Last Updated on 8 January, 2022 by Samuelsson
What are Futures contracts? Futures contracts are financial contracts that obligate buyers to purchase an asset at a set future price and date. For example, a buyer of wheat might buy a futures contract in March that entitles him to a predetermined amount of wheat in July, when he harvests his crops. Today, most futures contracts are standardized and traded at exchanges, enabling traders to use them to speculate in the price of a variety of commodities, metals, grains, and indexes, only to mention a few. In this article, we will have a look at what futures are, and why you might want to trade them!
A Very Brief History
The first futures contracts appeared in the Dutch Republic during the 17th century, and one of the most known examples was the tulip futures contract that
was traded during the Tulipmania in 1636. However, the first futures exchange is considered to be the Dojima Rice Exchange, that was founded after a series of bad harvests to meet the need of samurais that were paid in rice, and needed a stable conversion to money.
One of the most significant reasons why futures contracts were invented and have survived the test of time is that they mitigate risk for both parties involved in the transaction, and give a speculator the chance to profit from price fluctuations.
How Do Futures contracts Work?
For companies or other players, futures contracts can be used to protect themselves against unanticipated price swings. For traders, futures contracts allow trading assets that would otherwise be inaccessible. To grasp the concept of futures let’s first try to understand how two parties can benefit from issuing a futures contract:
- A producer of, let’s say wheat, sells his products to a bakery. Both want predictable prices. The wheat producer wants to know that he can sell his wheat for enough money to cover his costs and living expenses. The bakery wants predictable prices to keep stable pricing of its products so that they don’t deter customers from buying from them.
- Since both parties are interested in keeping predictable prices, they sign a contract that a given amount of corn is to be delivered at a set price and date. For example, they could strike a deal that 1000 bushels of wheat is to be delivered to the bakery at a price of x dollars, by the 31 of July.
Now, after signing a futures contract, both parties in the deal know what prices to expect, and can adjust their business accordingly.
These type of tailor-made arrangements we’ve just covered are called forward contracts, and are not traded on a regulated exchange. Forward contracts are mainly used to strike deals between companies that need a tailor-made agreement, and as a trader, you will not be dealing with forwards, but futures contracts traded on regulated exchanges.
Forwards VS Futures contracts
Futures contracts and forward contracts both work by an agreement to sell or buy a given asset at a set price and date. Here the main differences are listed:
- Most futures contracts are standardized so that they can easily be traded on a futures exchange. A forward contract can be customized after the needs of the parties striking a deal.
- Forwards are so-called “over-the-counter instruments”, which means that they don’t trade on centralized exchanges and that traders cannot access them for speculation. That’s not the case with futures contracts, that can be traded by everyone with a futures trading account!
- With futures contracts, settlement takes place at the end of each trading day. Forward contracts are only settled by the end of the contract term.
What Is a Standardized Futures Contract?
As a trader, you’re mostly concerned with typical standardized contracts and will not use the above mentioned forward contracts. The contracts you will trade have all been standardized to trade easily on an exchange The standardization applies to the following points:
- Unit of measurement- In what unit is your asset measured?
- Delivery- Do you want a physical or cash delivery?
- Quantity – How many of the chosen measurement units make one contract?
- Currency unit – In which currency is the futures contract denominated?
- Quote currency- In which currency is it quoted?
- Quality – Some assets could be of varying quality or grade. For example, it could be the purity of a metal.
If you don’t understand all the points, don’t worry. As a futures trader, you will mostly be concerned with the margin, delivery and contracts size, which we will touch upon soon!
Physical or Cash Delivery?
Every futures contract is set to expire on a specific date, and if you hold your contract until then, you will be delivered what is specified in the contract
Now there are two things that could happen here:
- You could take delivery of the physical quantity of what you’ve bought through the futures contract. For example, if one of the contracts is worth 200 barrels of crude oil, you will have to take physical delivery of 200 barrels of oil.
- You could also receive a so-called “cash delivery”, which means that you’re given the underlying value of the asset at the expiration date, denoted in the currency specified.
