Fun with Futures: Basics of Futures Contracts, Futures Trading

At first glance, the futures markets may appear arcane, perilous, suited only for those with nerves of steel. That’s understandable, as some tend to be more volatile in price than many traditional stocks and bonds.

But we often fear what we don’t know. Many futures contracts—such as those based on crude oil, gold, soybeans, and more—have origins quite literally at ground level (or below ground). What futures markets do over the short- and long-term can tell investors a lot about what’s going on in the world (how much it will cost to fill your gas tank before your summer road trip, for example).

Understanding how futures markets work, and perhaps even trading futures at some point, starts with some basic questions. What are futures and how do you trade futures? Let’s explore.

What Is a Futures Contract?

A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Typically, futures contracts are traded electronically on exchanges such as CME Group, the largest futures exchange in the U.S.

Most futures contracts are “standardized,” or effectively interchangeable, and spell out certain specifications, including:

• Quality and quantity of a commodity
• Unit pricing of the asset and minimum price fluctuation (tick size)
• Date and geographic location for physical “delivery” of the underlying asset (but actual delivery rarely happens, as most contracts are liquidated before the delivery date)

For example, a December 2018 corn futures contract traded on CME Group represents 5,000 bushels of the grain (trading in dollars per bushel) to be delivered by a certain date in December 2018. Crude oil futures represent 1,000 barrels of oil, and are quoted in dollars and cents per barrel.

Who Trades Futures Contracts, and Why?

According to Adam Hickerson, Manager, Futures and Forex, TD Ameritrade, "Futures have such a robust market. There are so many different parties and individuals trading futures, who combined provide access to deep liquidity, making it easier for all participants to conduct business and trade." The first group of traders are commodity producers and processors (aka, “commercials”) such as oil companies, grain millers, and precious metals miners. There are also speculators, such as big banks, hedge funds, and individuals who trade for a living along with retail traders.

The various market “players” have their own motivations for buying and selling futures—say, a grain processor that wants to “hedge,” or protect, against the prospect of a severe summer drought in the farm states of the U.S. Midwest that could send corn and soybean prices soaring.

Speculators, meanwhile, aim to make money—to “buy low and sell high” (or vice versa). Just like in the equities markets, speculators are looking to capitalize on the price fluctuations of the futures contract. They’re trying to turn profits on price moves.

Both commercials and speculators are essential to generate the necessary liquidity for properly functioning futures markets. They provide ample numbers of willing sellers for willing buyers. (A similar principle applies in stock and bond markets.)

What’s the History of Futures and How Did They Evolve?

Early versions of futures contracts have been traced back to rice markets in Japan in the early 1700s. But futures trading as we know it today began around 1848, when a group of grain merchants established the Chicago Board of Trade (CBOT).

A few years later, the CBOT established the first recorded “forward” contract—a predecessor of the futures contract—based on 3,000 bushels of corn. CME Group has since purchased the CBOT and several other exchanges over the past decade.

Why did futures take root in Chicago? The city’s location in the middle of the nation’s breadbasket made it a convenient place for buyers and sellers to meet. 

“Farmers raised livestock and grew crops and other agricultural commodities and brought them to market to sell to commercial entities,” according to MarketsWiki, a derivatives market database. “Substantial risk existed on both sides of that process. Buyers were vulnerable to the delivery of substandard products, or no products at all if the growing season had failed to produce enough of the commodity.”

Buyers “needed a way to ensure that the quantity and quality of commodity they needed would be available when they needed it. Farmers needed a way to know that a glut of available crops would not put them out of business.”

What’s the Role of Futures Exchanges?

Exchanges provide a central forum for buyers and sellers to gather—at first physically, now electronically. For the first 150 years or so, traders donned colorful jackets, stepped into tiered “pits” on the trading floors of the CBOT and other exchanges, and conducted business by shouting and gesturing. Today, so-called open outcry trading has largely been replaced by electronic trading.

Exchanges play another other important role in “guaranteeing” futures contracts will be honored; many exchanges operate “clearinghouses,” which serve as backstops or “counterparties” in every trade. The basic idea is to reduce or eliminate counterparty risk and ensure confidence in the markets.

What About the Role of Margin in Futures Trading?

In the equity markets, buying on margin means borrowing money from a broker to purchase stock—effectively, a loan from the brokerage firm. Margin trading allows investors to buy more stock than they normally could.

Margin works similarly, but is different in futures markets. When trading futures, a trader will put down a good faith deposit called the initial margin requirement. The initial margin requirement is also considered a performance bond, which ensures each party (buyer and seller) can meet their obligations of the futures contract. Initial margin requirements vary by product and market volatility and are typically a small percentage of the notional value of the contract.   

An individual or retail investor who wants to trade futures must typically open an account with a futures commission merchant (FCM) and post the initial margin requirement, which, in turn, is held at the exchange’s clearinghouse.

If prices move against a futures trader’s position, that can produce a margin call, which means more funds must be added to the trader’s account. If the trader doesn’t supply sufficient funds in time, the trader’s futures position may be liquidated.