The Basics of Futures

Futures contracts are financial assets just like stocks and bonds, but with some important differences. These differences are what make futures such an appealing investment for traders.

Buying on lay-away is just like buying a futures contract.

As a trader, your challenge is to anticipate price movements correctly and make the appropriate trade.

Some futures markets have daily price limits that restrict prices from moving by more than a specific predetermined amount and are meant to serve as circuit-breakers when trading becomes especially volatile.

As a trader looking to profit from movements in futures prices, you do not want to actually buy or sell bushels of oats, or bars of gold.

Only a small percentage of futures contracts traded are actually held to delivery.

No matter what the price of gold does after you buy the futures, you will be able to buy gold at that price per ounce - you have locked in this purchase price.

Leverage means that you need only commit a little money to control a lot of product.

Because a little money controls a lot of product, you can get a "big bang for your buck".

What are Futures?

Because futures contracts are standardized (with price as the only variable), buyers and sellers are able to exchange one contract for another and actually offset their obligation to deliver or take delivery of the commodity underlying the futures contract. Offset means to take an equal and opposite position in the futures market to one’s initial position.

Margins and Guaranteeing Futures

The exchanges and their members are able to guarantee all trades because they require all parties in a transaction to deposit performance bond margins. Performance bond margins are financial guarantees required of both buyers and sellers of futures contracts to ensure fulfillment of the contract obligations. That is, buyers and sellers are required to take or make delivery of the commodity or financial instrument represented by the futures contract unless the position is offset before the contract expiration.

Before entering into a transaction, both parties have to post an Initial Margin Requirement. The initial margin requirement is the amount of money a party must have on account with a clearing firm (your broker) at the time the order is placed. Initial margin funds must be on deposit before any trade can be accepted. Maintenance Margin is a set minimum margin (per outstanding futures contract) that a party to a futures contract must maintain in his/her margin account to hold a futures position. Initial margin requirements vary from commodity to commodity, but are generally between 5% and 10% of the total value of the contract.

Example
If March Corn futures are trading at $2.11/bushel, the initial Margin Requirement for CBOT Corn futures is $405.00 per contract, with a maintenance margin requirement of $300.00. Our speculator must have at least $405.00 on deposit with his broker before he could enter the market. He would need to have an account liquidating value of at least $300.00 per contract in order to stay in the position.

Let’s assume that our speculator has $1,000 in his account and decides to buy 2 contracts of March Corn at $2.35/bushel on January 2nd. He is able to buy this because he has more than the initial margin requirement of $810.00 ($405.00 initial margin x 2 contracts = $810.00). With a $50.00 round turn commission rate ($25.00 in and $25.00 out) our speculator’s broker would charge him $50.00 in commissions as well.

If March Corn settled at his entry price of $2.35/bushel, his account liquidating value would be $950.00 ($1,000.00 initial deposit - $50.00 commission) to buy 2 contracts of Corn. Since the liquidating value of the speculators account (funds on deposit + open position profit or loss) is greater than the maintenance margin requirement of $300.00 per contract or $600.00 for 2 March Corn, he is able to stay in the trade.

The next day, much to our speculators detriment, Corn prices drop by 5 cents. Our speculator now has an open position loss of -$500.00 and an account liquidating value of $450.00 ($1,000.00 - $50.00 commission - $500.00 open position loss = $450.00). Since this value is less than the Maintenance Margin requirement of $300.00 per contract, or $600.00, our speculator is on a Margin Call.

In order to keep the position, the speculator must either send enough money to bring the account back above the Initial Margin Requirement of $810.00 or liquidate the position. The Maintenance Margin Requirement is the minimum amount of money which must be in the account (including open position profits and losses) to maintain an open position in the futures market. If the value of the account dips below this level, then the account holder must either send additional funds to his/her broker or liquidate the position. Usually, traders have 5 business days to get funds posted to the account, but in some cases the brokerage firm may liquidate the futures positions in order to meet the Margin Call.

Reminder
Brokerages have the right to liquidate your position immediately, and many may require you to wire funds right away to avoid liquidation. Be aware that margin requirements are subject to change without notice.

Initial Margin is the minimum amount of money you must have in your account to open up a futures position. Maintenance Margin is the minimum amount of money you must have in your account to maintain the position.

