Futures trading is a complex yet potentially lucrative field within the broader financial markets. This guide aims to provide investors with a thorough understanding of what futures trading entails, the key technical aspects, examples, compliance requirements, regulatory landscape, and the various types of markets traded. Whether you are new to futures trading or looking to deepen your knowledge, this comprehensive overview will equip you with the essential information needed to navigate this dynamic market.
What Are Futures?
Futures are standardized legal agreements to buy or sell a specific commodity or financial instrument at a predetermined price at a specified time in the future. These contracts are traded on futures exchanges, which standardize the quantity and quality of the underlying asset.
I. Disclaimer
The material contained on this page is intended solely to help give an introduction to futures trading and in no way should be taken as futures trading advice or recommendations. We strongly encourage you to seek out further information about commodities trading from your broker or advisor, the U.S. Commodity Futures Trading Commission (CFTC), and the National Futures Association (NFA). Both the CFTC and the NFA host a variety of excellent commodities trading educational materials on their websites, some of which we have included in our own futures trading educational section for your convenience.
Key Concepts in Futures Trading
1. Futures Contracts
A futures contract is the fundamental unit of futures trading. Each contract stipulates:
• The Underlying Asset: This can be a physical commodity like oil, gold, or wheat, or a financial instrument like a currency, interest rate, or stock index.
• Quantity and Quality: Standardized amounts and specifications of the asset.
• Delivery Date: The date when the contract expires.
• Price: Agreed upon by the buyer and seller.
2. Long and Short Positions
• Long Position: An agreement to buy the underlying asset at a future date.
• Short Position: An agreement to sell the underlying asset at a future date.
3. Leverage and Margin
Futures trading often involves leverage, where a trader only needs to deposit a fraction of the total contract value (initial margin) to enter into a trade. Maintenance margin must be maintained to keep the position open.
How Futures Trading Works
Futures trading involves several key steps and concepts:
The terms commodities trading and futures trading are loosely used interchangeably.
Futures contracts are exchange-traded derivatives, so each exchange has a clearinghouse that acts as a counter-party on all contracts, sets margin requirements, and provides a mechanism for settlement.
As a counterparty on all contracts, the exchange acts as the buyer to every seller and the seller to every buyer, which minimizes the counter-party risk to traders. Thus, the clearinghouse assumes the default risk.
• Order Placement: Traders place orders to buy or sell futures contracts through brokers.
• Clearinghouse: Acts as the counterparty to both sides of the trade, reducing counterparty risk.
• Settlement: Can be either physical delivery of the asset or cash settlement.
Commodities Trading Margin Requirements / Performance Bond
Futures contracts are often traded on margin, meaning only a small percentage of the total cost is actually put forth initially by the trader. Margin requirements are the amount of collateral that a trader has to post to minimize the risk of them defaulting. The collateral is deposited into a margin account.
• Initial Margin: Set by the exchange and is the initial equity required to enter into a futures contract.
• Customer Margin: Set by FCM and IB, determined by market risk and the value of the contract.
• Maintenance Margin: The part of the “Good Faith” Initial margin deposit above that must be “Maintained” during marked to market price moves. Maintenance margin is typically the initial requirement assigned to bona fide Hedge accounts and must also be maintained. Maintenance margin is set by the exchange and the exchange adds 10% to arrive at the initial margin requirement for retail accounts.
• Margin Calls: Margin calls occur when the value of the original margin is eroded, and the broker requests additional capital to restore the amount of the initial margin. While these types of calls are usually made on a daily basis, periods of high volatility may require intraday margin calls. If the margin call is not paid on the same day, the broker has the right to close the position to meet the amount called, in which case the client is liable for any resulting deficiency in their account.
2. Example of a Futures Trade
Suppose a trader believes that the price of crude oil will rise in the future. They can enter into a long position by buying a crude oil futures contract at the current price. If the price of crude oil rises as anticipated, the trader can sell the contract at the higher price, realizing a profit.
Types of Markets Traded
1. Commodities Markets
Includes physical commodities like:
• Energy: Crude oil, natural gas
• Metals: Gold, silver, copper
• Agriculture: Wheat, corn, soybeans
2. Financial Markets
Includes financial instruments like:
• Currencies: USD, EUR, JPY
• Interest Rates: U.S. Treasury Bills
• Stock Indexes: S&P 500, NASDAQ
Compliance and Regulation
1. Regulatory Bodies
• Commodity Futures Trading Commission (CFTC): The primary regulator of U.S. futures markets, ensuring market integrity and protecting investors from fraud and manipulation.
• National Futures Association (NFA): A self-regulatory organization overseeing the practices of futures professionals.
2. Compliance Requirements
Futures traders and firms must adhere to strict regulatory requirements, including:
• Registration: Firms and individuals must register with the CFTC and NFA.
• Reporting: Regular reporting of trading activities and positions.
• Disclosure: Providing clients with comprehensive risk disclosure statements.
The Purpose of the Futures Market
The futures market serves several key purposes:
• Hedging: Allows businesses to hedge against price fluctuations in commodities they use or produce.
• Speculation: Provides opportunities for traders to profit from price movements.
• Price Discovery: Facilitates the discovery of future prices through the interaction of supply and demand.
Futures trading is a sophisticated investment activity requiring a solid understanding of market mechanics, compliance requirements, and regulatory oversight. By grasping the fundamentals of futures contracts, market processes, and the roles of key regulatory bodies, investors can better navigate the complexities of futures trading. Whether used for hedging or speculation, the futures market offers unique opportunities and challenges that can be mastered with knowledge and experience.
*Futures Trading is risky and not suitable for everyone.
