What are futures? How do you trade futures?

Futures , in English , literally means “future”. Specifically , it refers to the trading of spot goods at a certain time in the future, that is, the two parties to the transaction do not exchange physical goods and money at the moment of the transaction. Instead, they agree to trade at a certain time in the future at the current agreed price.

Futures trading is high-risk and highly leveraged, which may lead to large profits or losses quickly. If you do not have systematic learning and knowledge about the futures market, please do not trade futures.

For modern people, futures seem to be more closely related to financial products. But in fact, futures were originally invented to control and stabilize the prices of industrial and agricultural products and to serve the stability of people’s lives.

Later, with the vigorous development of the financial industry, investors realized that the futures trading model originally aimed at physical objects could also be applied to the financial field. After that, futures trading gradually gained a foothold in the financial investment industry and became a popular investment category. So what is unique about futures trading in the financial industry?

How do futures work?

A futures contract is a legal agreement in which two parties agree to buy or sell a specific quantity and quality of an asset at a predetermined price on a specific date in the future.

The operation process is as follows: the buyer and seller decide the object of the transaction (commodity or financial instrument), the time of transaction, and the price at the time of redemption, and hand over the contract to the guarantor. The buyer submits the deposit. Under the supervision of the guarantor, both parties perform the contract content after the expiration of the contract and pay the money and deliver the goods.

A futures contract must contain the following:

Underlying asset : This is the actual commodity or financial instrument underlying the contract, such as wheat, crude oil, gold or the S&P 500.

Contract size : This specifies the amount of an asset being traded. For example, a standard crude oil futures contract covers 1,000 barrels of crude oil.

Settlement Date : This is the date when the contract expires and settlement (i.e. the exchange of assets and money between the buyer and seller) must take place.

Delivery location : Especially for physical commodities, the contract will specify the location where delivery will take place.

Price : This is the price at which both parties agree to trade the underlying asset. This price is determined when the contract is signed and applied at the time of delivery.

Margin requirement : Futures trading usually requires both buyers and sellers to pay a certain percentage (e.g., 5% to 10%) of the contract value as margin to ensure contract fulfillment.

Standardization : Futures contracts are standardized, which means that in addition to price and quantity, all contract terms such as delivery date, contract size, and quality specifications are fixed.

Profits or losses in futures trading are primarily based on the movement of the contract price. When traders buy (go long) or sell (go short) a futures contract, they are predicting the future price movement of the contract.

• Buy (Go Long): If a trader predicts that the price of an asset will rise, they may buy a futures contract. If the price rises, they can sell the contract at a higher price, making a profit. Conversely, if the price falls, they will incur a loss when selling.
• Sell ​​(Go Short): If a trader predicts that prices will fall, they may sell a futures contract. If prices subsequently fall, they can buy the contract back at a lower price, making a profit. If prices rise, they will lose money when they buy back the contract.

Futures trading usually requires traders to submit a margin, which is a security deposit used to ensure the fulfillment of the contract. There are two types of margin:

• Initial Margin : This is the amount of money that must be deposited when opening a position, usually a small portion of the contract value (e.g. 5%-10%);
• Maintenance Margin : This is the minimum level of funds required to keep an open position. If the account funds fall below this level, the trader must deposit more funds, which is called a “margin call.”

If a trader’s account funds fall below the maintenance margin level and they fail to add margin in time, the broker may perform a forced liquidation. This means that the broker automatically closes the position in the market, regardless of the current market price. Forced liquidation is intended to reduce the risk of further losses while ensuring market liquidity and trading integrity.

How did futures develop?

The original model was that the two parties to the transaction made verbal commitments.

Later, as the scope of transactions expanded and the transaction volume increased, verbal promises became no longer credible due to drastic price changes, so a written contract became necessary.