In the Corn example, the initial margin was $405.00 per contract, meaning that a trader must have at least $405.00 per contract in his/her margin account before a Corn futures position can be entered into. After the position is entered into a balance of $300.00 per contract, the Maintenance Margin must be maintained in order for the position to be left open. If the available funds in the account (funds deposited + open position profit or loss) are less than the Maintenance Margin Requirement, then more funds must be deposited or the futures positions will be liquidated or offset by taking an opposite position in the futures market.

Reminder
Long or buy positions are offset or closed by selling, while short or sell positions are offset or closed out by buying.

The dual margining system (initial and maintenance) of the futures market ensures that all positions are adequately financed and the integrity of the futures market is secure. The exchanges set the minimum margin requirement based on the volatility and dollar value of the contract. Margin levels are subject to change both up and down at the discretion of the Exchange. Most brokerage firms charge the exchange minimum margin, but they are entitled to charge more. Be sure to check with your broker before entering into any futures transaction.

The Long and Short of Trading

There are two basic positions one can have in the futures markets, a long or short position.

A long position entails the purchase of futures contracts in anticipation of rising prices. A buyer enters into a long position when he/she purchases a futures contract. Long positions are profitable if the underlying futures contract increases in price during the holding period. Selling the same quantity and contract-month that one initially purchased offsets a long position. Long positions are typically used by consumers to hedge against rising prices and initiated by speculators in anticipation of higher prices.

A short position entails the sale of futures contracts in anticipation of lower prices. A short position is entered into by initially selling a futures contract. In the futures market, unlike the stock market, it is just as easy to establish a short position as a long position. Short positions are profitable if the underlying futures contract decreases in price during the holding period. Buying the same quantity and contract month that you initially sold offsets your short positions. If the resulting purchase price is less than the original sale price, a profit is achieved. However, if the resulting purchase price is greater than the original sale price, a loss is incurred. Commodity producers who wish to avoid potentially lower prices (as a short position increases in value and prices decline) usually establish short positions.

Calculating Profit/Loss

Determining the profit or loss associated with a position is the same regardless of either a long or short position. The profit or loss from a futures position is calculated as follows:

Profit or Loss = Sell Price - Buy Price x Contract Size x Number of Contracts

Example
Assume a speculator thinks that Corn prices will go down in the coming weeks. He sells 2 March Corn contracts at 235 cents per bushel ($2.35) initiating a short position.

Having studied the behavior of Corn using his Track ‘n Trade software, our speculator was correct, and Corn prices fell from 235 to 220 over the next two weeks. Given the -15 cent drop in Corn prices, our speculator has a $1,500.00 open position profit and decides to “cash in” his winning by buying 2 March Corn futures at 220.

Profit or Loss = Sell Price - Buy Price x Contract Size x Number of Contracts

= 235 - 220 = +15 cents
= $0.15 x 5,000 bushel contract size = $750.00 per contract
= $750.00 per contract x 2 contracts = $1,500.00 (before commissions and fees)

Now assume that another speculator buys 2 March Corn at 235 initiating a long position. After two weeks, prices drop by -.15 cents to 220, and he offsets the long position by selling 2 March Corn at 220. His loss from the transaction would be -$1,500.00 before commissions and fees.

Profit or Loss = Sell Price - Buy Price x Contract Size x Number of Contracts

= 220 - 235 = -15 cents
= -$0.15 x 5,000 bushel contract size = -$750.00 per contract
= -$750.00 per contract x 2 contracts = -$1,500.00 (before commissions and fees)

As you can see, whether you are long or short, the basic idea of speculating in the futures market is to “buy low” and “sell high.” In the futures market this can be done in any order. You can initiate a long position by buying the futures first and offsetting by selling at a later time. If the sale price (exit price) is higher than the purchase price (entry price), you profit. Or, you can initiate a short position by selling the futures first and then offsetting the contract(s) at a later time by buying them. A profit will always occur if the sale price is higher than the purchase price.

Points vs. Cents

The profit or loss amount is determined by the contract you are trading. Each futures contract is quoted in a slightly different manner, and as such your profit or loss calculation for most markets is slightly different. The following highlights the major markets and how they are quoted. Of course, Gecko Software’s Track ‘n Trade Pro® will convert price moves to profit or loss for you, but these examples will help you understand how it is done.