Of course, nearly all futures traded today use cash delivery. However, as a trader, you’re not intending to keep contracts until delivery. Instead, you will perform rollover right before the contracts expire.
What Is Rollover?
When people trade futures, they don’t want to receive bushels of corn, wheat, or a herd of lean hogs. Instead, they use them as a means of speculating in what direction price will head next. That’s why traders roll over their contracts at the end of each contract term.
Rollover simply means that you move positions in one futures contract to another. Once a contract expires, you cannot trade it any longer, and need to move on to the next contract that has a later expiry date.
If you happen to hold a position open in an expiring futures contract, it needs to be closed and reopened in the next contract.
How Do I Know When to Switch Futures Contract?
Most often, you should perform the rollover when the following contract is traded more heavily than the current contract. Volume for different futures contracts can be found at the website of the exchange. The most common futures exchanges where you can find this info are CME and CBOE.
However, sometimes you might want to replicate how your data provider calculates its rollovers. Since backtesting of strategies is done on a “patchwork” of futures contracts, you might want to do you rollovers at the same time as the data provider, if your strategy is backtested on that data. You can find these specific rollover dates by contacting your futures data provider, if it’s not already made available!
Margin and Leverage
Buying a futures contract is not like buying shares. Buyers of shares know how much money they need to pay by looking at what price the share is trading. If it trades at 5$, the investor knows that he needs 5$ to buy that share. However, with futures contracts, pricing is a little more complex. Futures contract don’t cost a specific amount to buy, but instead, they require a margin.
What Is Initial Margin?
The margin is set by the futures exchange, and determines how much money needs to be deposited in your account for you to be able to buy or sell short a futures contract. Most often, the margin is set to 5-15% of the total contract value. That means a futures contract worth 5000$ would only require 500$ if the margin rate was set to 10%.
What this means is that you’re trading with leverage. Through a futures contract with a margin rate at 10%, you could trade assets worth ten times more than the money deposited on your account. As with all types of trading, it’s paramount that risk is calculated correctly, and this applies even more so to futures contracts, because of their great leverage.
The margin rate varies with time and is set to reflect the volatility and risk of the market. With more volatile futures markets, it could be optimal with a higher margin rate, and vice versa.
When you’ve entered a trade, you don’t need to comply with the initial margin, but the margin maintenance.
The margin maintenance is how much money is needed to keep your position open and is lower than the initial margin to give some room for the trade to develop. If your losses shrink your capital so that you don’t comply with the margin maintenance, you risk a margin call. A margin call is when a broker demands you to deposit additional money to cover the margin. If money is not deposited, the broker will liquidate your futures position and you will be brought out of the trade.
Here you can find margin requirements for most futures contracts.
How Are Futures contracts Priced?
Ticks and Points
Pricing of futures contracts is a little different to stocks. Unlike shares that move in increments of one cent, futures move in increments of one tick at a time. The size of the tick depends on which
While the tick is the minimum price movement of a futures contract, a point consists of several ticks. Depending on which futures contract
you trade, it can vary a lot. For example, one point of the S&P 500 future consists of 4 ticks, giving it a value of $12.5*4=$50, whereas one point of the crude oil contract consists of 100 ticks, each at $10, giving it a point value of $1000.
How to differentiate between Ticks and Points
We understand that points and ticks futures contracts may be somewhat confusing at first. Here is a simple rule to differentiate between the two when looking at charts:
The tick is the change that occurs to the right of the decimal sign. The point is the change that happens to the left of the decimals sign.
So, if the E-mini S&P futures contract moved from 2700.00 to 2071.00, that would be an increment of one point. Instead, if it moved from 2700.25 to 2700.50, that would be an increment of one tick.
What is slippage?
For aspiring futures trader, it’s important to remember that slippage needs to be taken into account when trading. Slippage is when you want to enter a trade at a specific price, but cannot find any contract trading at that very price, requiring you to buy higher or sell short lower. For example, you might press the buy button when the S&P 500 futures contract trades at 2700.00, but get entered at 2700.25. In that case, you’ve had one tick in slippage.