Later, a third party was required to act as a guarantor, and the concept of “margin” was proposed to ensure that when the contract expires, both parties will buy and sell in accordance with the contract. The contract at this time is called a “forward contract”. The purpose of the “forward contract” is to prevent abnormal and large fluctuations in prices. Futures contracts are mainly signed for physical industrial and agricultural products. In 1571, the first commodity forward contract exchange, the Royal Exchange, was established in London.

With the widespread use of “forward contracts”, holding contracts has become a way to benefit in an environment of large price fluctuations.

Therefore, 82 businessmen established the Chicago Board of Trade in 1848 to provide information from all parties to investors, and launched the standardized contract “futures contract” in 1865 to replace the “forward contract”, allowing the resale of the contract, and optimizing the margin system, forming a futures market specializing in the buying and selling of standardized contracts.

Subsequently, with the rise of the financial sector, the underlying assets of “futures contracts” expanded from the original physical objects to a series of non-physical trading objects such as stock indexes, foreign exchange, and interest rates.

In futures trading in the investment field, there are hedgers, or hedgers, who lock in profits and costs by buying and selling futures and reduce the risk of price fluctuations brought about by time; the other type is arbitrageurs, or speculators, who hope to make profits from price fluctuations through futures trading and will bear more risks than hedgers.

What types of futures are there?

Futures are divided into commodity futures and financial futures according to the underlying assets.

1. Commodity Futures

Commodity futures are contracts in the financial markets that allow traders to buy or sell a commodity at a predetermined price on a specific date in the future. These contracts are standardized and include specific quantities, qualities, and delivery locations.

Commodity futures are traded primarily on specialized futures exchanges, such as the Chicago Mercantile Exchange (CME Group) and the London Metal Exchange (LME).

Commodity futures cover a wide range of products that can be broadly divided into the following categories:

• Energy: crude oil, natural gas, gasoline, fuel oil, etc.;
• Metals: including precious metals (gold, silver), and base metals (copper, aluminum, zinc, nickel, etc.);
• Agricultural products: soybeans, wheat, corn, cotton, natural rubber, palm oil, coffee, etc.;
• Livestock products : such as live cattle, lean pigs, etc.;
• Chemical products: methanol, low-density polyethylene (LLDPE), polypropylene (PP), etc.

2. Financial Futures

Financial futures are a type of financial derivative, which are standardized contracts on financial instruments or financial indices that are traded at an agreed price on a specific date in the future.

Unlike commodity futures, which are primarily based around physical commodities (such as agricultural products, energy or metals), financial futures are based on financial assets such as currencies, bonds or stock indices.

Stock Index Futures

Index futures, or Stock Index Futures, are financial futures contracts that use a stock price index, such as the S&P 500, NASDAQ 100 or Dow Jones Industrial Average, as the underlying asset. The value of the contract is determined by multiplying the stock price index by a pre-determined unit amount.

The essential meaning of stock index futures is that investors transfer the expected risk of the entire stock market price index to the futures market. The transaction content is the stock index, and neither the seller nor the buyer actually holds the stock.

These contracts allow investors to buy or sell an entire stock index at a specific price on a specific date in the future.

Here are some of the most common stock index futures in the United States:

S&P 500 Index Futures : Stock index futures contracts based on the S&P 500 Index. The S&P 500 Index is a stock index that tracks 500 listed companies in the United States. The 500 stocks include 400 industrial stocks, 20 transportation stocks, 40 utility stocks and 40 financial stocks. It is traded on the Chicago Mercantile Exchange.

Nasdaq Index Futures : A stock index futures contract with the Nasdaq Index as the underlying asset. The stocks included include all new technology industries. Nasdaq Index Futures is the world’s first stock index futures to adopt electronic trading methods.

Dow Jones Index Futures : The full name is Dow Jones Industrial Average Futures Contract. The underlying asset of its futures contract is the Dow Jones Industrial Average, abbreviated as DJIA, which was announced by Dow Jones Company in 1896 and currently includes 30 constituent stocks.

Interest Rate Futures

Interest rate futures are financial futures contracts whose value is based on a specific interest rate product. These futures contracts typically involve government bonds or other fixed income securities, enabling traders to hedge or speculate on interest rate changes.