Grains: Corn, Wheat, Oats, and Soybeans are quoted in cents per bushel, with a contract size of 5,000 bushels. A Corn price of 235 is really $2.35 per bushel. Each of these grains moves in 1/4 cent increments, which equates to $12.50 before commissions and fees. The profit or loss of a one cent move is $50.00 before commissions and fees.

Meats: The contracts are quoted in cents per pound. If Live Cattle is trading at 74.00, the price is actually 0.74 cents per pound. Meat prices move in 0.025 cents per pound increments, but usually the last 0.005 cent per pound is dropped, so a price quote of 74.02 is really 74.025, while a price quote of 74.17 is actually 74.175. Live Cattle, Lean Hogs, and Pork Bellies contracts call for delivery of 40,000 pounds, making a 0.025 cent per pound worth $10.00 before commissions and fees. The profit or loss of a one cent move is $400.00 before commissions and fees. Feeder Cattle prices are quoted the same way, except they call for 50,000 pounds, making a 0.025 cent move is worth $12.50 and a one cent move in Feeder Cattle worth $500.00 before commissions and fees.

“Softs” or Exotics: Coffee, Sugar, and Orange Juice are all quoted in cents per pound, but each has a different contract size. A Coffee price of 50.40 is 50.40 cents per pound, an Orange Juice price of 89.95 is 89.95 cents per pound, and a Sugar price of 762 is really 7.62 cents per pound (prices in Sugar are quoted in cents per hundred weight). Cocoa prices are quoted in dollars per metric ton, so a price of 1301 is really $1301 per metric ton.

The contract size for Coffee is 37,500 pounds, making a 1 cent move worth $375.00 before commissions and fees. Orange Juice futures call for delivery of 15,000 pounds, making a 1 cent move worth $150.00 before commissions and fees. Sugar is traded in 112,000 pound increments, making a 1 cent move in Sugar equal to $1,120.00 before commissions and fees. Cocoa contracts call for 10 metric tons at delivery, making a $1 move in Cocoa worth $10.00 before commissions and fees.

Metals: Gold and Platinum prices are quoted in dollars per troy ounce. Most quote vendors display their prices in this format as well, so prices are easy to read. A Gold price of 285.10 is $285.10 per troy ounce, while a Platinum price of 475.5 is $475.50 per troy ounce. However, each contract has a different contract size. Each Gold futures contract represents 100 troy ounces, so a $1.00 per troy ounce move equates to $100.00 before commissions and fees. Platinum futures represent only 50 troy ounces, as Platinum is much more rare than Gold. Each $1.00 per toy ounce move in Platinum is equal to $50.00 before commissions and fees.

Silver and Copper Futures are quoted in cents: cents per troy ounce in Silver, and cents per pound in Copper. A Silver price of 452.5 is actually $4.525 per ounce, while a Copper price of 70.20 is really $0.7020 per pound. Each Silver contract represents 5,000 ounces, making a 1.0 cent move equal $50.00 before commissions and fees. Copper contracts control 25,000 pounds of copper, making a 1.00 cent move equal $250.00 before commissions and fees.

Petroleum: Crude oil is quoted in dollars per barrel (bbl). A price of 20.50 is $20.50 per barrel. Each contract represents 1,000 barrels of oil, making a $1.00 barrel move equal to a $1,000.00 profit or loss before commissions and fees.

Heating Oil and Unleaded Gasoline are the same as at the pump (minus taxes and service station mark-ups) in cents per gallon. A price of 52.46 is $0.5246 per gallon. Both contracts call for delivery of 42,000 gallons; therefore, a 1 cent per gallon equates to $420.00 before commissions and fees.

Currencies: Currencies represent an exchange rate, or how many US Dollars it takes to buy one Swiss Franc, Japanese Yen, Euro, or Mexican Peso. Prices are quoted in many different fashions, but the basic convention is that a 0.01 move in the Swiss Franc or Yen equals $12.50 before commissions and fees because of the contract size. The Canadian Dollar, US Dollar Index, and Euro have a different contract size, and a 0.01 move equates to $10.00 before commissions and fees.

Financials: The same basic principles apply to the financial markets, which are generally quoted in terms of points. Prices are usually read as is, though some, like the treasury securities (US, TY, FV, TU), are traded in different combinations of 1/32nd or 1/64th. Each of these markets has the dollars per point already calculated into Gecko Software’s Track ‘n Trade Pro application, and a list of the different contract sizes and pricing terms are available from the various exchanges they trade on, as they do not follow a single convention.

