Futures Trading 
An Introduction To The World Of Future Trading
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Futures Trading  - Futures Contracts

Before we start to look at what constitutes a futures contract it is important to understand that futures trading is unlike any other market, in that many of the underlying assets being traded, are real, and in many cases, living or growing. The reason this is so important is simple to understand, once we stop and think a little. Put simply it is this  - as speculators or traders we now have to consider how the laws of supply and demand will affect the underlying assets on which we are speculating. There are very few other markets, where this occurs. 

Futures Trading - Supply & Demand

futures trading online worldI make no apology for the following example which I hope will make you realise that to be successful in trading futures, in anything other than the financial products, you are actually going to have to think, and read and broaden your outlook on the world in general. Put simply, if you are proposing to trade in grain futures, then you will have to become an expert in all the elements ( both natural and man made ) that may affect grain prices worldwide. More importantly, you will have to think laterally, and how one event can trigger a series of actions or events elsewhere. Let me give you a recent example which has nothing to do with the futures market, but everything to do with events, and unforeseen outcomes.

As I'm sure you know, construction work in Dubai is well under way building two of the largest and most challenging construction projects ever seen, The World and The Palm. Now bear in mind that this is construction is on a massive scale - what do you think would be the engineers biggest problem? - probably something you would never think of - the cost and availability of spare parts for the massive earth moving equipment! In running two such large projects simultaneously, and in order to meet the strict project deadlines, the entire world's supply of giant earth moving equipment was now working flat out 24 hours a day - something it had never been designed to do. With constant breakdowns, increasing demand and lack of availability, prices for basic components doubled then quadrupled. The manufacturers could quote whatever prices they liked for the parts, knowing that the market would have no choice but to buy.

Once the projects near completion, prices will no doubt fall again, and the market will settle back to its previous state. It's all to do with supply and demand! As a futures trader or speculator, this is how you will have to think - laterally.

Futures Trading - The Contract

OK - so what is a futures contract - let's say for example that you decide to subscribe to a magazine for a year. As the buyer you enter into an agreement with the publisher, that over the next twelve months you will receive a new publication every month, for the next 12 months, at a fixed price. This contract between you and the publisher is like a futures contract.

The buyer and seller have fixed the prices for different reasons. The buyer fixes the price to avoid the risk of higher prices later, the seller fixes the prices to guarantee a customer for his or her product. Both parties know the terms of the contract, which involve the production and delivery of a clearly specified product, at a fixed price,  at a fixed time. This in simple terms is the essence of a futures contract. In the futures commodity market it might be a grain merchant trying to fix the price for 6000 bushels of corn from the farmer, and for delivery in three months time. Now clearly, in order to have a meaningful and transferable market, we cannot have suppliers deciding on the quantity or quality of goods or services, so everything is specified as follows :

Now, you may have come across the term a 'zero sum game' which you might find confusing. What it means is simply this - in the futures market, each contract is between a buyer on one side and a seller on the other,  so dollars lost on one side of the contract are gained on the other. In other words the balance of risk is entirely symmetrical - it is just like a see-saw. If one goes down the other goes up, and visa versa, so risk is equal and unlimited on either side. Finally, unlike the options market where as a buyer we have a right, but no obligation, in the futures market, the futures contract represents an obligation for the seller to deliver, and for the buyer to pay and accept delivery. So to arrive at a definition we have the following :

A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of, and payment for, a commodity, bond, currency, or stock index, at a specified price, on a specified future date.

Future Trading - Derivatives

Now one of the terms you will hear a great deal in the futures and options market is the word derivative. All this means is that the contract is "derived" from an underlying asset. In order words the prices derive from the price movement of the underlying asset specified in the contract. So in an equity option, the underlying asset is the stock or share, and in futures trading of a pork belly contract, it would be the underlying pork bellies!

Futures Trading - Closing  A Contract

Finally, do you remember I mentioned about the possibility of physical delivery. Well according to the CBOT exchange, approximately 3% of contracts traded involve physical delivery of the contract on the settlement date. This is fine if you are the grain trader buying for the wholesale market, but not so good if you are a speculator who has forgotten to close the position. 

Every futures contract has a last day of trading, and all open positions must be closed out. This is done by making an offsetting futures trade to close. So if you have bought a futures contract to open, you must sell an identical futures contract back to close. Conversely if you have sold a contract to open the trade, then you must buy an identical contract back to close. Where the contract does not involve physical delivery, for example bonds, currency, indices etc, then the contract can be left alone, and the exchange will make a 'mark to market' settlement adjustment to close the position.

So if you plan to trade commodity futures, make sure you manage your trades with care, otherwise you might end up with more than you bargained for!

OK, so now we have some idea of what a futures contract is, let's see how the futures trading market works on a day to day basis.

 

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