The amount of slippage that you may incur varies a lot from trade to trade. Sometimes you might find that you’ve had no slippage at all, and other times you might get several ticks. Even if it’s quite rare you may even experience positive slippage once in a while.
How Can I Reduce slippage?
To reduce slippage you need to understand what’s causing it. Below we present four factors that impact slippage:
1. The Speed of Your Internet Connection
If your internet is slow, it might take some extra split seconds for your order to reach the broker. During that time, the market may already have moved away from your wanted price.
2. The Speed of Your Broker
As with the Internet connection, your broker could vary in speed. Make sure that you choose a futures broker that has a good reputation among traders for fast and reliable order execution!
3. The Liquidity of The Market
Low liquidity means that few contracts are traded, which lowers the chances of there being a bid at your requested price. The higher the volume of traded contracts, the better!
4. The Time of Day
Many Futures markets are open nearly 24 hours a day, and liquidity may vary depending on what time it is. For example, the index futures tend to have the greatest volume during the US session.
Most Liquid Futures Markets
Liquidity is paramount to reduce slippage. Here we have listed the 5 most liquid futures contracts.
1. S&P 500 E-mini (ES)
The S&P 500 is probably the most well-known index there is. This is also shown in the volume of the S&P 500 e-mini future, which is the highest of all futures contracts.
Tick Size: $12.5
Trading Hours: Friday 6:00 p.m. – 5:00 p.m. Eastern Time (ET) with trading halt 4:15 p.m. – 4:30 p.m.
2. 10 Year T-Notes (ZN)
The second most traded contract on the list is the 10-year T-notes futures contract.
Trading Hours: 5:00p.m. – 4:00p.m. (Sun-Fri) (Settles 2:00p.m.) CST
3. Crude Oil (CL)
Crude oil is the most traded futures contract of all commodity futures.
Trading Hours: Sunday – Friday 6:00 p.m. – 5:00 p.m. (5:00 p.m. – 4:00 p.m. CT)
4. 5-Year T-notes (ZF)
Tick Size: $7.8125
Trading Hours: SUN – FRI: 5:00 p.m. – 4:00 p.m.
5. Gold (GC)
The fifth most traded contract on the list is the gold market.
Trading Hours: Sunday – Friday 6:00 p.m. – 5:00 p.m. (5:00 p.m. – 4:00 p.m. CT)
Why Should You Trade Futures contracts?
Before ending this article by summarizing the main takeaways, we would like to mention some advantages of futures that we’ve not covered yet. To be honest, we’ve covered a lot of information, but never presented the main reasons why you should choose futures for your own trading.
1. Access to Many Markets
With futures, you have access to a range of commodities within many market categories. What about trading Soybeans, Wheat, Cattle while also keeping positions in various indexes and metals? It’s all possible with futures, which enables superior risk handling and diversification. Here you can view all futures that are available to trade. Quite impressive, isn’t it!
2. Liquid Markets
Many of the futures markets are very liquid compared to other forms of securities, which makes it easier to utilize small edges and market behavior that would otherwise be untradeable because of slippage.
3. Long Opening Hours
The futures markets are open nearly 24 hours a day on weekdays which is perfect for indexes, where overnight risk can be minimized by keeping stops on also throughout the night.
As we’ve covered before, futures contracts have in-built leverage. With the right knowledge and good risk handling, it could be used to your advantage and help you deliver greater returns!
Related reading: Do Futures Contract Pay Dividends?
Hopefully, you have now understood the main benefits of trading futures contracts, as well as learned the most important information to be able to understand what futures are. For traders who choose futures, we know that there is great potential to produce good returns at low risk, given how many markets there are to trade! However, it’s paramount that the risks with leverage, that are in-built into futures, are understood. If not, your trading career could be brought to an abrupt end! As with all types of trading, one needs to be careful and make sure to have an edge. (you can read more about edges here)
With that said, we don’t discourage people from trading futures contracts. Just be careful and perseverant, and you will be one of those who makes it!