Futures contracts are exchange-traded obligations. The buyer or seller is contingently responsible for the full value of the contract. The buyer goes long, or establishes a long position, and is obligated to take delivery of the commodity on the future date specified.
Futures contracts explained
A seller goes short, or establishes a short position, and is obligated to deliver the commodity on the specified future date. If the seller does not own the commodity, his potential loss is unlimited because he has promised delivery and must pay any price to acquire the commodity to deliver.
As prices change, gains or losses are computed daily for all open futures positions on the basis of each day’s settlement price. Gains are credited, and losses are debited for each open position, long or short. All accounts for firms and traders must be settled before the opening of trading on the next trading day.
A long position in a futures contract is an obligation in the future – not an option in the future
Byers and sellers benefit from organizations that act as clearing houses for the contracts. Clearing house enables futures positions to be offset easily prior to delivery.
To offset, close, or liquidate a futures position before delivery, an investor must complete a transaction opposite to the trade that initiated (opened) the futures position.
The offsetting transaction must occur in the same commodity, for the same delivery month, and on the same exchange.
About 98% of futures contracts are offset before delivery. Futures may be highly leveraged, that is, controlling large amounts of cash commodities with comparatively small amount of capital.
The last trading day is the day that the commodity or the option trades, as established by exchange rules. It is therefore, the last day the contract may be offset by means of entering closing orders. Any short futures contract not offset by the end of the last trading day must be settled by delievery; any long futures contract not offset by the end of the last trading day must be settled by acceptance of the commodity.
Futures contract specifications
The exchange on which a futures contract is traded (designated contract market) establishes the uniform contract specifications – making all contracts for a given commodity interchangeable.
Example: Any December wheat contract on the Chicago Mercantile Exchange (CME) is interchangeable.
Typically, there are four standardized parts to exchange-traded futures contract:
Quantity of the commodity (e.g., 5 000 bu corn or 100 oz gold)
Quality of the commodity (specific grade [basic grade] or range of grades may be acceptable for delivery, including price adjustments for different deliverable grades); a lower quality commodity delivered will discount the price and a commodity delivered higher in quality over the basis grade will generate a premium price – exchanges set the grades that 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 also specified by the designated contract market (DCM) or exchange, such as open outcry from 7:20 am to 2:00 pm CT for CBOT-regulated Ultra T-Bond options.
Althrough price is not standardized in a futures contract (it is determined between buyers and sellers), the exchange will specify a minimum incremental price movement (known as a tick) as well as the maximum price movement permitted in one day’s trading (price limit).
To trade futures, you open an account with a futures brokerage firm known as a futures commission merchant (FCM), who will execute your trades. You may deal directly with the FCM or go through an introducing broker (IB) or commodity trading adviser (CTA).
When you’re ready to trade, you give an order to buy or sell one or more contracts, either to open a position or to offset a position you hold. You pay a commission, called a round-turn, but only when you offset a position or the underlying is delivered at expiration.
The upfront cost of opening a position is the initial margin, or good faith deposit. This is a performance bond — a minimum of 10% of the cost of the contract, though sometimes more at the exchange’s discretion — that’s available to meet your obligation if the value of your contract falls.
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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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