Futures trading is the activity of buying and selling futures contracts on futures exchanges. Unlike a stock, which represents equity in a company that can be held for a long time, if not indefinitely, futures contracts have finite lives. They provide an economic function for users and producers of commodities and financial instruments, and can be and are used for hedging (protection) purposes. The word “contract” applies because you are not trading the actual commodity but rather a contract that requires delivery of the commodity in a stated month in the future unless the trade is liquidated before it expires.
The buyer of the futures contract (the party with a long position) agrees on a fixed purchase price to buy the underlying commodity (wheat, gold or treasury bonds, for example) from the seller at the expiration of the contract.
The seller of the futures contract (the party with a short position) agrees to sell the underlying commodity to the buyer at expiration at a fixed sale price. As time passes, the contract’s price changes relative to the fixed price at the time the trade was initiated. This creates profits or losses for the trader.
Price movement creates opportunity accompanied with risk for speculators looking to enter into the futures market either going long (which is initially buying) or going short (which is initially selling) futures contracts.
In most cases, delivery never takes place. Instead, both the buyer and the seller, acting independently of each other, usually liquidate their long and short positions before the contract expires; the buyer sells futures and the seller buys futures. Hedgers may on rare occasion intend on taking delivery. A speculator does not intend to take delivery.
When profits are obtained for the speculator by going long (buying) at a price that is lower than the selling price, the phrase is “buy low, sell high”. On the other hand the speculator may do the opposite and trade what is called the short side of the market. This simply means that the sell order (the short position) is established first and the offset, which is a buy, will be accomplished later. However, in either case profits are achieved only if the buy price is lower than the sell price. For short sellers it simply means that they are entering the market selling first and buying to offset at a later time. You can see that it doesn’t matter which comes first the buy or the sell, it is simply has to be that the buy price is lower that the sell price to accomplish a profit. If the opposite is done the result will be a loss.
As said earlier, trading or investing in futures is different than trading or investing in stock. Besides the differences listed earlier, the trader’s financial obligation is different. Stocks, in general, you pay for the stock you bought. You then own the stock. You have no further obligation. If you buy stocks on margin you are actually paying for the stock by taking a loan from the broker to pay for the stock.
Usually the investor takes a loan in the amount of one third to two thirds of the value of the stock and pays for the balance with funds he already has on deposit with the brokerage firm. In futures, the trader does not “pay for” any commodity. Rather the margin requirement is established for the purpose of the trader “making good” on any losses that occur when trading. A better term than margin is a “good faith deposit” or “performance bond”. The funds for a performance bond is placed on account from which commission costs and losses from trading are to be deducted and profits to be added. Margin criteria is established by the exchanges on which the contracts are traded. The amount of margin requirement is relative for the general risk involved with each contract.
A margin call is issued when and if the margin account balance drops below the required level for the contracts that are held overnight. Day trading (entering and exiting a trade on the same day) requires less margin.
The clearing firm is responsible for maintaining and collecting margin deposits. If a margin call is issued, the account holder is to deposit the required funds in a timely manner (usually sent the day the call is received). Should the funds not be received in a timely manner, the account is subject to liquidation without the client’s consent.
For speculators, futures have important advantages over other investments:
- If the trader’s judgment is good, he can generally speaking make more money in the futures market faster because of the high leverage available and because futures prices tend, on average, to change more quickly that real estate or stock prices. On the other hand, bad trading judgment in futures markets can cause greater losses than might be the case with other investments.
- Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10% – 15% and sometimes less) as margin, yet he can make a profit or incur a loss on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place. (Compare this to stock investor who generally has to put up at least 50% of the value of his stocks.) Moreover the commodity futures investor is not charged interest on the difference between the margin and the full contract value. (More on margins later).
- In general, futures are harder to trade on inside information. After all, who can have the inside scoop on the weather or an accurate assessment of world supply and demand information. The open outcry method of trading whether in a trading pit or via a computer–as opposed to a specialist system–insures a very public, fair and efficient market.
- Commission charges on futures trades are small compared to many other investments, and the investor pays them only when a trade is transacted.
- Most commodity/futures markets are very broad and liquid. Transactions can be completed quickly, lowering the risk of adverse market moves between the time of the decision to trade and the trade’s execution.