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Futures Trading Basics – Futures Investing

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Introduction

 

 

A futures contract is an agreement to buy or sell a specific amount of a commodity, or a financial instrument at a specific price on a specific date in the future.

To help you understand why businesses, and individuals trade futures, we will be covering the futures trading basics by examining how futures contracts can be used, the key components that make up a contract, and how much it costs to trade a futures contract.

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Investing Basics: Futures

 

 

One use of a futures contract is to allow a business, or individual, to navigate risk and uncertainty.

Prices are always changing, but with a futures contract people can lock in a fixed price to buy or sell at a future date – as locking in a price lessens the risk of being negatively impacted by price change.

Let’s look at how this might work for businesses using the coffee industry as an example.

If the price of coffee beans goes downs, its good news for coffee shops, but bad news for coffee farmers.

However, if the price of coffee beans goes up, the tables turn.

 

 

With coffee bean futures, both coffee producers and users are able to lock in prices ahead of time.

Now lets look at how this might work for individuals.

Say you’re looking to buy a new home in a year, and you’re afraid interest rates might rise and increase your mortgage payment.

You can offset a potential interest rate increase by trading interest rate futures, such as a 30-year US treasury bond, or 10-year treasury note depending on your time horizon.

 

 

A second use of futures contracts is to allow traders to speculate on the price movements of commodities, currencies, stock market indices, and other assets.

For example, consider the fluctuations in the price of a commodity like gold. A futures trader can potentially profit by correctly guessing the direction that the price of gold will move.

But if the futures trader guesses wrong, he could lose his entire investment in the contract.

 

 

Characteristics Of A Futures Contract

 

Now that you know how a futures contract is used, lets look at five key components of a contract. These are also known as standard contract specifications.

First, there is trading hours.

 

 

Futures markets are open virtually 24 hours per day, six days per week. However, each product has its own unique trading hours.

Next, each contract specifies the tick size.

Tick price is the minimum price increment a particular contract can fluctuate.

Tick sizes and values vary from contract to contract – and the differences in tick size are due to leverage, which we’ll explain more when we get to cost.

A third standard component is contract size.

 

 

Each commodity, or financial instrument, has a standardized contract size that doesn’t change.

For example, one contract of crude oil always represents 1,000 barrels.

One contract of gold futures represents 100 troy ounces, and one contract of E-mini S&P 500 futures represents $50 times the price of the S&P 500 index.

Another component is contract value, which is also known as a notional value.

This is the current market value of the commodity represented in a futures contract.

To calculate this, multiply the size of the contract by the current price.

As you just learned, the E-mini S&P 500 contract is $50 times the price of the index. If the index is quoted at $2,250, the value of one E-mini contract would be $112,500.

Finally, there’s delivery.

 

 

Contracts are either financially settled, or physically settled.

Financially settled futures contracts expire directly into cash at expiration. This includes products like the E-mini S&P 500 index future.

Physically settled futures contracts expire directly into the physical commodity. This includes products like crude oil.

For example, anyone long a contract in crude oil at expiration will receive 1,000 barrels of crude oil.

 

 

However, don’t be worried about 1,000 barrels showing up at your front door as most brokers don’t allow clients to take physical delivery.

You’re required to close the position before the delivery date, and if you don’t, it will most likely be closed for you.

You can find more information about contract specifications on your brokers website.

 

Real Applications Of Futures Contracts

 

 

Now to understand how much it costs to trade a futures contract, lets look at an example.

Suppose a crude oil futures contract is trading at $50.

 

 

At this price, 1,000 barrels of crude oil would cost $50,000, but a trader doesn’t actually have to come up with this amount.

With a futures contract, a trader could control the $50,000 worth of crude oil with just a small deposit.

This deposit is called the initial margin requirement, and it refers to the minimum amount of funds a trader needs to enter into a futures contract.

The initial margin requirement is set by the exchange, and is subject to change – but in our example, we’ll say that to purchase one crude oil futures contract, the trader had to put up $3,000 for margin to control nearly $50,000 in oil.

Any gains or losses from this $50,000 will be added or subtracted from the $3,000 margin requirement.

 

 

As you can see, futures can allow you to leverage a relatively small amount of capital to control a larger underlying asset.

Because of this leverage, small changes in the price of the underlying asset have a much larger impact on the futures contract.

Keep in mind that although leverage allows for strong potential returns, it can also result in significant losses.

And if losses are substantial, you will have to add more money to cover losses – this is known as a margin call.

 

 

Now you know how futures contracts can be used, what the contract specifications are, and how much a futures contract costs.

If you’re interested in learning more about futures, its important that you expand your investing education before you make investments – but at Invest In Wall Street, we’re here to help.

 

 

Quick Recap

Futures Trading Basics

 

  • A futures contract is an agreement to buy or sell a specific amount of a commodity, or a financial instrument at a specific price on a specific date in the future

 

Futures Contracts Are Used For Several Purposes….

 

1. One use of a futures contract is to allow a business, or individual, to navigate risk and uncertainty

 

  • Prices are always changing, but with a futures contract people can lock in a fixed price to buy or sell at a future date – as locking in a price lessens the risk of being negatively impacted by price change

 

2. A second use of futures contracts is to allow traders to speculate on the price movements of commodities, currencies, stock market indices, and other assets

 

  • For example, consider the fluctuations in the price of a commodity like gold. A futures trader can potentially profit by correctly guessing the direction that the price of gold will move

 

 

Characteristics Of A Futures Contract

Remember, there are five key characteristics that are unique to a futures contract….

 

1. Trading Hours

 

  • Futures markets are open virtually 24 hours per day, six days per week. However, each product has its own unique trading hours

 

2. Tick Size

 

  • Tick price is the minimum price increment a particular contract can fluctuate
  • Tick sizes and values vary from contract to contract – and the differences in tick size are due to leverage, which we’ll explain more when we get to cost

 

3. Contract Size

 

  • Each commodity, or financial instrument, has a standardized contract size that doesn’t change
  • For example, one contract of crude oil always represents 1,000 barrels
  • One contract of gold futures represents 100 troy ounces, and one contract of E-mini S&P 500 futures represents $50 times the price of the S&P 500 index

 

4. Contract Value aka “Notional Value”

 

  • This is the current market value of the commodity represented in a futures contract
  • To calculate this, multiply the size of the contract by the current price
  • As you just learned, the E-mini S&P 500 contract is $50 times the price of the index. If the index is quoted at $2,250, the value of one E-mini contract would be $112,500

 

5. Delivery

 

  • Contracts are either financially settled, or physically settled
  • Financially settled futures contracts expire directly into cash at expiration. This includes products like the E-mini S&P 500 index future
  • Physically settled futures contracts expire directly into the physical commodity. This includes products like crude oil
  • Most brokers don’t allow clients to take physical delivery
  • You’re required to close the position before the delivery date, and if you don’t, it will most likely be closed for you
  • You can find more information about contract specifications on your brokers website

 

 

 

 

 

And this is all that futures entails. It is essentially like all other CFD and derivative trading where two parties exchange a contract for a set quantity for an underlying asset at a specific price and future date.

There are many reasons why people may choose to trade or incorporate a small fraction of these financial instruments in their portfolio – either to allow people to experiment and predict sudden price movements or to “play the market” while using price speculation.

Its important to know the attributes of a futures contract – also referred to as the “standard contract specifications” – and includes the following: Trading Hours, Tick Size, Contract Size, Contract Value (Notional Value), and Delivery (Which can either be classified as financial or physical delivery).

Its important that you memorize the following contract terms if you are interested in either investing in or trading futures – since they help contribute to the amount of risk that you are willing to take on.

Which speaking of risk, futures investments are fairly known by traders and investors alike for their leverage, liquidity, and volatility. And as you can already tell, this can go one of two ways if you are not careful about how you choose to invest in the futures market.

Of the course, in this module, we will be covering these reoccurring themes in more depth as we analyze the futures asset in greater detail.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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