Margins, Cents, Points & the Power of Leverage

Before entering into either a long or short position, one must post a performance bond or have the initial margin requirement. Because it is only necessary to post a fraction of the underlying value of the worth of the underlying contract, futures are a highly leveraged trading vehicle.

Initial margin requirements vary from market to market, but are generally only 3% to 18% of the value of the underlying contract value.

Example
If March Corn is trading at 211 per bushel ($2.11/bushel), the current initial margin requirement is $405 per contract. Each Corn futures contract represents 5,000 bushels of Corn, so the underlying value of a contract of Corn at 211 is $10,550. In other words, for $405 you can control $10,550 worth of Corn. By putting up just 3.9% of the value of the contract, you can control 5,000 bushels of Corn. (Margin requirements are subject to change without notice.)

In this example, a 1 cent move in the price of Corn ($50.00 before commissions and fees) represents a 12.3% return on the Initial Margin Requirement. This is the power of leverage. A small move in the price of the futures contract can mean a large move in your account.

Because of this kind of leverage, a 3.9% move in the price of Corn could give you a 100% return, double your money, or a loss of it all, if properly or improperly positioned. The power of trading on margin is that a small move in the price of the underlying equates to a large return (either positive or negative) on the money posted.

Just as physical leverage increases the amount of force used, like a pulley lifting very heavy objects, financial leverage increases the amount of money, which can be made or lost in the markets. As they say in Chicago, “The futures markets have made millionaires of more young men than Rock and Roll.”

However, we want to point out that leverage is a two-edged sword. Over leveraging your trading is a sure fire way to lose your money. Because of the leverage of a roulette wheel, each bet on a specific number pays off at 35 to 1. If you bet “6” and the ball bounces and lands on “6”, every $1 you bet is paid back to you with $35 dollars.

Let’s say you start off with $1 and bet “6” and win. You now have $35 and bet it all on “6”, which comes up again. You take your $1,225 winnings and let them ride on “6” again and win, reaping $42,875. Let it ride again, making a phenomenal $1,500,625. You let it ride one more time, and up pops “00.” You lose everything.

Though roulette is strictly a game of chance, the above results are possible with futures because of the leverage involved. If you buy 1 Corn futures contract at 210 and the price goes up to 219, you have enough open position profit to post margin for a second contract. Prices then rise another .04 cents, and you buy a third contract. With Corn prices having risen .13 cents, you were able to buy 3 contracts with an initial investment of only $405.00. However, all it takes is a .05 cent decline in the price of Corn and all your profits are gone. If you were lucky enough to see another 5 cent rise, you would yield a $1,450.00 profit or a 358% return on the initial margin.

It is possible to make highly leveraged, and possibly highly profitable, transactions in the futures markets by trading with relatively little financial cushion and pyramiding contracts. However, it has been our experience that those who practice this type of trading generally do not end up making money, but losing it.

Most people are attracted to trading futures because of the leverage involved, and it is the leverage that seems to ruin most traders. Though futures trading should only be done with genuine risk capital, this does not mean you should take undo risk. As a general rule of thumb, traders should learn to diversify their risk, only placing a small percentage of their capital at risk at any given time.

Though this style of trade will reduce the largest “bang for your buck” in the short run, it may prevent you from losing everything. In order to learn this game, you need to be able to stick around to learn all the rules (both written and unwritten), and the only way to stick around is through prudent money management.

Orders to Manage Your Future

The size of your account and the amount of risk you are personally able to bear is a completely personal matter. Some very successful traders—like Richard Dennis, who is rumored to have parlayed $1,000.00 into several millions in the futures markets—have made fortunes starting with relatively small sums of money. Most professional fund managers risk as little as 1% of their account equity on any given trade.

Unfortunately, both of these methods are probably out of the question for most people starting out in the futures market. The odds of turning $1,000.00 into several million in a couple of years is akin to hitting “6” on the roulette wheel 5 times in a row, but risking 1% of a $1,000 means only risking $10.00 per trade, which is just not practical. By postponing your entrance into the futures market until you have, for example, a $5,000.00 minimum of genuine risk capital (not the kids college fund, the rent, or your next mortgage payment), you could achieve a level of diversity and risk, theoretically then risking 10% of your account ($500.00 before commissions and fees) on any one trade realistically. This would greatly reduce your risk of ruin and increase your ability to trade longer and hopefully become more proficient in the long run.

