Understanding Futures Contracts: Beginner’s Guide
New to futures or looking for a refresher? This article is designed for you. Dive into the basics of futures contracts, how contracts trade on a futures exchange, the different ways customers use these instruments and the benefits that futures provide. Gain a stronger understanding of how futures work and why more market participants are using derivatives in their trading strategies today.
This course covers:
- Contract Specifications
- Contract Trading Codes
- Expiration and Settlement Processes
- Tick movements
- Futures Price Limits
- Notional Value
- Futures Market Transparency
- Roles of Speculators and Hedgers
What is a Futures Contract?
Forward and futures contracts are financial instruments that allow market participants to offset or assume the risk of a price change of an asset over time.
A futures contract is distinct from a forward contract in two important ways: first, a futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Second, this transaction is facilitated through a futures exchange.
The fact that futures contracts are standardized and exchange-traded makes these instruments indispensable to commodity producers, consumers, traders, and investors.
A Standardized Contract
An exchange-traded futures contract specifies the quality, quantity, physical delivery time, and location for the given product. This product can be a commodity, such as 100 barrels of crude oil to be delivered in the month of May, or it can be a financial asset, such as the euro value of 10,000 shares of a particular stock in the month of November.
The specifications of the contract are identical for all participants. This characteristic of futures contracts allows a buyer or seller to easily transfer contract ownership to another party by way of a trade. Given the standardization of the contract specifications, the only contract variable is price. Price is discovered by bidding and offering, also known as quotes, until a match, or trade, occurs.
Futures contracts are products created by regulated exchanges. Therefore, the exchange is responsible for standardizing the specifications of each contract.
The exchange also guarantees that the contract will be honoured, eliminating counterparty risk. Every exchange-traded futures contract is centrally cleared. This means that when a futures contract is bought or sold, the exchange becomes the buyer to every seller and the seller to every buyer. This greatly reduces the credit risk associated with the default of a single buyer or seller.
The exchange thereby eliminates counterparty risk and, unlike a forward contract market, provides anonymity to futures market participants.
By bringing confident buyers and sellers together on the same trading platform, the exchange enables participants to enter and exit the market with ease, making futures markets highly liquid and optimal for price discovery.
A futures contract is a legally binding agreement to buy or sell an underlying asset at a specified time in the future. The contract specifies the quantity, delivery location, and delivery date of the underlying asset.
The underlying asset can be a physical commodity or a financial product. For physical commodities, the exchange sets acceptable grades of the commodity to ensure quality. For financial products, the contract specifies the value of the asset, such as the U.S. dollar value of 100,000 Australian dollars.
The contract size, or quantity of the product delivered for a single contract, is also specified in the futures contract. The exchange determines the contract size to meet the needs of market participants. For example, participants who cannot risk the exposure of a full-sized contract can use a smaller contract size, such as the E-micro S&P 500 futures contract.
Delivery location is an important consideration for physical commodity markets with significant transportation costs. For example, the random-length lumber contract at CME Group specifies delivery in a specific state and in a certain type of boxcar.
Every futures contract is referred to by its delivery month. Traders refer to the contract by the month in which delivery will occur, such as the March Corn contract or the December WTI contract. Delivery can occur anywhere from one month to several years in the future, and the exchange specifies when delivery will occur within the month. Trading for a contract typically halts a few days before the specified delivery date.
Understanding Contract Trading Codes
What are Trading Codes?
The display format of futures contract codes is fundamental to understanding pricing across multiple expirations.
Contract display codes are typically one- to three-letter codes identifying the product followed by additional characters indicating the month and year of expiration. The format of a contract code varies according to the asset class and trading platform. Many contract codes originated on the trading floor to convey maximum information with the fewest characters and migrated intact to the electronic environment.
For this exercise, let’s first look at the E-mini S&P 500 futures contract. The CME Globex contract code this product is ES, which is also the contract code used on CME ClearPort. Now let’s look at the Eurodollar futures contract. On CME Globex, this contract is identified by the code GE. On CME ClearPort, this product is identified by the code ED. It is therefore important to be aware that contract codes can vary across platforms.
For contract expiration, additional characters added to the right of the contract code indicate month and year.
Each calendar month expiration is identified by a single letter as follows:
- January – F
- February – G
- March -H
- April -J
- May – K
- June – M
- July – N
- August – Q
- September -U
- October – V
- November -X
- December -Z
Available contract expiration months may vary by product, but the letter following the contract code always indicates expiration month. The expiration year is indicated following the month as a numeric value.
Let’s construct the display code for the E-mini S&P 500 futures contract expiring January 2019. The first determining factor is trading platform and for this example we will use CME Globex. For CME Globex the E-mini S&P contract code is ES. Following ES, we add the expiration month, which for January is the letter F. Finally, we add a 9 for 2019. Therefore the display code for the E-mini S&P 500 futures contract expiring in January 2019 is: ESF9.
Futures Expiration and Settlement
Price discovery is the process of determining a fair and common price for an asset through the interaction between buyers and sellers in a regulated exchange. The futures market is particularly efficient in this process due to the instantaneous dissemination of information, providing bid and ask prices to all participants around the world.
