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Basics of Futures Trading

  • A commodity futures contract is an agreement to buy or sell a particular commodity at a future date
  • The price and the amount of the commodity are fixed at the time of the agreement
  • Most contracts contemplate that the agreement will be fulfilled by actual delivery of the commodity
  • Some contracts allow cash settlement in lieu of delivery
  • Most contracts are liquidated before the delivery date
  • A commodity futures option gives the purchaser the right to buy or sell a particular futures contract at a future date for a particular price

Typical Users of the Futures Markets

  • Most participants in the futures markets are commercial or institutional commodities producers or consumers
  • Most participants are “hedgers” who trade futures to maximize the value of their assets, and to reduce the risk of financial losses from price changes
  • Other participants are “speculators” who attempt to profit from price changes in futures contracts

Understanding the Basics

A futures contract is quite literally how it sounds. It’s a financial instrument-also known as a derivative-that is a contract between two parties that agree to transact a security or commodity at a fixed price at a set date in the future. It is a contract for a future transaction, which we know simply as “futures.” The vast majority of futures do not actually result in the delivery of the underlying security or commodity. Most futures transactions are purely speculative, so it’s an opportunity to profit or hedge risks, and not usually used to take delivery of the physical good or security for most traders.

There are many types of futures contract to trade. They include:

  • Interest Rates
  • Metals
  • Currency
  • Grains
  • Stock Index
  • Energy
  • Softs
  • Forest
  • Livestock

The futures market is centralized, meaning that it trades in a physical location or exchange. There are several exchanges, such as The Chicago Board of Trade and the Mercantile Exchange. Traders on futures exchange floors trade in “pits,” which are enclosed places designated for each futures contract. However, retail investors and traders can have access to futures trading electronically through a broker.

Trading Futures

Some things to consider before trading futures:

Leverage:

Control a large investment with a relatively small amount of money. This allows for strong potential returns, but you should be aware that it can also result in significant losses.

Diversification:

Access a wide array of investments including oil and energy, gold and other metals, interest rates, indexes, grains, livestock, and more.

After Hours Market:

Futures markets trade at many different times of the day. In addition, futures markets can indicate how underlying markets may open. For example, stock index futures will likely tell traders whether the stock market may open up or down.

Liquidity:

The futures market is very active with a large amount of trading, especially in the high volume contracts. This makes it’s easier to get in and out of trades. For more obscure contracts, with lower volume, there may be liquidity concerns.

Hedging:

If you have an existing position in a commodity or stock, you can use a future contract to protect unrealized profit or minimize a loss. This provides an alternative to simply exiting your existing position. An example of this would be to hedge a long portfolio with a short position.