What Is a Futures Contract ?

What Is a Futures Contract ?

What is Futures Contract ?

A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The asset is usually a commodity, a stock index or a currency.

The contract specifies when it will be delivered and at what price. Most contracts specify that the asset must actually delivered, although some allow a cash settlement instead. Most contracts are paid off before the delivery date.

The role of the exchange is important in providing a safer trade. The contracts go through the exchange’s clearing house, which technically buys and sells all contracts.

The value is that you know it will be executed, instead of having to trust a trader on the trading floor or some anonymous electronic trading platform. Futures are traded on the commodities futures exchange, which is regulated by the cftc. Buyers and sellers must be registered with the

The exchange also makes contracts easier to trade, by making them fungible. This means that they are interchangeable — As long as they’re for the same commodity and delivery month, and have the same specifications for quality, quantity, delivery date, and delivery locations.

The advantage of fungibility means that, if a contract is bought and then subsequently sold, it is considered “offset”. This allows it to be extinguished without ever having to go to its agreed-upon date.

How Futures Contracts Affect the Economy?

Futures contracts are often used by companies that want to lock in a certain price for oil, natural gas or other materials they need to operate. They are also used by farmers to lock in a sales price for their livestock or grain.

For these businesses, futures contracts guarantee they will receive their supplies, or have a buyer for their product. they plan to actually transfer possession of the good under contract. The contract also allows them to know the revenue or costs involved. for them, the contracts reduce a great deal of risk.

More commonly, futures contracts are used by investors and even speculators purely to make a profit. They have no intention of transferring any commodity. Instead, they will purchase an offsetting contract at a price that will make them money. In a way, they are betting in the future price of that commodity.

Types of Futures Contracts

Commodities

The most important is the oil futures contract because they set current and future oil prices. This is the basis for all gasoline prices. other energy-related futures contracts are written on natural gas, heating oil and rbob gasoline.

Commodities contracts are also written on metals, agricultural products, livestock, and financials such as currencies, interest rates and stock indices. For more, see commodities futures.

Forward Contract

This is a more personalized form of futures contract, in that the delivery time and amount are customized to meet the specific needs of the buyer and seller. In some forward contracts, the two may agree to wait and settle the price when the good is delivered. 

A forward contract is usually a cash transaction common in many industries, especially commodities.

Futures Option

Instead of buying an actual futures contract, the option gives the purchaser the right, or option, to buy or sell the contract. It specifies both the date and the price.

Forward Rate Agreement

This is an over-the-counter forward contract on a short-term interest rate. The buyer of a fra is a notional borrower, i.e., the buyer commits to pay a fixed rate of interest on some notional amount that is never actually exchanged. 

The seller of a fra agrees notionally to lend a sum of money to a borrower. FRAS can be used either to hedge interest rate risk or to speculate on future changes in interest rates. article updated april 2, 2013

Futures contracts are a derivative product typically used by hedge funds to gain more leverage in the commodities market.

Trading Futures Markets

 

Futures markets are some of the most popular day trading markets, and will probably be the first type of market that you trade.

Futures markets are available based upon many different underlyings, such as stock indexes, currencies, and commodities, so you can choose a market that suits not only your trading style, but your personality as well. These articles will describe each type of futures market, and explain how futures contracts work, and how they are used in day trading.

  • Futures markets
  • Futures contracts

Futures Markets

Futures markets are available based upon stock indexes (such as the nasdaq or ftse 100), currencies (such as the euro to us dollar exchange rate), commodities (such as gold and silver), agricultural products (such as corn and wheat), and even weather (seriously, you can actually trade snow).

These articles will describe the different types of futures market, and list

 some of the most popular day trading markets within each type.

  • Futures markets.
  • Trading futures markets.
  • Stock index futures markets.
  • Currency futures markets.
  • Ccommodity futures markets.
  • Single stock futures.
  • Weather futures markets.

Futures Contracts

Futures contracts describe the trading parameters for each futures market, and provide the information that is needed to trade each market, such as their symbol, expiration date, the exchange that offers the market, and their tick size and value (minimum price movement and monetary value).

These futures contracts articles will explain each piece of information, and show how the information is used in day tradng.

Futures Expirations and Active Trades

As discussed in my article about futures contract expiration dates, futures contracts expire at regular intervals (e.g. monthly, every three months, etc.), and once a futures contract has expired, it can not be traded any more. 

So, what do you do if you have an active trade using a futures contract that is about to expire, and you want to keep the trade active past the futures contract expiration date?

Exiting and Entering

Keeping a trade active through a futures contract expiration is very simple, and only requires simultaneously exiting the trade using the expiring futures contract, and entering the trade using the about to be current futures contract. 

For example, a trade on the euro to us dollar futures market that was active on the third friday of september, could be kept active by exiting the trade using the september contract, and entering the trade using the december contract.

