A futures contract is a type of financial derivative. For the producer or consumer of a commodity, for corporate borrowers, lenders and holders of share and bond portfolios with genuine risks to hedge, futures trading is risk insurance, a prudent exercise in financial management.
Speculators in futures markets provide the liquidity needed to make it all work.
Commodities Markets
Commodities are the raw materials and products, which form the basis of world trade, but can be non-commodity items such as financials. For example, the diverse categories:
- Metals: Gold, platinum, silver, copper, tin
- Energy: Crude oil, ethanol, unleaded gas
- Raw Materials: Wool, cotton, lumber
- Farm Products: Pork bellies, cattle, orange juice
- Agricultural: Soybeans, corn, wheat
- Financials: Interest rates, currencies, bonds, indexes
Commodities markets are traded via futures brokers at any of the futures exchanges, such as Chicago Board of Trade (CBOT), Chicago Merchantile Exchange (CME), London Metal Exchange (LME), Sydney Futures Exchange (SFE), etc. Traders may use online brokers who usually provide special futures trading software and may also include charting software.
What are Futures Contracts?
Futures trading is simply buying and selling contracts, which are not for the sale or purchase of the actual commodity but rather agreements to buy or sell a certain amount of the commodity at a fixed price on a certain date in the future.
Because they are contracts to be consummated in the future, traders can relieve themselves of their obligations by entering into an offsetting (opposite) contract – “closing out” the position without actually delivering or taking delivery of the commodity. Actually, physical deliveries of goods occur in only 2% of transactions.
High Leverage of Futures Contracts
A major attraction to futures markets and one of the principal reasons for their remarkable growth is the so called high leverage available to traders. This occurs because only a small initial deposit is required to trade – usually about 5 per cent of the value of the contract. Therefore, from the trader’s point of view, a relatively small price rise can mean dramatic profit on the deposit outlay. However, leverage, with its multiplier effect, is a two-edged sword and can equally lead to substantial losses should the price run against the trader.
Leveraging Example:
When buying or selling a contract on deposit, the trader is in fact trading the value of the whole contract. For example, depositing $2000 to trade a gold contract (assume a 5.7% deposit ), the trader is in fact dealing in about $35,000 and makes a profit or loss on the whole amount.
Assume the gold contract's price rises 5.7 per cent, which is the value of the deposit. The profit is therefore $2000 and there is now $4000 in the trader’s open position. Conversely, should the price fall by 5.7 per cent, the trader has now lost the whole investment.
Trading and Risk
In the above example, the trader may have been prudent enough to protect the investment with a “stop loss” and been stopped out of the market for a smaller loss. It is essential to only trade on a sensible scale in relation to trading resources available. Any account should be able to withstand a series of controlled losses and still be able to continue trading.
It should be accepted as a principle of trading that losses will occur. The recognition to take losses before they become damaging is an essential prerequisite to trading profitably in the long term.
Buying Long or Selling Short
Using trading jargon, buying a contract is to go "long", expecting prices to rise in order to make a profit. What is appealing to traders in futures markets is the additional ability to sell "short", expecting prices to go down in order to make a profit.
Speculating in futures markets is a trading business involving high risk management and is not for the faint-hearted. However, the rewards are handsome for those who have trading discipline and can stand the pressure.
References:
- “How to Make Profits in Commodities”, W.D. Gann. Lambert- Gann Publishing Co. Pomeroy, WA. 1976.
- “Future Stock: A Full Introduction to the World of Futures Trading”. Stephen Alder et al. Horwitz Graham Books. Maryborough, Australia, 1988
Harry P. Schlanger - Hello, I started out as a physicist working for research organisations. Mostly in the area of heat transfer in solids and porous media. ...
