What Are Futures, How Pricing Works, and Benefits of Trading Futures

Dec 13, 10:05 am
trading futures

Futures are financial derivate instruments, widely used by investors and traders alike. Unlike the OTC markets which are de-centralized, the futures markets are centralized and exchange traded financial instruments, regulated by the U.S. Commodities Futures Trading Commission. The main benefits of trading futures markets are the low cost of entry for some assets which would typically require larger collateral as well as the ability to trade on leverage.

What is a futures contract?

A futures contract is an agreement between a buyer and a seller, who agree on a predetermined price for an asset to be delivered on a predetermined date. A very simple example of a futures contract is an agreement to purchase a house. You simply conclude the contract with the seller, where both the parties agree to a price, and the house is owned by you at a specified date.

As you can see, by concluding this rather simple agreement, the buyer and the seller have locked in a price. If the home values start to appreciate within the period, you as the buyer would have made some profit on the deal, while on the other hand if property values depreciated, you would have made a loss on the deal.

Of course, in the futures markets you don’t have to take the delivery of the underlying asset. You can simply sell your long contract before it expires.

In the futures markets, similar agreements are struck every day across multiple commodities ranging from crude oil barrels and bushels of wheat to financial futures such as currencies and stock indexes.

How does futures contract pricing work?

The futures contracts track prices of the underlying asset. For example, if you were trading gold futures, then the price is closely related to the spot market rate of gold. There are times when you will find price imbalance but thanks to algos and arbitrageurs; these imbalances are quickly balanced out.

Futures trading terminology

To trade futures contracts, the trader should have a good understanding of the terminology that is being used.

Contract Months: Every futures contract has a contract month when it expires. Not all futures instruments have the same contract months. For example, the Nasdaq100 futures have a quarterly expiration, while crude oil futures expire on a monthly basis. The twelve months of the year are identified by a code as shown below.

January (F)April (J)July (N)October (V)
February (G)May (K)August (Q)November (X)
March (H)June (M)September (U)December (Z)

Exchanges: There are many futures exchanges across the globe, but for the most part, four major futures exchanges stand out from the rest. They are,

  • CME Group (Chicago Mercantile Exchange)
  • ICE (Intercontinental Exchange)
  • EUREX (Eurex Exchange)
  • LIFFE (London International Financial Futures Exchange)

Within the above, the CME Group and ICE are two most popular futures exchanges.

Futures symbol: The futures ticker has its own format and differs from that of the currency/forex markets or the stock markets. Some of the most commonly traded futures assets and their tickers are mentioned below:

Gold (GC)E-Mini S&P (ES)Nasdaq (ND)British Pound (B6)
WTI Crude Oil (CL)E-Mini Dow (YM)30-day Fed Funds (ZQ)10-Yr T-Note (ZN)
Natural Gas (NG)E-Mini Nasdaq (NQ)U.S. Dollar (DX)Canadian dollar (C6)
Brent Oil (QA)S&P500 (SP)Euro (E6)Live Cattle (LE)
Silver (SI)Dow (DJ)Japanese Yen (J6)Lean Hogs (HE)

The futures contract prices are quoted in the format of <SYMBOL><CONTRACT MONTH><YEAR>.

Therefore, a WTI Crude oil futures contract for January 2017 would read as CLF17, or a December 2016 Gold futures contract reads as GCZ16.

What are the benefits of trading futures over other markets?

The futures markets offer a lot of benefits, and in fact, many investors use the futures market alongside their investments. Due to the derivative nature of the futures markets, traders and investors are particularly drawn to these markets. Some of the main benefits of trading the futures markets are:

  • Low cost of entry: Futures trading has a low cost of entry, from margin requirements to the commissions and other fees that you pay. This low cost of entry makes the futures markets particularly popular among retail traders.
  • Go long or short: The futures markets allow you to go long or short on any market with ease. This is particularly useful for investors who have long exposure to the equities and can, therefore, speculate or hedge their exposure in the futures markets.
  • Day trading: Many brokers offer lower margin requirements to day trade, as long as you close out your trades by the end of the day. These margin requirements, from as low as $400 on some select futures contracts means that retail traders can trade with relative ease without having to put up too much money upfront
  • Leverage: Futures markets are leveraged meaning that one contract can control significant units of the underlying commodity. For example, one standard contract of crude oil controls 1000 barrels.
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John has over 8 years of experience specializing in the currency markets, tracking the macroeconomic and geopolitical developments shaping the financial markets. John applies a mix of fundamental and technical analysis and has a special interest in inter-market analysis and global politics.

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