Futures Trading Terms
Futures trades take place at any of a number of centralized exchanges, often in open-outcry auction-style trading pits, but electronic trade-matching platforms (such as the Chicago Mercantile Exchange’s Globex system, for example), are growing in importance every year. In every transaction, the exchange clearinghouse is substituted as the buyer to the seller and the seller to the buyer, thereby guaranteeing performance and eliminating counter party risk.
Buying a futures contract is called taking a “long” position. Selling a futures contract is referred to as taking a “short” position. A long futures position profits when the futures price goes up, and a short futures position profits when the futures price goes down. Maturing futures contracts expire on specific dates, usually during the contract month. At any time before the contract matures, the trader may offset, or close out, his or her obligation by selling what was previously bought or buying what was previously sold
Hedgers and Speculators
Futures market participants may be divided into two broad categories: Hedgers, who actually deal in the underlying commodity or financial instrument and seek to protect themselves against adverse price fluctuations, and speculators (including professional floor traders), who seek to profit from price swings. The futures markets exist to facilitate the management of risk and are thus used extensively by hedgers – individuals or businesses who have exposure to the price of an agricultural commodity, or currency, or interest rates and take futures positions designed to mitigate their risks. This requires the hedger to take a futures position opposite to that of his or her position in the actual commodity or financial instrument.
Speculators or day-trader are attracted to futures trading because they see the opportunity to profit from price swing in instruments. Speculators take advantage of the fact that the futures markets offer them access to price movements; the ability to offset their obligations prior to delivery; high leverage (low margin requirements); low transaction costs; and ease of assuming short as well as long positions. In pursuit of trading profits, speculators willingly take risks that hedgers wish to transfer. In this process, speculators provide the liquidity that assures low transaction costs and reliable price discovery, market characteristics that, in turn, make futures markets attractive to hedgers.
Customers who trade futures are required to post margin deposits with an exchange member firm, which, in turn, must deposit margin with the exchange. Margins are not payment against the market value of the instrument, but rather, are a performance bond — a good-faith deposit — to ensure the ability of market participants to honor their financial commitments. To minimize this risk, the exchange demands that contract owners post a form of collateral, known as margin. The amount of margin changes each day, involving movements of cash handled by the exchange’s clearing house.
Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day’s trading.
Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. Maintenance margin is the minimum amount of equity that must be maintained in a margin account to ensure against default, i.e. minimum good faith deposit.
In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay (deposit into your margin account). It is said that in the futures market, more than any other form of investment, price changes are highly leveraged; meaning a small change in a futures price can translate into a huge gain or loss.
Delivery is the act of actually delivering (for sales) or accepting delivery (for purchases) of the underlying contract after trading has ceased.
There are two main methods of delivery:
Cash delivery—settling against an agreed reference rate such as the closing value of a stock index.
Physical delivery—where the amount specified of the underlying asset of the contract is delivered by a seller of the contract to the exchange, and by the exchange to buyers of the contract.
There are many different kinds of futures contract, reflecting the many different kinds of tradeable assets of which they are derivatives. For e.g. E-mini S&P500, E-mini Nasdaq, Soybean,Wheat Gold Etc .Originally, futures contracts were traded only on commodities, in a market dominated by the Chicago Mercantile Exchange (CME). However, after their introduction in the 1970s, contracts on financial instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets.
Chicago Board of Trade (CBOT) — financials (bonds), maize, oats,
Chicago Mercantile Exchange — financial futures, lumber, live cattle, feeder cattle,
International Petroleum Exchange – energy including crude oil, heating oil, natural gas
London Commodity Exchange – softs, grains and meats
New York Board of Trade – Softs : cotton, orange juice, sugar
New York Mercantile Exchange – Energy and metals: crude oil, heating oil,
Pricing and Limits
Contracts in the futures market are a result of competitive price discovery. Prices are quoted, as they would be in the cash market: in dollars and cents or per unit (gold ounces, index points). Prices on futures contracts have a minimum amount that they can move. These minimums are established by the futures exchanges, are known as “ticks.”
For futures traders, it’s important to understand how the minimum price movement for each instrument will affect the size of the contract. Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day’s close, and the results remain the upper and lower price boundary for the day.
The exchange can revise this price limit if it feels it’s necessary. It’s not uncommon for the exchange to abolish daily price limits in the month that the contract expires (delivery or “spot” month). This is because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract. In order to avoid any unfair advantages, the CTFC and the futures exchanges impose limits on the total amount of contracts or units of a instrument in which any single person can invest. These are known as position limits and they ensure that no one person can control the market price for a particular commodity.
Volume and Open Interest
Volume and open interest are measures to determine the liquidity of a futures market – the more liquid a market, the faster and easier that trades can be executed. Volume is a running count of the number of futures transactions that have occurred during the day, whether a buy or a sell. It is the number of futures contracts that have changed hands. Open interest is the number of futures contracts outstanding, that is, that have not been closed or offset. Official volume and open interest figures are calculated and disseminated by futures exchanges at the end of the trading day, and usually printed in newspapers along with futures prices.
A trader needs to have a source of futures prices. Prices are supplied by futures exchanges and are also available on the Internet.To get up-to-the-minute futures prices, you need to subscribe to a news vendor such as Reuters or Telerate.
Industry abbreviations exist both for the type of futures contract and the trading month. For instance, a E-mini s&p futures contract traded on CME and expiring in September 2005 is abbreviated as ESU5 where ES represents the E-mini s&p futures, U represents the month of September, and 5 is the last digit in the expiration year, 2005.