Futures Trading 101: Let’s Start with the Fundamentals

This post will be talking about the futures market, which involves considerably more risk than traditional forms of investing. Before proceeding with futures trading, it’s important to know the basics of investing in the financial markets.

If you’ve never heard the term “futures” or “futures trading” before, don’t worry. The average retail trader is familiar with the idea of trading stocks, but futures don’t come up much in those conversations.

When I first heard about futures trading, I had only seen the stock and options markets. It turns out that the futures market has existed for centuries and is one of the largest financial markets today. But instead of trading shares like those who trade on the stock market, futures traders participate in the exchange of specialized contracts.

The price at which you enter into these contracts will be determined by the market value of the underlying asset at that time.

If none of that makes sense, that’s fine. We will revisit some of these ideas shortly. But first, let’s look at the basics of futures trading.

The Basics of Futures Trading

Futures trading is a form of speculation in which you bet on whether the price of an asset will go up or down in the future.

If you expected a stock to rise in value, you’d buy shares to sell later at a higher price. With the futures market, traders buy a contract which represents a certain quantity of the asset, to be exchanged at a future date.

This way, if the underlying asset increases in value, the contract’s value increases proportionately, and when you sell it, you receive the difference. If, on the other hand, you think that the commodity will drop in value, you can short the same contract. The flexibility offered by this arrangement allows retail investors to speculate on markets they otherwise may not be able to access.

The idea behind futures trading is the same as trading other instruments: by buying or selling (shorting) contracts now, you’re betting on how prices will change in the future.

To do this successfully requires extensive knowledge and understanding of market fluctuations and trends. Before attempting to do any of that, understand what takes place when two traders interact in the futures market.

What are Futures Contracts?

Futures contracts are financial contracts between two parties. They are traded in the futures market the same way shares of a company are traded in the stock market.

By entering a trade with a futures contract, one party agrees to buy an asset at a future date at a specific price. The other party consents to sell the asset at a specified price in the future.

These contracts are standardized, meaning they are all the exact same with respect to price, quantity, and expiration dates. Certain futures markets are highly liquid, allowing rapid buying and selling of these securities by retail investors and large funds alike.

A Crude Example

Imagine you have a business that supplies oil to another business, like a gas station. You may need to sell 1000 barrels of oil in one transaction, multiple times per year. You know that the cost per barrel will fluctuate over time (it generally rises), but you don’t want to pay a premium when prices increase. You also don’t want to buy the barrels too early and take a loss if prices drop too low.

Instead, you may enter into a futures contract with the owner of the gas station. You both agree on the following: $50 per barrel today plus delivery charges when it’s time for delivery tomorrow, at a specified time like 6:00 PM PST. Both parties sign their names on their respective copies of this contract.

Then, when it’s 6:00 PM, one party delivers 1,000 barrels worth of crude oil, fulfilling their part.

The other party had consented to take this delivery in exchange for $50 per barrel (plus associated delivery costs). If oil had suddenly risen to $60, it does not matter. The two parties share a contractual obligation to carry out their transaction, typically at the profit of one and the loss of another.

Some investors buy futures to limit risk based on market movements. Others make bets on how specific assets will perform over time, based on macroeconomics. But ultimately, everyone in the futures market is speculating on the value of these contracts rising or falling on a daily basis.

What types of futures exist?

1. Equity stock futures

Equity stock futures are a type of financial futures contract that allows investors to speculate on the price of particular equity stock. They are traded on an exchange, like any other stock or option. The investor pays the seller when purchasing the contract and receives payments from the seller when they buy back their position. Equity stock futures are settled in cash, unlike commodity futures which require physical delivery of assets like gold or oil. With equity stock futures, you won’t receive an unexpected delivery of goods.

2. Currency Futures

Currency futures allow investors to hedge against currency risk. For example, a company that operates in more than one country might have foreign currency exposure. To protect themselves from fluctuations in exchange rates, they can enter into a trade where they either sell or buy the currency they have exposure to at some point in the future. This practice is hedging, a common way of managing risk.

