Futures Trading Basics

A futures contract is a standardized exchange-traded agreement with obligations for both buyer and seller. Depending on the product, final settlement involves physical delivery or a cash calculation. Futures resemble forwards in fixing a future price relationship, but exchange trading, clearing and margin mechanics differ.

Futures contracts are traded in futures exchanges worldwide and covers a wide range of commodities such as agriculture produce, livestock, energy, metals and financial products such as market indices, interest rates and currencies.

Why Trade Futures?

The primary purpose of the futures market is to allow those who wish to manage price risk (the hedgers) to transfer that risk to those who are willing to take that risk (the speculators) in return for an opportunity to profit.

Hedging

Businesses employ a long hedge to offset rising purchase costs and a short hedge to offset falling selling prices. The net effective price depends on quantities, timing and the relationship between local cash and futures prices; it is not automatically fixed exactly.

Speculation

Speculators accept price exposure in pursuit of profits without necessarily having the matching physical business exposure. Their orders can contribute liquidity and price discovery, but that does not guarantee lower volatility or a profit for the speculator.

Futures speculators take up a long futures position when they believe that the price of the underlying will rise. They take up a short futures position when they believe that the price of the underlying will fall.

Example of a Futures Trade

For a hypothetical historical example, in March a speculator buys one May soybean future at $9.60 per bushel. Assume 5,000 bushels per contract and $3,500 initial margin. The margin is collateral held through the brokerage and clearing system, not the full contract value or a maximum-loss limit. These inputs are not current quotes or margin requirements.

Come May, the price of soybeans has gone up to $10 per bushel. Since the price has gone up by $0.40 per bushel, the speculator can exit his futures position with a profit of $0.40 x 5000 bushels = $2000.

If the price instead falls from $9.60 to $9.20, the same 5,000-bushel exposure loses $2,000 before costs. Daily mark-to-market and changing margin requirements can create funding needs before the intended exit. Fees, slippage and financing are excluded from both examples.