IndexFutures trading markets are financial derivatives. The value of a futures contract is ‘derived’ from the value or cash price of an underlying asset. Originally the entire futures industry was related to the agricultural markets. Today futures markets exist for many commodities.
The Chicago Board of Trade (CBOT), established in 1848, was the first modern futures market. Futures markets used to be traded open outcry, by brokers on the floors of the exchanges but today can be traded electronically.
The futures market enables price discovery in that the flow of buying and selling on the market sets the price. Futures also allow risk management, or hedging. Hedgers wish to reduce market risk. Speculators take on risk and the potential for profit or losses. Unless there is someone else to take the other side of the trade then there is no trade. Futures markets are highly liquid, however, so this is unlikely. The futures market represents a huge amount of buyers and sellers competing on the exchange. Other futures contracts include option contracts and swaps.
In legal terms, futures are a legally binding contract obligating the buyer to purchase an asset (or the seller to sell an asset) such as a physical commodity or a financial instrument at a specified price and date in the future. The term “futures contract” and “futures” essentially refer to the same thing. For example, anyone talking about buying or selling “gold futures” is referring to the gold futures contract.
Futures apply to exchange traded commodities such as:
Commodities are bought and sold on the cash market, and they are traded on the futures exchanges in the form of futures contracts. Some of the largest futures exchanges include the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX) and NYSE Euronext.
A futures contract is based on a standardized quality and quantity of the underlying asset. The vast majority of futures contracts are settled in cash. In other words there will be no physical delivery of the actual asset. Futures are very highly leveraged and have a margin requirement that must be settled daily. Margin requirement is the amount of money you must have in your account calculated as a percentage of the value of the position you have taken. It will cover any loss in value of that position.
The two primary uses of futures are hedging and trading.
Hedgers make investments to reduce the risk of adverse price movements in an asset. For example, buyers and sellers of commodities often use futures markets to hedge their positions. A wheat farmer wishing to secure a selling price for next season’s crop can do so on the futures market. The farmer is locking in the price they will receive for their commodity in the future. Simultaneously a bread making company can secure the price of wheat to be delivered in the future. They are securing the price at which they will buy the commodity in the future. One party is buying while the other is selling.
If the price of wheat rises by the time the farmer is obliged to deliver then they make a loss because they could have secured a higher price by waiting. However, if the price of wheat has declined then the farmer profits because they receive more than the current market price. Because the price of the commodity is fixed in advance, futures can help in financial planning for those producing or buying commodities.
Portfolio managers wishing to hedge their portfolio of stocks may use index futures trading to try and preserve the value of falling shares.
Index Futures trading is also used by speculators. Speculators provide liquidity in the market and in fact make up the vast majority of futures trading.
Traders can go long or short on futures contracts and for each buyer there must be a seller. In other words it’s a zero sum game. The winners are balanced out by the losers. If you think the market is going to rise or “bullish”, you can buy a futures contract in the expectation that you will sell at a higher price. If you believe the market is going to fall or “bearish” you sell a futures contract and buy it back at a lower price later. Futures contracts are very liquid and can be bought and sold pretty much immediately, long before the expiry date.
With leverage a trader can gain exposure to the movement of the market with less money. However leverage magnifies both gains and losses. Typically the trader only puts up a small portion of the underlying value of the asset. This is known as your deposit or initial margin. Deposits and margin requirements differ depending on the commodity. It is possible to accrue losses that exceed the amount you deposit to place a bet and you may be requested to send more margin. This is also known as being on margin call.
Each futures contract has its own specifications which are easy to find out through a broker or on the internet. Examples of contract specifications are given for a currency at (Currency Trading) and an agricultural commodity at (Commodities Trading). Below is an example for the contract specifications of a stock index, the Dow Jones Industrial Average:
Ticker Symbol: DJ (The ticker symbol is used by the exchange to identify the contract)
Contract Size: $10 x Dow Jones Industrial Average. If the Average is trading at 14000 then one futures contract is valued at $140,000 ($10 x 14000).
Tick Size: One index point = $10. This is the minimum price fluctuation possible.
Trading Hours: Globex Electronic Trading Platform (Mon-Fri 5:00 p.m. previous day – 4:15 p.m. US Central Standard Time. Trading halts from 8:15 a.m. – 3:30 p.m.)
Open outcry on the Trading Floor (Mon-Fri:8:30 a.m. - 3.15p.m. CST)
Contract Months: Quarterly in March (H), June (M), September (U) and December (Z).
Last Trade Date/Time: 3:15 p.m. on Thursday prior to 3rd Friday of the
contract month. On Globex trading can occur up to 8:15 a.m. on the 3rd Friday
of the contract month.Traders should know the contract specifications for the market they are going to trade. Other specifications such as margin requirements and the limit of price moves permissable.
Each futures contract has a pricing unit or tick size. For example traders engaging in index futures trading may trade the Dow Jones Futures contract and one index point in the Dow Jones has a value of $10. If you were to buy one Dow Jones futures contract at 14000 and sell it at 14100 you would make a profit of $1000 or (100 points x 10) not including commission. If the market declined and you sold it at 13900 you would make a loss of $1000. Similarly if you were sell one Dow JonesIndex futures trading contract at 14000 and buy it back at 13900 you would make also a profit of $1000.
Index Futures trading then offers high leverage, high liquidity, low transaction costs, the ability to go long or short and portfolio diversification. However,Indexfutures trading can be very volatile and the high leverage requires effective risk management otherwise large losses can result. Many traders make use of Fundamental Analysis, Technical Analysis Indicators and/or Chart Patterns when Index futures trading.
Futures are not the only method of trading their underlying assets. Exchange Traded Funds (ETFs), Contracts for Difference (CFDs) and Spread Betting are alternative methods of accessing these markets.