The underlying asset of interest rate futures is usually a government bond or interest rate instrument. When you buy an interest rate futures, you are actually agreeing to buy or sell the underlying interest rate instrument at a specific price on a specific date in the future. This allows investors to protect themselves from interest rate fluctuations or profit from predicted interest rate changes.

Common interest rate futures are summarized as follows:

Treasury bond futures : These are futures contracts based on short-term (e.g. 2-year, 5-year), medium-term (e.g. 10-year), and long-term (e.g. 30-year) Treasury bonds issued by the U.S. government. For example, 10-year Treasury bond futures are a very active market.

European government bond futures : such as futures based on German government bonds (Bunds).

Eurodollar Futures : These are futures contracts based on the interest rate on U.S. dollars held at overseas banks and are among the most active interest rate futures contracts in the world.

Short-Term Interest Rate Futures (STIR Futures): For example, 3-month futures based on the UK’s LIBOR (London Interbank Offered Rate).

Foreign exchange futures

Foreign exchange futures are a type of financial derivative, which are standardized contracts that allow traders to buy or sell a specific amount of a foreign currency at a predetermined exchange rate on a specific date in the future.

These contracts are traded on specialized futures exchanges, such as the Chicago Mercantile Exchange (CME Group).

In a foreign exchange futures contract, the buyer commits to buy a specific amount of a currency at an agreed exchange rate on a specific date in the future, and the seller commits to sell the currency on the same terms. These contracts are standardized, with fixed expiration dates, amounts, and delivery conditions.

Common foreign exchange futures are listed below:

EUR/USD futures : Based on the exchange rate between the Euro and the U.S. Dollar, this is one of the most popular Forex futures.

JPY/USD futures : Based on the exchange rate between the Japanese yen and the U.S. dollar.

GBP/USD futures : Based on the exchange rate between the British pound and the U.S. dollar.

Australian Dollar/US Dollar (AUD/USD) futures : Based on the exchange rate between the Australian Dollar and the U.S. Dollar.

Canadian Dollar/U.S. Dollar (CAD/USD) futures : Based on the exchange rate between the Canadian dollar and the U.S. dollar.

Swiss Franc/US Dollar (CHF/USD) futures : Based on the exchange rate between the Swiss Franc and the US Dollar.

What are the characteristics of futures trading?

Standardized Contracts : Futures contracts are highly standardized, meaning the contract size, delivery date, minimum price fluctuation, etc. are all pre-set. This standardization makes futures contracts easy to trade on exchanges.

Daily settlement: There is no limit on the number of transactions per day, which allows investors to obtain timely profits and losses and decide to add or stop losses immediately without waiting for the market to close. In contrast, the settlement of stock transactions generally adopts the T+2 model;

Time constraints: Based on the development of the “forward contract” model, futures trading has an “expiration date” and must be delivered before or on the expiration date, otherwise the exchange will force the position to be closed or delivered in kind;

Leveraged trading: Futures trading adopts a margin system. When investing, you only need to pay a margin of 5% to 10% of the transaction amount to conduct 100% of the transaction. As a result, the profit and loss ratio is magnified by the same proportion, just like leveraging a small amount of funds to leverage a large transaction;

Diversified assets : Futures markets encompass a wide range of asset classes, including agricultural products, metals, energy, currencies, and financial instruments such as stock index and interest rate futures.

Shorting is more flexible: Shorting futures trading does not require borrowing first and then repaying. Traders can sell futures contracts directly, even if they do not actually hold the contract. Short futures contracts can be closed by buying to close the position, or in some cases, completed through cash settlement or physical delivery.

How to buy futures?

Purchasing futures contracts usually requires going through a dedicated futures broker or a full-service broker that offers futures trading services.

Here are some well-known brokers:

Chicago Mercantile Exchange (CME Group) : Although not a direct broker, CME Group is the world’s largest futures and options market, and many brokers offer trading through this platform.