3. Commodity Futures

Commodity futures contracts are based on the price of a single commodity, such as oil or gold. They are traded on an exchange and in units of specific quantity.

For example, if you buy a commodity future for $10/barrel of oil, you agree to pay $10 per barrel at a specified date. That’s a contract that requires you to buy one standard unit (1,000 barrels) of crude oil from your counterparty at some point in time after entering into this agreement with them.

4. Interest rate futures

Interest rate futures are used to speculate on the future value of interest rates. They are based on a benchmark interest rate, such as the federal funds rate.

Interest rate futures trade on exchanges, and ultimately settle in cash.

5. VIX Futures

VIX Futures are used to hedge against volatility in the stock market.

Because they have a lower level of liquidity than other futures contracts, it can be challenging to find an active market for VIX Futures at any given time.

To see a full list of the products available on the Chicago Mercantile Exchange (CME), visit this link. Each of these symbols represents a separate futures contract and market.

Futures Contracts and Pricing

Futures contracts are priced using the spot price of an underlying asset, adjusted for interest, time, and paid out dividends.

You won’t have to calculate any of this yourself. But this is the reason that futures contracts from different months have distinct prices. Take a look at the differences between the Gold Futures contracts at the time of writing this article:

Symbol	Days (til expiration)	Exp	Bid	Volume
/GCV22	5	Oct 22	1631.60	16,693
/GCX22	36	Nov 22	1640.00	1,364
/GCZ22	65	Dec 22	1651.60	237,202
/GCG23	128	Feb 23	1665.00	3,411

As you can see, the price varies based on the time left on the contract, as speculators in the market try to gauge where the underlying asset’s value will be in the future. At the time of writing this, gold price is $1643 per oz. Going by the bid prices above, the market judges that gold will continue to fall through October, but perhaps recover by the end of November.

Futures Trading Terminology

Margins, leverage, and ticks are some more basics that must be understood well before beginning any real futures trading. Ensure that before you take any trades of your own, you are well-acquainted with the math behind any transaction with futures contracts.

Margins

Margins are the minimum deposit you must have in your account before trading a futures contract. The higher the margin requirement is, the more money you need to have in order to take on a margin position.

A lower margin implies needing less money to trade, but it also means a greater chance of wiping out your entire position in one move.

When trading stocks on margin, traders often are required to put up 50% of the position size, with the broker providing the other half. If you buy $100,000 worth of stock with 50% on margin, you only need $50,000 in your account to hold the position. Your profits (and losses) are effectively doubled, because you’re using only half the money typically required for that trade.

With futures, however, most brokers offer significantly better margin rates, especially for day trading. A contract may have a required initial margin of $25,000, but brokers may require just $1,000 from the trader to take a position.

Leverage

The word leverage can mean different things in different contexts. Leverage is a tool for borrowing funds to increase the size of one’s position, beyond what would be possible through capital alone.

When trading, leverage can be a blessing or a curse. Profits are much larger when price moves in the trader’s favor, and in futures, they can be significantly better compared to other markets.

But when it doesn’t go as planned, losses on a highly leveraged position can be disastrous. In the worst cases, traders have lost much more than 100% of their capital by overleveraging and not managing their futures positions properly.

Mark-to-market margin

Perhaps the greatest, and somewhat under-discussed advantage of futures is how margin and leverage can be used to scale positions infinitely. This is called mark-to-market margin. The initial margin for futures contracts is based on your account’s balance, rather than your remaining funds.

What this means is that you can use unrealized profits from your open positions to qualify to open more positions. Skilled traders will open a position, go into profit, and add to their position over time. This lets them increase profits exponentially as they add more contracts to a long trend, while never depositing any extra money.

This practice is something only the most expert traders should be doing, as everything can fall apart very quickly if the market reverses. When overleveraged, your account will likely not have much room for losses, and you may face a margin call if your losses grow too much.

