Futures are a kind of contract that guarantees the delivery of a certain amount of a product or commodity at a certain time in the future at a certain price. These products include tangible goods, such as corn, gold, oil and pork bellies, as well as intangible products, such as currency and stock indexes.
Here’s how futures trading works and what you need to know before diving in.
What is futures trading?
Futures trading is an agreement between a buyer and seller to exchange a good in the future for a preset amount of money. The buyer agrees to pay the cash at the future date, and the seller promises to deliver the product at that time. This point is important — with a futures contract, the buyer is agreeing to take delivery of the commodity, and sometimes taking delivery of that product (such as oil, cattle or sugar) requires a lot of physical infrastructure.
Futures trading usually is the province of highly sophisticated participants, often those who use the commodity or product being traded. But it also includes traders who simply speculate on the price movement of the futures.
The key players in the futures markets include:
- Commodity producers and users: These players are buying or selling futures to hedge their bets on a commodity’s price. They use or produce the commodity and want to guarantee a sale at a set price of part or all of the commodity. In this way, they reduce their risk and lock in a price in an often-volatile market. They either deliver the quantity of the commodity or take delivery of it.
- Speculators: These players are purely bettors, placing their chips on how they think a commodity is going to move. They’ll never take delivery of a physical commodity and will close their position before the delivery date.
- Other hedgers: These players may own an investment that is exposed to a commodity, so they buy or sell futures to hedge or protect their other investment.
These three groups consist of companies in the given commodities industry, individual and professional traders, and institutional investors, such as pension funds, hedge funds and others.
Top futures exchanges
These traders are exchanging standardized contracts that are swapped on a futures exchange. In the U.S., many of the top futures exchanges are run by CME Group, including the following:
- Chicago Mercantile Exchange (CME): offers contracts on many agricultural products as well as those on financial products
- Chicago Board of Trade (CBOT): noted for its exposure to agricultural commodities
- New York Mercantile Exchange (NYMEX): specializes in energy futures
- Commodity Exchange (COMEX): noted for its metals futures
Commodities trading is regulated by the U.S. Commodity Futures Trading Commission (CFTC). The CFTC oversees not only commodities futures (such as for corn and soybeans) but also futures for financial products (such as for currency and stock indexes).
Futures contracts explained
Because they’re standardized, futures contracts specify everything a trader should know about the contract.
They’ll specify the following things:
- The amount in each contract and the unit (bushel, barrel, ounce, etc.)
- The currency unit the price is quoted in
- The delivery date
- How the trade will be settled — either physical delivery or cash settlement
Futures contracts were created to minimize the risk of price fluctuations in a commodity, so companies that need and produce the commodity can access the market and lock in a future price today. Let’s run through an example to get a sense of how a futures contract plays out.
Imagine a cereal manufacturer needs to ensure a supply of corn at a reasonable price over the winter, avoiding a potential shortage and a subsequent price spike. This producer buys 200 contracts to take delivery of 1 million bushels of corn in December of the following year, 15 months out.
On the other side of the contract is a corn producer — an agricultural giant that wants to be sure it gets a fair price for 2 million bushels of its corn next December to avoid an oversupply and unexpectedly lower prices due to a good harvest. It sells contracts on 1 million bushels to the cereal maker and the remaining contracts to various other buyers.
In this example, both parties can benefit by trading some risk, with each locking in future prices at a price that looks good today. Of course, a speculator may jump into the market, expecting the price of corn to rise, and buy corn futures too, maybe buying some from this corn producer. This speculator may sell them later to the cereal maker if it wants to secure more corn.
Regardless of who buys and sells the futures contracts, both buyer and seller must put up a portion of the contract’s value called margin, typically 3% to 12%. This margin is held by the futures clearinghouse as a security on the contract. As the value of the contract fluctuates over time, the parties to the contract may have to add money to the margin to maintain the contract.
After each trading day, the clearinghouse settles the daily accounts between the buyer and seller. If the contract increased in value, it transfers the increase in cash from the seller’s margin account to the buyer’s, and vice versa if the stock fell. If either the buyer or seller falls below the minimum margin level required by the clearinghouse, they’ll have to deposit more money.
Finally, when the delivery date arrives, that’s when the buyer and seller settle up the contract. The buyer will pay the agreed amount, and the seller will deliver the fixed quantity of goods. It’s important to reiterate that a buyer may be agreeing to take physical delivery of goods for commodities in the future or to settle accounts in cash with financial products.