Interactive Brokers : Suitable for advanced and professional traders, offering a wide range of trading tools and low fees.

Charles Schwab : Provides futures trading services through its acquisition of TD Ameritrade. Schwab is known for its customer service and powerful research tools.

E*TRADE : Acquired by Morgan Stanley, it provides futures trading services and is known for its easy-to-use platforms and tools.

Fidelity Investments : Focuses primarily on stocks and other investment products, but also offers futures trading.

How risky is trading futures?

Futures trading is known for its high risk and high return , and the leveraged trading model is the main cause of its risks.

Let’s take a simpler example.

The futures price of cotton is 10,000 yuan/ton, and an investor buys 5 tons of cotton futures contracts (total value is 50,000 yuan). The investor submits a 10% margin (5,000 yuan) to buy assets worth 50,000 yuan.

If the cotton futures value rises by 1,000 yuan (futures price is 11,000 yuan/ton) at the close of the day, the increase is 10%. If the investor decides to sell, the profit is 5,000 yuan (55,000 – 50,000), and the profit ratio reaches 100%.

That is to say, the futures price rose by 10%, but the profit ratio reached 100%, and the leverage was 10 times.

On the contrary, if the value of cotton futures falls by 1,000 yuan on the same day, a drop of 10%, the investor will lose 5,000 yuan, a loss of 100%. At this time, if the investor wants to continue holding the cotton futures contract, he must immediately add margin.

From this we can see that the leveraged trading model and margin system of futures trading allow futures investment to be carried out in the form of “small risk for big gain”, and its risk ratio is much greater than that of stocks.

What are the differences between futures and options?

A futures contract is a legal agreement whereby two parties agree to trade an asset at a predetermined price on a specific date in the future.

Options contracts give the buyer (holder) the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specific price on or before a specific date in the future.

1. Rights and obligations

With a futures contract, both the buyer and the seller are obligated to deliver an asset at an agreed price on a specific date in the future.

An option contract only gives the buyer the right, the option, that is, at any time before the contract expires, they can choose whether to exercise the option. This is a right, but not an obligation. The option seller has no rights, but must bear the obligation to fulfill the contract. If the option buyer chooses to exercise the option, the seller must fulfill the delivery commitment. In compensation for accepting this obligation, the option seller receives a premium at the beginning of the contract.

2. Risk Exposure

In futures trading, the profit and loss risks borne by both parties are unlimited.

In option trading, the option buyer’s profit may be unlimited, and the loss is limited to the option premium; the option seller’s profit is at most the option premium, and the loss may be unlimited.

3. Security Deposit

Both buyers and sellers in futures transactions must pay a margin.

In option trading, option buyers do not need to pay margin, and the option fee (or premium) they pay is their maximum loss. This fee is paid once when buying the option, and there is no other payment obligation after that. Option sellers need to pay margin because they face potential unknown losses.

4. Hedging

Hedging is a risk management strategy used to reduce potential financial losses due to price fluctuations.

This typically involves the use of derivative instruments, such as futures, options or swaps, to hedge existing or anticipated risk exposure.

Whether hedging using futures or options, the goal is to reduce uncertainty and protect investors from adverse price movements.

• Hedging with futures

In the futures markets, hedging typically involves buying or selling futures contracts to protect an existing asset or an anticipated purchase of an asset from price fluctuations.

Its main purpose is to hedge price risks and ensure future price stability. It can reduce the impact of spot market price fluctuations, especially for commodities or assets whose prices are greatly affected by seasonality and market fluctuations.

For example, a farmer concerned about falling corn prices during harvest time might sell corn futures contracts in the futures market ahead of time to lock in the current price.

• Hedging with options

Protect existing investments against adverse price movements by purchasing call or put options.

For example, a stock investor who is concerned about a falling market may purchase a corresponding number of put options as protection. If the stock price falls, the options appreciate in value, thereby offsetting some of the losses on the stock investment.