Futures Contracts Explained: Getting Started in Futures Trading

Investing
Futures

What is a futures contract?

A futures contract, quite simply, is an agreement to buy or sell an asset at a future date at an agreed-upon price.

Futures contracts are standardized agreements that typically trade on an exchange. One party to the contract agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The other party agrees to provide it.

Here’s how it works:

An airline company may want to hedge its bets against an unexpected increase in jet fuel prices. Its traders will therefore seek to enter into a futures contract to lock in a purchase price closer to today’s prices for jet fuel. So they may buy a futures contract agreeing to buy 1 million gallons of JP-8 fuel, taking delivery 90 days in the future, at a price of 3 dollars per gallon.

Someone else naturally wants to ensure they have a steady market for fuel. They also want to protect themselves against an unexpected decline in fuel prices, so they will gladly enter into either a futures contract.

In this example, both parties are hedgers, rather than speculators. They are turning to the futures market as a way to manage their exposure to risk, rather than make money off of the deal directly.

There are also people who seek to make money off of changes in the price of the contract itself, when bought or sold to other investors. Naturally, if the price of fuel rises, the contract itself becomes more valuable, and the owner of that contract could, if it chose, sell that contract for someone else who is willing to pay more for it. It may make sense for another airline to pay 10 cents per gallon for a contract to save 20 cents. And so there is a lively and relatively liquid market for these contracts, and they are bought and sold daily on exchanges.

These contracts aren’t just bought and sold over jet fuel, but over almost any asset that’s commonly traded. Commodities represent a big part of the futures trading world: Futures contracts are issued on everything: eggs, gasoline, ethanol, lumber, precious metals. The list goes on. All these commodities have markets and market makers and traders constantly monitoring them.

Non-Commodity Futures Trading

As mentioned above, the futures market isn’t all about hogs, corn and soybeans. You can also trade futures shares of ETFs and even individual stocks and bonds as well. Some traders trade these vehicles extensively because of the greater potential for leverage. A trader can take a substantial position while putting up a relatively small amount of cash.

One common application: Someone who wants to hedge his exposure to the U.S. stock market may short-sell a futures contract on the S&P 500. If stocks fall, he makes money on the short, balancing out his exposure to the index. Conversely, the same investor may feel confident in the future, and seek to buy a long contract – essentially leveraging his portfolio.

Mechanics

Futures contracts, which you can actually readily buy and sell over exchanges, are standardized. Each futures contract will typically specify all the different contract parameters:

  • The unit of measurement.
  • How the trade will be settled – either with physical delivery of a given quantity of goods, or with a cash settlement.
  • The quantity of goods to be delivered or covered under the contract.
  • The currency unit in which the contract is denominated
  • The currency in which the futures contract is quoted.
  • Grade or quality considerations, when appropriate. For example, this could be a certain octane of gasoline or a certain purity of metal.

If you are getting involved in trading futures, you have to be careful. Most casual traders do not want to find themselves obligated to sign for receipt of a trainload of swine when the contract expires. But these abstract contracts represent, and are derived from, the movement of actual goods.

Risk

Many speculators borrow a substantial amount of money to play the futures market. It’s the only way to magnify relatively small price movements to a point where they potentially create profits that are worth the time and effort. But borrowing money also increases risk: If markets move against you, and do so more dramatically than you expect, you could lose more than you have invested.

Margin and Leverage

Leverage and margin rules are a lot more liberal in the futures and commodities world than they are for the securities trading world. While your stock broker won’t let you borrow more than the amount you have put up, a commodities broker may allow you to leverage 10:1 or even 20:1, depending on the contract. The exchange, typically the Chicago Board of Exchange (CBOE), sets the rules.

The greater the leverage, the greater the gains, but the greater the potential loss, as well: A 5 percent change in prices can cause an investor leveraged 10:1 to gain or lose 50 percent of his investment. Borrowing is the only way to magnify relatively small price movements to a point where they potentially create profits that are worth the time and effort. But borrowing money also increases risk: If markets move against you, and do so more dramatically than you expect, you could lose more than you have invested. This naturally means that speculators in the futures markets should have the discipline not to overexpose themselves to any given risk.

Getting Started

If you believe the futures markets are right for you, it’s not difficult to get started. Open an account with a broker that supports the markets you want to trade. The futures broker will likely ask how much experience you have with investing and what your income and net worth are. These questions are designed to determine the amount of risk the broker will allow you to take on, in terms of margin and positions.

There is no industry standard for commission and fee structures in futures trading. Commissions can be per trade or for a round trip, which includes getting in and out of a contract. Every broker provides varying services. Some provide a good deal of research and advice, while others simply give you a quote and a chart. To help you get started, NerdWallet laid out the commission schedules of some of the most popular futures brokers.

Virtual Accounts

Some sites will allow you to open up a virtual account. You can practice trading with “paper money” before you commit real dollars to your first trade. This is an invaluable way to check your understanding of the futures markets and how the markets, leverage and commissions interact with your portfolio. If you’re just getting started, we highly recommend spending some time trading in a virtual account until you’re sure you have the hang of it.

Even experienced investors will often times use a virtual trading account to test a new strategy. Depending on the broker, they may allow you access to their full range of analytic services in the virtual account.