The nearer (to expiration) contracts are usually more liquid, i.e. there are more traders
trading them. Therefore, prices are more true and less likely to jump from one extreme to
the other. But if you thought the price of gold would rise until September, you would choose
a further-out contract (October in this case) – a September contract doesn’t exist.
Neither is there a limit on the number of contracts you can trade (within reason – there must
be enough buyers or sellers to trade with you.) Many larger traders/investment
companies/banks, etc. may trade thousands of contracts at a time!
All futures contracts are standardized in that they all hold a specified amount and
quality of a commodity. For example, a Pork Bellies futures contract (PB) holds 40,000lbs
of pork bellies of a certain size; a Gold futures contract (GC) holds 100 troy ounces of 24
carat gold; and a Crude Oil futures contract holds 1000 barrels of crude oil of a certain
A Short History of Futures Trading
Before Futures Trading came about, any producer of a commodity (e.g. a farmer growing
wheat or corn) found himself at the mercy of a dealer when it came to selling his
product. The system needed to be legalized in order that a specified amount and quality
of product could be traded between producers and dealers at a specified date.
Contracts were drawn up between the two parties specifying a certain amount and
quality of a commodity that would be delivered in a particular month…
…Futures trading had begun!
In 1878, a central dealing facility was opened in Chicago, USA where farmers and dealers
could deal in ‘spot’ grain, i.e., immediately deliver their wheat crop for a cash settlement.
Futures trading evolved as farmers and dealers committed to buying and selling future
exchanges of the commodity. For example, a dealer would agree to buy 5,000 bushels of a
specified quality of wheat from the farmer in June the following year, for a specified price.
The farmer knew how much he would be paid in advance, and the dealer knew his costs.
Until twenty years ago, futures markets consisted of only a few farm products, but now
they have been joined by a huge number of tradable ‘commodities’. As well as metals like
gold, silver and platinum; livestock like pork bellies and cattle; energies like crude oil and
natural gas; foodstuffs like coffee and orange juice; and industrials like lumber and cotton,
modern futures markets include a wide range of interest-rate instruments, currencies,
stocks and other indices such as the Dow Jones, Nasdaq and S&P 500.
Who Trades Futures?
It didn’t take long for businessmen to realize the lucrative investment opportunities
available in these markets. They didn’t have to buy or sell the ACTUAL commodity (wheat or
corn, etc.), just the paper-contract that held the commodity. As long as they exited the
contract before the delivery date, the investment would be purely a paper one. This was
the start of futures trading speculation and investment, and today, around 97% of futures
trading is done by speculators.
There are two main types of Futures trader: ‘hedgers’ and ‘speculators’.
A hedger is a producer of the commodity (e.g. a farmer, an oil company, a mining
company) who trades a futures contract to protect himself from future price changes in his
For example, if a farmer thinks the price of wheat is going to fall by harvest time, he can
sell a futures contract in wheat. (You can enter a trade by selling a futures contract
first, and then exit the trade later by buying it.) That way, if the cash price of wheat does
fall by harvest time, costing the farmer money, he will make back the cash-loss by profiting
on the short-sale of the futures contract. He ‘sold’ at a high price and exited the
contract by ‘buying’ at a lower price a few months later, therefore making a profit on
the futures trade.
Other hedgers of futures contracts include banks, insurance companies and pension fund
companies who use futures to hedge against any fluctuations in the cash price of their
products at future dates.
Speculators include independent floor traders and private investors. Usually, they don’t
have any connection with the cash commodity and simply try to (a) make a profit buying a
futures contract they expect to rise in price or (b) sell a futures contract they expect to
fall in price.
In other words, they invest in futures in the same way they might invest in stocks and
shares – by buying at a low price and selling at a higher price.
The Advantages of Trading Futures
Trading futures contracts have several advantages over other investments:
1. Futures are highly leveraged investments. To ‘own’ a futures
contract an investor only has to put up a small fraction of the value of the
contract (usually around 10%) as ‘margin’. In other words, the investor
can trade a much larger amount of the commodity than if he bought it
outright, so if he has predicted the market movement correctly, his
profits will be multiplied (ten-fold on a 10% deposit). This is an
excellent return compared to buying a physical commodity like gold bars,
coins or mining stocks.
The margin required to hold a futures contract is not a down payment but
a form of security bond. If the market goes against the trader’s position,
he may lose some, all, or possibly more than the margin he has put up. But
if the market goes with the trader’s position, he makes a profit and he gets
his margin back.
For example, say you believe gold in undervalued and you think prices will
rise. You have $3000 to invest – enough to purchase:
10 ounces of gold (at $300/ounce),
or 100 shares in a mining company (priced at $30 each),
or enough margin to cover 2 futures contracts. (Each Gold futures
contract holds 100 ounces of gold, which is effectively what you
‘own’ and are speculating with. One-hundred ounces multiplied by
three-hundred dollars equals a value of $30,000 per contract. You
have enough to cover two contracts and therefore speculate with
$60,000 of gold!)
Two months later, gold has rocketed 20%. Your 10 ounces of gold and
your company shares would now be worth $3600 – a $600 profit; 20% of
$3000. But your futures contracts are now worth a staggering $72,000 –
20% up on $60,000.
Instead of a measly $600 profit, you’ve made a massive
2. Speculating with futures contracts is basically a paper investment.
You don’t have to literally store 3 tons of gold in your garden shed, 15,000
liters of orange juice in your driveway, or have 500 live hogs running
around your back garden!
The actual commodity being traded in the contract is only exchanged on
the rare occasions when delivery of the contract takes place (i.e. between
producers and dealers – the ‘hedgers’ mentioned earlier on). In the case of
a speculator (such as yourself), a futures trade is purely a paper
transaction and the term ‘contract’ is only used mainly because of the
expiration date being similar to a ‘contract’.
3. An investor can make money more quickly on a futures
trade. Firstly, because he is trading with around ten-times as much of the
commodity secured with his margin, and secondly, because futures markets
tend to move more quickly than cash markets. (Similarly, an investor can
lose money more quickly if his judgment is incorrect, although losses can
be minimized with Stop-Loss Orders. My trading method specializes in
placing stop-loss orders to maximum effect.)
4. Futures trading markets are usually fairer than other
markets (like stocks and shares) because it is harder to get ‘inside
information’. The open out-cry trading pits — lots of men in yellow
jackets waving their hands in the air shouting “Buy! Buy!” or “Sell! Sell!” —
offers a very public, efficient market place. Also, any official market
reports are released at the end of a trading session so everyone has a
chance to take them into account before trading begins again the following
5. Most futures markets are very liquid, i.e. there are huge amounts
of contracts traded every day. This ensures that market orders can be
placed very quickly as there are always buyers and sellers of a commodity.
For this reason, it is unusual for prices to suddenly jump to a completely
different level, especially on the nearer contracts (those which will expire
in the next few weeks or months).
6. Commission charges are small compared to other investments and
are paid after the position has ended.
Commissions vary widely depending on the level of service given by the
broker. Online trading commissions can be as low as $5 per side. Full
service brokers who can advise on positions can be around $40-$50 per
trade. Managed trading commissions, where a broker controls entering and
exiting positions at his discretion, can be up to $200 per trade.
Important risk warning: There is risk of loss trading futures.
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What is Futures Trading?