Futures Trading Basics



futures-trading-basicsLearning how to trade futures can be a little daunting at first, but really there’s nothing to worry about. Once you’ve carried out a few test trades and got your head around a little terminology, you’re ready to go.

The hardest part is deciding in which direction the market is currently trending. Unfortunately there’s no shortcut here, market knowledge only comes with experience.

Fortunately, you can now gain that experience using a virtual trading account, this is not something that was available to traders of old; they had to learn the hard way and would often burn through $50,000 in the process.

The birth of the internet has made learning about futures a whole lot easier than ever before. The days of reading an old dusty book written in 1974 are long gone. Now you have access to videos, webinars and the aforementioned virtual trading account.

In this futures trading guide we’ll cover everything you need to know about trading futures contracts. We’ll cover how to choose a broker, what contracts to trade and when to trade them.

So let’s get started!

What are Futures Contracts?

A futures contract is a formal agreement to buy or sell a specified quantity of an underlying asset, i.e. coal or oil at sometime in the future. The futures market is a zero sum game, for every dollar made, someone else loses a dollar, therefore every futures contract needs to have an opposing contract before a trade can actually take place.

Futures’ are traded on a number of exchanges around the world. In the U.S the most popular exchanges are the New York Mercantile Exchange NYMEX and the Chicago Mercantile Exchange CME.

There are two different types of futures contract, a standard contract and an E-mini futures contract. E-minis are around 1/5th the size of a standard contract and therefore allow smaller investors to take part in the futures market.

You can trade futures on any number of different underlying assets such as:

Commodities: Including orange juice, corn, palm oil, heating oil, gasoline, coal, gold and silver.

Indices: Including S&P 500, NASDAQ, FTSE and Dow Jones futures.

Single Stock Futures: Which are based on individual stocks.

Currencies: Including USD/EUR, USD/JPY.

How to Trade Futures Contracts

The futures market is essentially a wholesale market. For example, when you go to the grocery store to buy milk, it’s usually in a half gallon carton. When trading futures, you can buy milk too, except that it’s 200,000lbs! That’s a lot of milk.

Because of the large size of these “wholesale” transactions, very few people ever trade futures with the intention of actually using or consuming the assets they trade. There’s just far too much of it! Imagine if 200,000lbs of milk arrived one day.

No, the vast majority of futures traders buy and sell only to profit from price movements. Traders like these are called speculators and they trade futures in search of high-yield investment opportunities. Once you understand how to trade futures, you can do the same.

Futures Trading Example

Let’s say Rachel thinks the price of Crude Oil will rise over the next couple of months, whilst Peter believes the price of Crude Oil will fall over the next couple months. Let’s assume the current date is February 15th and the contract price for a April Crude Oil futures contract is $100.

Rachel would therefore enter a buy order for one March Crude Oil futures contract at a price of $100 with your online futures broker. And Peter would enter a sell order for one March Crude Oil futures contract at a price of $100 with his broker.

Both of these orders will be routed directly to the futures exchange which handles Crude Oil. Both orders will be paired and executed, obligating both parties to the terms of the futures contract.

In essence, upon the April expiration date of the contract Rachel must purchase 1,000 barrels of Crude Oil at a price of $100, and Peter is obligated to sell 1,000 barrels of Crude Oil at a price of $100 regardless of the price at expiration.

If the price of Crude Oil is $85 at expiration, Peter has made a profitable trade worth $15 per 1,000 barrels ($15,000), whilst Rachel has made a loss of $15 per 1,000 barrels ($15,000).

If either party were to hold their Crude Oil futures contract through until expiration, they would technically be required to deliver or take delivery of 1,000 barrels of Crude Oil.  But since the purpose of our investment is purely speculative they must offset their futures contract before the expiration date to prevent the re-tendering process.

So, before the April expiration date, Rachel places an order to sell one April Crude Oil futures contract at $85, and Peter enters a buy order for one April Crude Oil futures contract at $85.

The orders would then be sent to the appropriate exchange, where they would be paired and executed, relieving both parties of their obligation to deliver or take delivery of the asset. Peter has now locked in his profit of $15 per 1,000 barrels ($15,000) at Rachel’s expense.

Contango and Backwardation

In certain situations the price of a commodity for future delivery is higher than the spot price, or a far future delivery price is higher than a near future delivery price. This is known as contango, the reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.

Futures Brokers

If you’re going to trade futures the first thing you’ll need is a futures broker. You’re choice is going to come down either a full service or discount futures broker. Since you’re reading this I’m assuming you want to manage your own trades and therefore not rely on a broker’s advice.

If that’s the case you should consider choosing a discount broker that puts an emphasis on training and education. You’ll find this type of broker to be more expensive than so called deep discount brokers, but by paying a little extra in the beginning you’ll become a much more successful and profitable trader in the long run.

Conclusion

As you can see there’s a lot to learn, but if you take it step by step you should soon get the hang of it. You’ll be surprised just how simple they are when you actually start trading them. The main thing to take away from this is that there’s no substitute for experience. You won’t be right all the time, especially at the beginning, but with a little dedication and practice you’ll soon be making profitable trades.




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