Ideally, the orders to exit the trade using the expiring futures contract, and enter the trade using the about to be current futures contract, should be processed at the same time, in order to keep the trade at the same profit or loss. 

If for some reason it is not possible to process the orders at the same time, then a few seconds delay should not cause any problems (unless the exiting and entering happens to be performed at a highly volatile moment).

Updating the Targets and Stop Loss

In addition to exiting the trade using the expiring futures contract, and entering the trade using the about to be current futures contract, the trade’s targets and stop loss prices will probably need to be updated (because different futures contracts are not usually at the same price at the same time).

For example, a trade on the euro to us dollar futures market that has an exit price of 1.2550 using the expiring futures contract, and an entry price of 1.2556 using the about to be current futures contract, would need to have its targets and stop loss prices updated by adding six points (1.2556 – 1.2550 = 6).

Ideally, the update of the trade’s targets and stop loss prices should be performed immediately after the trade has been entered using the about to be current futures contract, but a few seconds delay should not cause any problems, unless the trade happens to be near one of its targets or its stop loss when the trade is exited and entered.

Futures Market Expiration Dates

Futures markets (e.g. the euro to us dollar futures market) are traded using futures contracts, which are divided into several (usually four or more) contracts throughout the year.

Each of the futures contracts is active for a specific amount of time, during which it can be traded, and the contract then expires, and can not be traded any more. 

The date upon which a futures contract expires is known as its expiration date, and the expiration dates are fixed for each futures market by the exchange that provides the market (e.g. the cme group for the euro to us dollar futures market).

Standard Expiration Dates

There are four expiration dates which are considered the standard futures market expiration dates. The four standard expiration dates are the third friday of every third month, which in 2020 (next year) will be as follows:

  • March 18th
  • June 17th
  • September 16th
  • December 16th

The standard expiration dates apply to most of the stock index futures markets (e.g. the nasdaq 100 futures market), most of the stock index options markets (e.g. the s&p; 500 options market), and some of the individual stock options markets, and are known as triple witching friday because of the three types of markets that are expiring.

Additional Expiration Dates

There are also several expiration dates that are equally as important, but they are not known as the standard expiration dates (or as triple witching friday).

The additional expiration dates can be any day of any month, such as the monday before the standard expiration dates, which is the expiration date for most of the currency futures markets (e.g. the euro to us dollar futures market).

Finding The Expiration Dates

The expiration dates for each futures market are provided by the contract specifications for each futures market, which are provided by the exchange that provides the market, and are usually available via the exchange’s web site (e.g. http://www.cmegroup.com/, etc.).

Calculate the Size of a Futures Market Trade

 

Futures markets have fixed tick values (i.e. the value of the smallest possible price movement), so calculating the size of a trade on a futures market (i.e. the number of contracts that can be traded) is quite straightforward, as long as you know where to find the information that you need (i.e. the contract specifications).

Difficulty: easy

Time required: 2 minutes

Here’s how:

Tick size and tick value – The tick size is the smallest possible price change, and the tick value is the value of the smallest possible price change. 

The tick size and the tick value are provided by the contract specifications for each futures market, either directly as the tick size and tick value, or indirectly as the tick size and contract value.

For example, for the eur futures market, the tick size is 0.0001, and the contract value is $125,000, and the tick value is calculated as the contract value multiplied by the tick size which equals $12.50:

Tick value = $125,000 x 0.0001 = $12.50

Maximum acceptable risk – The maximum acceptable risk is the amount of

 money that you are willing to risk for an individual trade, which obviously 

can be whatever amount you choose, but according to the 1% risk 

management calculation the maximum acceptable risk should be 1% of your

 trading account.

For example, for a trading account with a balance of $50,000, the maximum acceptable risk is calculated as the trading account balance divided by 100 which equals $500:

Maximum acceptable risk = $50,000 / 100 = $500

Trade size – For futures markets, the trade size is the number of contracts that are traded (with the minimum being one contract). the trade size is calculated using the tick value, the maximum acceptable risk, and the size of the stop loss.

For example, for a trade on the eur futures market (which has a tick value of $12.50), with a stop loss of ten ticks, and a maximum acceptable risk of $500, the trade size is calculated as the risk divided by the stop loss in ticks divided by the tick value which equals 4 contracts:

Trade size = $500 / 10 / $12.50 = 4 (rounded to whole contracts)

Example – the complete calculation for the trade size (as one formulae) is as follows:

Trading account size / 100 / stop loss size (in ticks) / tick value = trade size

Which for a trade on the eur futures market, for a trading account with $20,000, and a trade with a stop loss of ten ticks, is as follows:

$20,000 / 100 / 10 / $12.5 = 1 (rounded down to whole contracts)