Ticks

A tick is the smallest price change allowed for any given commodity or financial product. For example, in S&P 500 E-mini futures, each price increment is one quarter of a point. It may seem insignificant, but the value of a single tick can vary greatly depending on the underlying asset.

In some cases, the value of a single tick can be as small as $0.01. When it comes to the S&P 500 E-Minis, one tick is $12.50. Considering the market moves several points in minutes at times, it’s easy to see how a careless trader can earn an expensive lesson.

If our trader is trading crude oil or natural gas, trades will be based on an underlying commodity with smaller increments than stocks and bonds.

Share traders and option traders often deal in positions of 100 shares at a time. In futures, with assets such as oil and gold, traders are more often only taking single contract positions. While one contract represents dozens to thousands of units of a particular instrument (a Crude Oil contract controls 1,000 barrels), it’s important to know the math and true size of any position before trading.

Why trade or invest in futures?

Now you know a little bit about the basics of trading futures: contracts, pricing, margin, and leverage. Futures are more complicated than buying and selling shares of your favorite company. Considering the high risk of speculating with leverage, why trade futures at all?

1) Futures can be used to hedge physical assets in storage.

You can use futures to hedge physical assets that are in storage.

For example, if you have a large number of soybeans stored in a warehouse, and you’re concerned that their price will rise before they’re used or sold, you could hedge them by investing in futures contracts.

Chances are, you’re not a farmer, but millions of contracts are traded for this purpose every year.

2) Futures provide flexibility.

You can buy or sell at any time until the contract’s expiration date. You are not required to hold the position for the full lifetime of the contract, so you can take your profits or cut losses early.

3) Futures allow you to leverage your money.

The leverage itself becomes an asset once investors utilize it correctly.

If you have a volatile investment, futures will let you lock in a price for your future purchase. This guarantees that you’re at least getting the asset’s cost at the time of your purchase.

Futures contracts also allow you to short-sell, so that if the value drops, you’ll be able to make up the difference with the money from selling it short, and vice versa if the value rises. The best part is that all active futures are quite liquid, making it easy to hedge and enter or exit positions.

4) Futures Stabilize the Market

This reason for trading futures escapes even most futures traders. By allowing speculation on these assets, they actually help increase the efficiency of that market. For example, if someone wants to invest in the S&P 500 Index, but is unaware of what to expect, futures help to offset any extraordinary changes that may occur, especially in the short term.

In addition, not everyone can afford the staggering costs of investing in some of these assets directly, especially with the size required to earn any reasonable profit. Rather than trying to invest in every company that is on the S&P 500, going long on a futures contract is an alternative that can be more lucrative than trading the equivalent ETF.

5) Futures offer unique opportunities for growing capital quickly.

At the end of the day, we’re here to make money. But not everyone has enough capital to aggressively scale their businesses. Futures trading is a powerful business, due to the potential for scaling as an individual.

If you’re not an amateur, and just don’t have the capital, trading stocks can be quite limiting. A good day on one stock might earn a day trader 3 or 4%. For a capable trader who has significantly less than $100,000 to use, these returns are hardly worth replacing a decent day job. But in futures, especially with limited capital, gains of over 100% are not unordinary.

It also helps that there are opportunities now for traders to earn funded futures accounts by passing an evaluation via prop firms. These opportunities exist for stocks in some cases, but the experienced trader will naturally gravitate toward better leverage and profit percentages. Knowing that these markets exist for traders in that situation is a comfort that some of us know well and appreciate.

Conclusion

This wraps up our first mini lesson on speculation in the futures market. While this article covers the basics of futures trading, it is by no means a complete blueprint for making consistent money as a trader in these markets.

Keep in mind that futures trading is ultimately a separate category from stock trading. Due to its high leverage, there is always a risk of losing more than the capital invested on any particular trade. But if you develop a sound strategy with good trading habits, the futures markets can reward you well.

I hope this helps you understand a little more about what goes on in the derivatives market. Once you’re done here, head over to lesson #2 to learn more about the world of futures trading.