Understanding Futures Markets
2022-01-07 | Raghee Horner
The futures market has evolved over the years. It’s evolved from hedging contracts for farmers to contracts on assets of all kinds – including Bitcoin. If you’re considering jumping into futures, you’ll want to understand how futures markets work. Let’s take a look at the world of futures trading.
Futures Contracts Explained
Futures trading means buying into a futures contract of a particular commodity, at a predetermined price, at a specified time in the future. This is commonly known as a long position.
Futures contracts can also be a commitment to sell a particular commodity, at a predetermined price, on a specific date in the future. This is known as a short position.
These futures contracts are standardized, meaning each one comes in a specific size. These sizes vary among each type of commodity.
In their most basic sense, commodity futures are what I like to call the grocery store of the world and include: rice, milk, butter, corn, wheat, soybean, cattle, cocoa, orange juice, and more. The list is enormous. However, not all of these commodities are liquid enough for speculation.
For example, lumber and rice, while very necessary commodities, are not necessarily great for speculating because the open interest and volume are quite low in the market. In contrast, corn and soybeans are very liquid because the demand and volume are high. This means they become better options for speculation.
When I talk about futures in my classes, I like to separate out these types of commodities from other futures based on metals, financial instruments, indices, and more. Here are some examples:
- Gold, silver, platinum, palladium, and copper
- Two, five, ten, and thirty-year Treasury notes
- S&P 500, Nasdaq, Dow, and Russel
As you can see, the availability of futures contracts has become increasingly extensive. This is just a very narrow list of what is available to trade today.
Two Approaches to Trading Futures Contracts
There are two types of traders in futures. The first kind of futures trader is one that actually wants to take possession of commodities itself (e.g., wheat, corn, gas, etc). For instance, if you are a farmer or a corporation like Pillsbury, you know you will be needing wheat. Futures are a way to essentially lock into a certain price.
Futures trading began with this very practical application. After a period of time, speculators realized (much like in stocks) that they can speculate on the price of the commodity through a futures contract.
These types of futures traders, otherwise known as retail traders, have no intention to supply or to buy the underlying asset. Retail traders will liquidate the futures contract before they are ever obligated to take possession of the commodity.
Both types of traders have this in common: they are trading based on predicted price movement of the commodity.
In addition to price speculation opportunities, the retail trading industry takes note of the hedging advantages of futures. This creates a “want” to get that same hedging benefit in other areas.
If a farmer can hedge corn, why can’t a bank, portfolio manager, or an individual trader, hedge their holdings with something like currencies? It could also be treasuries, a volatility index, and of course – the indices.
I believe the hedging application, which is broadly used by, as we call it, “big money,”(people with millions under management) is why the market expanded past commodities and into some of these less tangible types of products, even extending out into currency.
There is also the business of being in an exchange. The futures exchange, Chicago Mercantile Exchange (CME), is always studying where there is demand and what kind of contract size there is demand for. The CME observes public behavior and interest and provides a contract to let people either hedge or speculate on.
Now we have Bitcoin futures, right? I mean, we know Bitcoin does not actually exist in the physical realm and yet people want to hedge it or they want to trade it. It is proof that we’re heading into that less commodity, more intangible world.
Why Trade Futures Versus Options?
We will use an index as an example here. The preference to go to an options contract on the S&P versus going to the S&P futures comes down to less cost and less risk. If you are long on a call in options, then your risk is no more than whatever you paid for that call. That call can go to zero, but that option cannot go negative when it comes to the underlying.
The S&P futures contract could not only move against you in a way that you may not be able to exit, that is the dreaded gap. If the market moves enough, the futures market could essentially freeze up and trading will stop, maybe even go negative.
In futures you can lose more than what is in your account. There are things in the futures market that can present far more risk than just owning a long call. That’s a horrific reality, but It does not happen often. Unless someone does not understand position size, contracts, trading hours, etc. These things, for the most part, can be avoided. Futures traders accept this risk because of the leverage.
Although leverage in futures can be risky and often intimidating, what is very exciting (and probably where the industry is moving to) is the choices of contract sizes. This is one way to minimize risk. We can not avoid risk trading any asset class but it can be mitigated.
Once you understand what the risks are and you develop the discipline to stay within your trading plan and your position you will understand why trading futures can be a great asset class to add to your trading.
The Benefits of Trading Futures Contracts
Futures give us the best access to commodities. In many cases, trading futures is the only access to these commodities. The appeal of futures really starts with leverage and many times the uniqueness of the contract. Futures give us access to markets that are not necessarily available through stocks, ETFs, or their options.
They also give traders leverage. They give traders nearly 24 hour access to that market. You have far more liquid markets in futures.
Another reason to take advantage of futures trading is the 60/40 tax treatment. The tax treatment of futures is far better than the tax treatment of options trading or stock trading for that matter. This is something you would need to discuss with your accountant.
Whether or not you trade futures, you still have to watch them. Through futures, you are getting a much more global look at the market as opposed to a very narrow U.S. 9:30am to 4pm ET view.
Through futures we can see what the interest is on a wide variety of instruments and what market behavior is throughout different countries.
In addition, the futures market now offers various contract sizes, including full size contracts. There are also, and far more popular, micro and mini contracts on many commodities, and financial symbols. Micro and mini contracts have a smaller per dollar value. Smaller contracts have much less risk because the dollar value is much smaller. If you have one of these abrupt unforeseen moves you will have less money on the table.
Micros are probably one of the most popular types of contracts that are coming out right now. And it’s because micros initial margin requirement, is less than many other well-known contracts. This is making futures accessible to even more traders!
To learn more about futures and start getting all the benefits of trading futures contracts, join me in our Futures Room for live trading, Q&A, trade alerts, and daily recaps. Take advantage of our trial membership: only $7 for 7 days!