Types of futures markets
There are two broad kinds of futures markets: commodities futures and financial futures. Here are some major products that are exchanged in each.
- Commodities futures: These commodities consist of the following categories:
- Metals (including gold, silver, platinum)
- Agriculture (including corn, soybeans, coffee, cotton, sugar, wheat)
- Energy (including oil, gasoline, jet fuel, natural gas)
- Livestock (including hogs, pork bellies, cattle)
- Financial futures: These products consist of the following categories:
- Foreign exchanges (including contracts that de-risk currency fluctuations)
- Indexes (including contracts covering the S&P 500)
- Interest rates (including swaps of interest payments)
- U.S. Treasury futures (including contracts on U.S. debt)
There are many other kinds of commodities and financials traded on the exchanges.
How to trade futures
It can be relatively easy to get started trading futures, though it pays to quickly educate yourself before wading in too deep. Many discount brokers offer futures trading — including the larger full-service brokers — but more specialized futures brokers also are available.
In addition to the usual personal information, the broker will ask you questions about your income and assets to gauge how much risk you will be allowed to assume.
While a broker may have a low account minimum to open an account or none at all, that doesn’t mean that you’ll be able to trade immediately if you deposit the minimum. Each futures contract has its own minimum initial margin, depending on the broker. Often that minimum is a few thousand dollars, so you’ll need at least that amount to get in the game. And then if the contract moves too much against you, you’ll have to deposit more cash to maintain it.
For example, if you’re in the market for an E-mini futures contract on the S&P 500, you’ll need at least $6,600 at one broker to open a contract. Once you have an open position, the broker gives you a bit of wiggle room to hold the contract. As long as your account has at least $6,000 in value (the contract plus any cash), you’re in good standing. When it dips below that amount, the broker will call on you to immediately deposit cash to make up the deficit or sell the contract.
If you’re unable to obtain the ability to trade futures directly, it’s possible to buy exchange-traded funds (ETFs) that give you exposure to commodities futures. These ETFs often are categorized by commodity type (gold, oil, etc.), and some even offer leveraged exposure to the price of the commodity. Plus, you can make a bet on either the upward or downward move of the commodity. There are at least 100 commodity ETFs trading in the market. A sugar ETF? Yes, there is.
What are the risks of futures trading?
There are two major risks in trading futures, especially commodities futures: price volatility and leverage. Traders like the leverage and price volatility of commodities because they have a chance to profit very quickly, but there is a risk of losing a lot of money just as quickly. Savvy traders avoid exposing themselves to too much risk in any one position.
Here’s what you should know about each one.
Commodity prices can fluctuate a great deal, often in response to unexpected factors, such as catastrophic weather or natural disasters (hurricanes, earthquakes) or more mundane events (an extra long winter or a rainy summer). And commodities may fluctuate for no reason at all or merely because some speculators run the price up or down.
Using a margin account, commodities exchanges allow traders to put up only a portion of the contract’s value in order to own it, giving the trader leverage. In other words, this practice allows traders to own more contracts than they have the money for currently. So this leverage allows a small amount of money to control a much larger amount of money.
As long as the trade moves in the trader’s direction (increasing in value), the trader won’t have to deposit more money into the margin account. However, if the contract decreases in value enough, the trader must put more money into the account or otherwise sell the contracts. It’s possible that a volatile price swing (see point No. 1) could lose more than the trader initially invested. If you can’t meet the margin call on a timely basis, the brokerage will sell enough to do it for you.
Is futures trading right for you?
Trading is tough, and it’s even tougher in commodities markets than in (slightly) more predictable arenas, such as the stock and bond markets. The price of commodities can fluctuate violently sometimes, and the leveraged nature of futures contracts can force a futures trader to put up substantial cash just when it’s in short supply.
Individuals often don’t have enough information to compete with well-informed institutional and professional traders. These pros know their specific markets thoroughly and have information flow that may never be reported in traditional news outlets. If a big institution decides to move, it can shift the whole market, and small individual players are forced along with it.
Traders in any market — but perhaps especially in the futures markets — need to have strong risk management. They should understand when to close a position, especially a losing position, so they don’t risk a catastrophic loss. Psychologically, that’s one of the toughest things to do, but it’s the most important because it limits the damage to your bankroll from any one trade.
Futures trading can be tough for a new trader, and it requires a higher level of sophistication and trading acumen than stock investing. But it’s popular because the leveraged nature of futures contracts makes possible a rapid gain on a small change in the commodity’s price. Of course, it’s just as easy to lose money on a small downtick in price too.