Types of Orders

At the core of all risk management and trading is using the appropriate order for your market objective. The following are some basic definitions of the common order types, all of which can be replicated in Gecko Software's Track 'n Trade Pro charting software.

The market order is the most common type of order. With a market order, the customer states the number of contracts of a particular delivery month of a specific commodity he/she wishes to buy or sell. The price of the order is not specified, as the market order is filled “at the market” or at the current price when the order enters the trading pit. Market orders are placed when the speculator or hedger wants in or out of the market fast, since time is the most important factor in this type of order, not price. Market on Close is a common variation of this type of order, and is used when the trader wishes to have his/her order executed during the closing of the market (closing range). The Market on Open is another common variation, instructing the order to be filled during the markets opening price range.

The limit order specifies a price limit at which the order can be filled. The limit order can only be filled at the specified price “or better.” For example, a customer wishing to buy two July Corn contracts at 210 when July Corn is trading at 211 would place the following order: “Buy two July Corn at 210, limit.” Buy limit orders must be placed at the current market price or lower. The lower the price the better, and limit orders can only be filled at the specified price or lower.

A customer wishing to sell two July Corn contracts at 215 when July Corn is trading at 211 would place the following order: “Sell two July Corn at 215, limit.” Sell limit orders must be placed at the current market price or higher. The higher the price the better, and sell limit orders can only be filled at the specified price or higher.

When a buy limit is placed above the market it can turn into a market order and get filled immediately. If the current price is below the limit price, the market is in a better situation and the buy limit becomes a market order. The same principle applies to sell limits: when a sell limit is placed below the market, it becomes a market order if the higher market price is better.

Gecko Software’s Track ‘n Trade Program helps you learn all these rules by allowing you to simulate and practice placing these orders and making sure you have each order under your belt before ever moving on to trade the live markets.

A stop order is not executed until the market reaches the specified price level. Once the stop level is hit, the stop order becomes a market order. Opposite of limit orders, buy stops are always placed above the market, while sell stops are placed below the market.

A customer wishing to buy July Soybeans at 485 when the current market price is 475 would place a stop order as follows: “Buy one July Soybean at 485, stop.” If the Soybean market trades as high as 485 or is bid at 485, the order would become a market order and would be filled as quickly as possible.

A customer wishing to sell July Soybeans at 465 when the market is currently priced at 475 would place a stop order as follows: “Sell one July Soybean at 465, stop.” If the Soybean market traded as low as 465 or was offered at 465, the order would become a market order and would be filled as quickly as possible.

Example
Stop orders are usually used to liquidate earlier transactions, to cut losses, or protect profits. Let’s assume that a speculator bought three July Corn at 210 and the market is currently trading at 225. He/she may wish to protect some of his/her 15-cent profit per contract ($2,250.00 profit before commissions and fees) by placing a sell stop at 220, to protect 10 cents ($1,500 of the profit before commissions and fees). Placing the following order would do this: “Sell three July Corn at 220, stop.”

There are many other different types of orders, such as stop limits and market if touched orders, but the above orders are the most commonly used and are really the only orders a beginning trader needs to learn.

Look Before You Leap: A Message from the CEO

Before starting a business it is important to have a business plan and have adequate capital. Most new businesses start off with a dream, and the proprietor’s willingness to work hard. Despite hard work, they can fail because of unforeseen difficulties, poor preparation, or lack of capital. Remember this when starting your trading business: try to have adequate capital and plan for the unforeseen by developing and testing a trading plan.

Before trading, it is imperative that you develop a trading plan.

Your trading plan should be capitalized with money you can afford to lose. Generally trading funds are categorized as genuine risk capital if it is money that you can afford to lose. Again, this is not your child’s college education fund, the mortgage money, or grocery money. Proper planning and adequate capitalization are the cornerstones of any new venture.

The first step in building a house is drawing up plans for the completed house. The workmen who erect the house consult the blueprints when placing walls, sinks, appliances, and electrical outlets. The transition from bare ground to a finished home is laid out in the blueprints, or the plan for the completed structure. Trades should be planned with as much detail. Every situation should be planned for, so decisions are not made in the heat of the moment when money is on the line.

The goal of your trading plan is to allow you to make decisions before things happen, giving you a blueprint for trading before entering the market. A basic trading plan should include the following features as a minimum: