Futures Trading: Everything You Need To Know(1/2).

Futures Trading: Everything You Need To Know(1/2).

Forwards and Futures are derivative instruments that represent an agreement that involves buying & selling of something at a future date with a predetermined price known as the forward price, which is determined today. At its inception, it was typically used for managing risk in the agricultural products by farmers/producers. As these were originally intended for producers looking to manage business costs at its infancy, it has since evolved into a fundamental component of the investment industry. They have many uses in various forms, even though they are complex they can fundamentally alter the traits of any portfolio if used properly with the right knowledge, and tools & I am here to help you achieve that. To know about futures it is good to know about forwards, so without further delay let’s dive into the depth of forwards and futures in today’s post.

What Is Forward Contract?

Forward contracts are the first and as a matter of fact base for all other derivative instruments which helps us to purchase or sell something on a future date. To understand it in detail let’s continue with the example of our old friend Jack who will make us understand this better. If you don’t know about our good friend Jack and also want to know about the derivative market you can read Derivative Market For Beginners. Jack’s main business is processing of petrol with crude oil. He’s worried about the rising price of crude oil and similarly, there is John the crude oil exporter who is worried about decreasing price of crude oil to below $30 per Barrel. Jack is buying crude oil currently at $33.41 per Barrel and he is thinking that it’s going to increase up to $40 in a month’s time. They both are trying to save themselves from the fluctuation and volatility of the changing oil price, so they decided to enter into a contract of John selling Jack 10,000 Barrels of crude oil at $33.41 per barrel after one month. Now let’s imagine that after one month the market price of crude oil went up to $37.41. Jack as a petrol processor can buy 10,000 Barrel Crude Oil at $33.41 because of forwards contract entered with John and save $4 per Barrel. Similarly, John lost $4 per Barrel in this deal.

From the above example, we can get an idea about what forward contracts are and how they work. They are invented with a view to let producers and farmers, as well as buyers, mitigate the risk of loss, which could arise from price fluctuation, due to its trading in the market by different traders and speculators. Forwards contract are used as Over The Counter(OTC) trading instrument, they couldn’t be traded in centralized exchanges due to problems like:

  1. It carries credit default risk because all execution of the contract is fully dependent on their counterparts, as they are not regulated there is no clearing-house to guarantee the settlement of forwards at expiration.
  2. It is customized to fulfill the requirements of only interested parties hence not standardized, it is not transferable and traded in exchanges publicly for the general public.

Futures Contract With Example.

Due to these problems, the futures contracts were born. Unlike forwards, the futures are standardized legal agreements and are traded on specific venues such as futures contracts exchanges. This means that contracts are subject to a particular set of rules that may include, for instance, the daily interest rates, the size of the contracts, etc. It is uncertain, but the primitive form of future markets was created in Europe during the 17th century. However, Dojima rice exchange is regarded as the first futures exchange to be established in the early 18th century. Similar to the forward contracts, futures contracts were used primarily for hedging against the risk of loss in the market, resulting from the volatility and various other factors. These days futures are widely used by speculators looking to gain exposure to anything from commodities segments, like oil to orange juice, precious metals to livestock. Additionally, they are even used to gain exposure to financial assets like individual stocks, Treasury, bonds, popular indices, and now even Bitcoin & Other Blockchain Assets.

Let’s take this further with our above example of Jack & John. In the above case, I gave an example of a contract between two parties, for one buying crude oil, and another selling it without any regulatory authority and standardization. Now let’s take this further, if instead of personal contract, Jack bought futures contracts from regulated exchanges like the Chicago Mercantile Exchange (CME), where this same contract for oil is regulated. Hence it is called a futures contract. In other words, future contracts are regulated and standardized forward contracts. Going further with the example, in CME 1 contract of crude oil represents 1,000 barrels of crude oil, so Jack needs to purchase 10 contracts if he wants to buy 10,000 barrels of crude oil; the delivery of which is guaranteed by the exchange, along with the transparent public price and easy transferability of that contract with its exchange platform. Futures Exchanges in the USA are regulated by the  Commodity Futures Trading Commission (CFTC).

Largest Derivative Exchanges Worldwide

Top Futures Exchanges On The World
Top Futures Exchanges

As per the data published by Statista on March 2020, the Largest derivatives exchanges by numbers of contracts traded where forwards(over-the-counter), futures, options, and swaps are taken into consideration are given below chronologically.

  1. National Stock Exchange Of India
  2. CME Group
  3. B3
  4. Intercontinental Exchange
  5. Eurex
  6. CBOE Holdings
  7. Nasdaq
  8. Korea Exchange
  9. Moscow Exchange
  10. Shanghai Futures Exchange(including Shanghai International Energy Exchange)

How Futures Market Work.

Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change. Let’s look at how this might work for businesses taking the reference from the example of our old friend Jack. If the price of crude oil goes up it is profitable to John, and if the price of crude oil goes down it is profitable for Jack. With crude oil futures, both Jack and John can lock in prices ahead of time. Let’s take one more example of an individual, in the first case you might be planning to buy a house next year, but you are afraid that interest rates might go up. You can offset that increase by trading on interest rate futures available. In the second case, the use of futures contracts is to allow traders to speculate on the price movement of commodities, currencies, stock market indices, and other assets that can make a profit or loss.

You got an idea about how crude oil futures, or any other futures contract works. Now, let’s look at the standard contract specifications. There are four components for a futures contract to trade on the exchanges.

  1. When Futures Market Open.
  2. Tick Size & Tick Value.
  3. Contract Size & Contract Value/Notional Value.
  4. Delivery.

When Futures Market Open:

If you are wondering about when futures market open, the trading hours vary in different exchanges as per their time zone and the futures contract. If you want to know about when the futures market open and are traded on the floor of the exchanges you can find top 10 futures exchanges of the world’s trading hours below:

Trading Hours NSE India

Trading Hours CME Group

Trading Hours B3

Trading Hours Intercontinental Exchange

Trading Hours Eurex

Trading Hours CBOE

Trading Hours Nasdaq

Trading Hours Korea Exchange

Trading Hours Moscow Exchange

Trading Hours Shanghai Futures Exchange

Tick Size & Tick Values In Futures Market:

Each contract specifies the tick size. Tick size is the minimum price increment a specific contract can fluctuate. It is the minimum not the maximum, so the trading instrument can increase or decrease more than a specified tick size. This varies with various futures contracts. Apart from the tick size, you will also hear a term tick value, this is different from tick size. Tick size is the minimum price increment that a trading instrument can move, and the tick value is the amount you will gain or lose if the trading instrument moves by 1 tick size. Confused? Let’s continue with our example of Jack, we said 1 crude oil futures contract represents 1000 Barrels. The tick size for crude oil is $0.01 and the tick value for it is $10. To put in simply Tick Value= Tick Size * Standard lot(the value which is represented by 1 contract). In this scenario, if the crude oil futures were trading at $33.41, it must move a minimum of $o.o1 upward or downward. If the price falls to $33.40 a contract to sell 1 contract of oil, gains $10, and a contract to buy 1 standard lot losses $10. The tick size and tick value of some of the major futures are

Instrument Tick Size Tick Value
Gold 0.1 $10
Crude Oil 0.01 $10
S&P500 0.25 $12.5
Nat Gas 0.001 $10

Contract Size & Contract Value In Futures Market:

Futures Contract Standard

Contract size is the realizable quantity of any trading instruments that holds a futures contract. Let’s make this clear with our above example of Jack, we have said that 1 contract of crude oil represents 1000 barrels, it means that 1 contract size of crude oil represents 1000 barrels and anyone who purchases 1 contract size of crude oil is purchasing 1000 barrels of Brent crude oil. This is one of the factors that make the futures contract standard because these represent exact quantities that buyers and sellers are buying or selling, based on the terms of the contract of a specific future contract. These are specified by the exchanges or regulators, an individual is not required to calculate the standardized size of the futures contract.
The contract size of some of the popular future contracts are given below.

Instrument Symbol Contract Size Contract Value
E-mini S&P 500 ES $50 * S&P 500 Index $147,772.50
Gold 100-oz GC 100 troy ounces* $172,884.90
Silver 5000-oz SI 5000 troy ounces $76,195
Brent Crude Oil QA 1000 Barrels $35,300
WTI Crude Oil CL 1000 Barrels $33,600
Bitcoin Futures BT 5 Bitcoin $44000
US Dollar Index DX $1000 * Index $99,809
Nifty 50 Futures Nifty 50 Futures $2 * Nifty 50 $18,978.5

* 1 troy ounce = 31.1 grams.
All calculations are done by taking
spot rate of 25th May,2020.

From the above table you now have an idea of what contract value or notional value is, if you are not, then let me put it in a mathematical equation where
Contract Value/Notional Value = Contract Size * Spot Price of Underlying asset
This is very essential in calculation of hedge ratio and option value as well(These will be covered in other posts).

How Future Contract’s Delivery Work:

Futures Expiration & Delivery

In terms of delivery future contracts are of two types firstly cash-settled, which means you can close the contract just before expiration. Secondly, physically settled, which means you can take the physical delivery of the underlying assets.

Some traders prefer to hold the contract and go to settlement, which means there are legal delivery obligations associated with the original contract, for some contracts this delivery will take place in the form of a cash settlement, and for other, physical delivery of the underlying commodity. Let’s take an example of physical delivery, a coffee processor, looking to acquire coffee beans may take delivery of physical coffee beans, and a coffee farmer, who is looking to deliver his beans gives physical delivery to that producer. Although, many metals, energy, and agricultural products have the characteristics and obligation of physical delivery only a small portion of the traders opt for physical delivery. Most of the traders and brokers offer the cash-settled instruments. It is advised you always ask your broker about the same, before you start trading. You don’t want 1000 barrels of oil delivered to your front door at the expiration.

What is Futures Contract Rollover & Expiration?

In this section you can find what and when futures contract rollover and expire. You must have heard about the terms related to the expiration of futures like Expiration, Offsetting & Rollover. Let’s dive a bit deeper into these terms:

Expiration:

This means the last day when a trader can trade futures contract. This is generally on the 3rd Friday of expiration months, these however varies depending upon the contract. Before expiration, a trader generally has 3 options:

1. Offsetting The Contract:

Offsetting the position means to fully close the trade by taking the counter position to the previous trade. For Example, If a trader is holding a long position(buy) of 5 contracts in Brent Crude oil then he/she can offset that position by short position(sell) of 5 contracts of Brent Crude oil. The difference between his/her initial position and offset position is profit or loss. Let’s say if the initial position of 5 contract long was opened at $33.41 and the offsetting position was opened at $33.5 the trader made a profit of $450($0.09 * 5 * 1000). This is a common and mostly used method by the traders where one can realize profit or loss on the position.

2. Rollover

As the name suggests, it is the process where traders push forward the expiration date to enjoy the exposure to the market, by offsetting expiring position, and opening the same position on the same instrument, whose expiry is in further future. To perform this there are two methods

a.Leg In
Leg In means closing the contract and then opening the contract, with some time gap between the execution of position.

b.Position Roll
Position roll or initiate a spread means opening the new contract and closing the expiring contract with no time gap. You might be wondering what is the difference between Leg In & Position Roll? Both seem to be the same, but don’t forget that, the futures market is very volatile with high liquidity, and you can suffer slippage, which is the difference between opening and closing price of your two positions. So, Unlike Leg In, Position Roll helps you save losses from slippage.

3. Take/Make Delivery

If the trader doesn’t opt any of the two methods discussed above before the expiration, the contract expires. After Expiration the contracts move to a settlement process, the trader with the short position is obliged to make the delivery, and the trader with the long position is obliged to take the delivery, as per the conditions of the contract. In some markets they are cash-settled and in some they are physically settled, so as always it is good to ask your broker or service provider about the same.

Why Trade on Futures Market Vs Stock Market?

Stock Market Vs Future Market

Ok, you might be thinking, now I know about futures, and what should be done in order to start trading. Still, I am confused about why we should trade futures, instead of stocks, which are also trading instruments, and also the futures contract’s underlying assets. Stocks are also publicly traded on the spot market. Hold your horses I am getting into it now.

You should opt-in for trading futures, if you are planning about, and is stuck because of the question of why, then here are the solution to your problem.

1. More time to plan and execute:

Futures market give access to make adjustments to your trades for 24×7, this helps traders take the opportunity, which can arise at any time in the market. In the stock market, they open for a limited time, and they don’t give access to manage your trade after market hours, which can cause problems. Let me make this clear by an example, suppose, you have a long position on the stock market(let’s say amazon stock), as the US economy in the globalization is affected by the events that happen outside of the US, which, generally happens outside of US stock trading hours, you are stuck with the position. Unlike stock markets, in the futures market, which operates 24/7, you can act on your trade any time you like, plan your position and stay safe from events that happen even after the stock market’s trading hours.

2. Greater Opportunity Of Day Trading:

As a day trader in the stock market, For example, in the US, you may be aware that carrying out 4 or more cycles in a single security per week is you are required to keep a minimum of $25,000 in your account with the broker. Similarly, a stock trader can trade up to a value of 4 times their maintenance excess whereas, in the futures market, you don’t need to have minimum account size for day trading, hence you can start with very small amount, ranging from 3% to as much is comfortable to you. Another reason the futures market is great for a day trader, is that with an equal amount they invest in stock, they can gain much more exposure to notional value. Lastly, futures markets provide traders to take short positions even though there is no availability of shares, which is a must, in case you are trading stocks in the spot market.

3. High Liquidity:

Futures market is very liquid, to look at the liquidity, two factors need to be considered. Open interest(the opened and existing position), and the buy and sell orders yet to be executed. Futures contract are standardized, and hold high notional value within the single contract, which is far more than in the spot markets, or ETF of the same underlying assets. Due to the participation of a variety of parties like hedge funds, buyers & sellers, traders, speculators, you don’t need to worry about not being able to close your position due to lack of interest and liquidity in the market.

4. Leverage:

Leverage Trading

This is one of the most charming things, in the futures market. In the spot market, you can get a very small leverage, whereas, in the futures market, you can control very large notional value with small capital. Let’s make this clear with an example, say you have $20,000 to trade in gold. You can exercise three options, First, to buy physical gold @ $1700/ounce, this way you can own around 12 ounces(i.e 20,000/1700) of gold. The second option, you can buy ETF shares of GLD @$160.90/share. this way, you can control around 12.4 ounces(i.e (20,000/160.9)/10) of gold, and the third option is to buy a futures contract, this way you gain exposure to around 200 ounces(i.e 20,000/10,065) of gold. You can see how much leverage can help you gain exposure. However, always be aware of leverage, as this can help you give you more exposure with little, but it also can expose you to more loss, make proper use of them. They can help you maximize your gain potential, if not used properly, they can empty your money fast. Think about how much comfortable you are, in case your trade go against you, and always remember to use stop loss around that level, while you are on leverage.

5. Portfolio Protection Via Diversification::

Futures and options on futures provide market participators, the possibility to hedge against market risk by sector, and to raise or lower the levels of desired exposure, in times of anticipated or unanticipated event-driven volatility. Suppose, A market participant is invested in amazon stock & tesla stock and is looking to reduce exposure, to protect him/her against expected notifications, that can increase price volatility. By taking a short position in the E-Mini NASDAQ futures in the futures market, and offsetting sector-specific exposure, he/she can protect him/herself against short-term downside risk, and also offset potential declines around specific economic events.

I tried to make this post as short as possible, I will be discussing, how futures are calculated, where you can trade futures apart from the top 10 exchanges, what are initial and maintenance margin, futures trading strategies, which futures are profitable to trade, how to use stop loss properly and many more relevant topics in upcoming posts. So stay tuned.

As always if this article helped you gain knowledge, and better understand the futures market, please like this post and you can also share this post on your social media. You can like & follow Facebook Page, where you will get the notification, once I publish further posts. If you want me to cover anything more in my further posts, let me know in the comment below or on Facebook. Thank You for reading, happy learning and trading.