Futures contracts are exchange-traded agreements where the buyer or seller is conditionally liable for the entire value of the contract. When a buyer takes a long position, he commits to taking delivery of the commodity on the specified future date.
Futures contracts explained
When a seller takes a short position, they commit to delivering the commodity on the specified future date. If the seller does not own the commodity, he faces unlimited potential losses, as he is obligated to deliver and must purchase the commodity at any price to fulfill the contract.
As market prices fluctuate, daily gains or losses are calculated for all open futures positions based on that day’s settlement price. Profits are credited, while losses are debited for each position, whether long or short. All accounts must be settled before the next trading day begins.
A long position in a futures contract is an obligation in the future – not an option in the future
Buyers and sellers benefit from organizations that serve as clearing houses for futures contracts. These clearing houses facilitate the easy offsetting of futures positions prior to delivery.
To offset, close, or liquidate a futures position before the delivery date, an investor must execute a transaction opposite to the one that originally opened the position.
The offsetting transaction must occur in the same commodity, for the same delivery month, and on the same exchange.
Approximately 98% of futures contracts are settled before delivery. Futures can be highly leveraged, allowing traders to control significant quantities of cash commodities with a relatively small capital investment.
The last trading day is the final day on which a commodity or option can be traded, as dictated by exchange rules. On this day, the contract can still be offset by placing closing orders. If a short futures contract is not offset by the close of the last trading day, it must be settled through delivery. Similarly, any long futures contract not offset by the end of this day must be settled by accepting the commodity.
Futures contract specifications
The exchange where a futures contract is traded, known as the designated contract market, sets uniform contract specifications, ensuring that all contracts for a given commodity are interchangeable.
Example: Any December wheat contract on the Chicago Mercantile Exchange (CME) is interchangeable.
Typically, there are four standardized parts to exchange-traded futures contracts:
Quantity of the commodity (e.g., 5 000 bu corn or 100 oz gold)
Quality of the commodity, whether a specific grade (known as the basic grade) or a range of acceptable grades, is established for delivery, with price adjustments made for different deliverable grades. Delivering a lower quality commodity results in a price discount, while a higher quality commodity over the basis grade commands a premium price. The exchange determines which grades are eligible substitutes.
Time for delivery (e.g., December wheat to be delivered)
Location approved for delivery
Trading hours for futures and options contracts are determined by the designated contract market (DCM) or exchange. For example, Ultra T-Bond options regulated by the CBOT may trade via open outcry from 7:20 a.m. to 2:00 p.m. CT.
Although the price in a futures contract is negotiated between buyers and sellers, the exchange sets a minimum incremental price movement, known as a tick, and also defines the maximum price movement allowed within a single trading day, referred to as the price limit.
To trade futures, you must open an account with a futures brokerage firm, known as a futures commission merchant (FCM), which will execute your trades. You can either deal directly with the FCM or work through an introducing broker (IB) or a commodity trading adviser (CTA).
When you’re ready to trade, you place an order to buy or sell one or more contracts, either to open a new position or to offset an existing one. A commission, known as a round-turn, is paid only when you offset a position or when the underlying asset is delivered at expiration.
The upfront cost to open a position is called the initial margin, or good faith deposit. This margin acts as a performance bond, typically set at a minimum of 10% of the contract’s value, although it may be higher at the exchange’s discretion. The margin ensures that funds are available to meet your obligations if the value of your contract declines.
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Price change of futures
The market value of a futures contract constantly changes during the trading day and throughout its term. Changes in the cash price of the underlying commodity and other fundamental factors cause price change. If the price of a contract you bought goes up, you have a profit, and if it goes down, you have a loss. The opposite works for holding short position
At the end of each trading day, the exchange’s clearinghouse moves money either into or out of its members’ accounts. The process is based on the shifting value of their contracts. The process is called marking to market. The clearinghouse is an agency that’s responsible for clearing and settling trades.
After you’ve opened a position, you must maintain the required margin level. It is called the maintenance margin. You have to carry it all the time and add money to your account if necessary.
The exchange also sets maintenance margin requirements. And in most cases, it differs from initial margin requirements.
Margin helps control the risk to which traders are exposed. If market prices start to move rapidly and the market volatility increases, margin rates can be increased.
It helps to ensure that traders don’t expose themselves to risks that exceed the capital in their accounts. Higher margin requirements can also slow trading, as traders can take fewer positions with the same money.
Futures buyers and sellers
There are two parties to every futures transaction — the buyer and the seller. The buyer holds a long position. At the same time, the seller shorts the market. So if you want to trade futures, you can go long or short. When an order is filled, you have an open position. After that, the contract typically goes into a pool at the exchange’s clearinghouse with all the other filled orders. And if you want to close your position, you offset it with an equal number of the same futures contract with the opposite action.
For example, if you have purchased a contract or have a long position in two October US Treasury note futures and want to close it, you would sell, or take a short position in two October US Treasury note futures. This purchase ends your obligation to deliver.
To offset a futures contract, you don’t have to find the investor who was on the other side of your original futures contract. Once a futures position has been cleared by a futures clearing firm, the firm becomes the buyer for every seller and the seller for every buyer. In other words, when you give the order to offset your existing trade, the clearing firm will consider that your new, offsetting trade cancels your old futures position.
Understanding delivery issues
If you don’t offset your position, you must make or take delivery of the item underlying the contract at expiration. The seller must make a delivery, and the buyer must take it. The contract specifies where, when, and how delivery may take place.
Physical delivery is the exception rather than the rule nowadays. As a result, more than 98% of futures contracts are terminated before expiration.
Cash-settled contracts don’t permit physical delivery. Instead, they are settled with a cash payment determined by the price change in the last two trading days before expiration. Or you can offset it as explained above.
How does futures trading work?
Futures are traded on regulated exchanges – designated contract markets (DCMs). The number of exchanges changes over time because of consolidation and the launch of new venues.
Historically, futures traders arrived at price discovery, or what the buyer would pay and the seller would accept, through an often frenetic auction system on an exchange floor known as open outcry.
This live trading system persists on some exchanges. However, it has been replaced by fully automated trading programs that match buyers and sellers electronically. On exchanges where both systems still exist, e-trading hours may overlap with floor trading hours and operate around the clock, with short daily breaks and a weekend interruption.
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