In this auction-style environment, traders can find fair and efficient trades, regardless of their location. Bid and ask quotes for the same contract are updated in real-time across the globe, providing transparency and equal pricing for all participants, whether retail or institutional.
The constant change in supply and demand, combined with news from around the world, results in bids and offers that fluctuate in response to every trade made in the market. As a trader, you can rely on the quotes displayed on your screen and trade with confidence knowing that you are receiving the same price as others trading the same product at the same time.
The open auction system assimilates all available information, leading to increased market efficiency and reliability of prices from one trade to the next. The end result is a global marketplace that facilitates fair, efficient, and transparent price discovery for all participants.
Futures Contract Profit or Loss
In the futures market, traders participate to either earn profits or protect themselves against potential losses. However, the method of calculating profits and losses varies across markets, so it is important for traders to understand the calculation methods used in the specific market they are trading in. To determine the profit or loss for each contract, traders must be aware of factors such as contract size, tick size, current trading price, and the purchase or sale price of the contract. For instance, WTI Crude Oil futures represents the value of 1,000 barrels of oil, with its price quoted in dollars per barrel and a minimum tick size of $0.01.
To calculate the current value of a contract, traders must multiply the current trading price by the size of the contract. The dollar value of a one-tick move is obtained by multiplying the tick size by the contract size. Once the value of a one-tick move is known, traders can determine their profit or loss by multiplying it with the number of ticks the futures contract has moved since they acquired it. They can then calculate their total profit or loss by multiplying this result with the number of contracts they hold.
Traders should also understand the potential impact of market volatility on the value of their open positions. To do this, they can analyze the average price move for the contract and corresponding tick value. For instance, the 14-day average true range for the ES and Silver futures contracts are 15 and 0.32 respectively. This means that the value of a typical daily move in dollars for the ES contract is $375, while for the SI contract it is $800. Therefore, traders should plan their risk and reward based on the potential size of average moves in the contracts they are trading.
Speculators are participants in the futures market who accept risk in order to make a profit. They can achieve this by buying low and selling high or selling first and later buying at a lower price. There are various types of speculators, including individual traders, proprietary trading firms, portfolio managers, hedge funds, and market makers.
Individual traders have benefited from electronic trading, which has given them better access to price and trade information, while proprietary trading firms provide traders with education and capital to execute a large number of trades per day. Portfolio managers use futures markets to increase or decrease the overall market exposure of a portfolio without disrupting the delicate balance of investments, while hedge funds use advanced investment strategies to maximize returns.
Market makers are important to the trading ecosystem as they help facilitate the movement of large transactions without effecting a substantial change in price. All types of speculators bring liquidity to the market place, which is a crucial market function that enables individuals to easily enter or exit the market. In contrast to speculators, hedgers aim to offset or eliminate risk and have a vested interest in the underlying asset of each contract.
Understanding the Role of Hedgers
What is meant by a Hedger?
Hedgers are individuals or firms who participate in futures markets and buy or sell physical commodities. This group includes producers, wholesalers, retailers, and manufacturers who are affected by changes in commodity prices, exchange rates, and interest rates. To mitigate the effects of such changes on their bottom line, hedgers use futures contracts to manage and offset risk. Unlike speculators who seek profit from market risk, hedgers use futures markets to minimize risk.
For instance, a corn farmer worried about the price of his crops when he sells them in the fall can hedge his exposure by selling a corn futures contract. If the price of corn drops at harvest, the farmer will see a loss in the local market but will gain in the futures market. If prices rise, the farmer will suffer a loss in the futures market but gain in the local market. This way, the hedged farmer is protected from adverse price movements.
There are several types of hedgers in commodities markets, including buy-side and sell-side hedgers, as well as merchandisers who both buy and sell commodities. Various industries now use the risk management potential of futures contracts to secure prices for different assets, such as steel, crude oil, and precious metals. Overall, hedging allows market participants to benefit from added price protection.
In either scenario, the hedged farmer has added protection against adverse price movements. The use of futures enabled him to establish a price level well before he sells the crop in his local market.
Types of Hedgers
There are several types of hedgers in the commodities markets:
- Buy-side Hedgers: Concerned about rising commodity prices
- Sell-side Hedgers: Concerned about falling commodity prices
- Merchandisers: They both buy and sell commodities. Their risk is different than the directional risk of a traditional buying and selling hedger. Their risk is the spread or difference between the purchase and selling prices that determine their profitability.
Trading Venues (Pit vs. Online)
The futures market has evolved over time to include both traditional trading floor transactions and electronic trading. Although electronic trading has become more prevalent in recent years, the trading pit still exists and continues to play a significant role in futures trading.
In the past, all futures business was conducted on the trading floor where traders and floor brokers met in designated areas called pits to buy and sell futures contracts. Only members or individuals associated with a member of the respective commodity exchange were allowed to transact business on the floor, while those who were not members had to go through a broker. This method of trading was visually dynamic, with traders in colourful jackets shouting orders and using hand signals.
However, the advent of new technology in the 1990s allowed futures trading to transition to electronic platforms and online brokerages, leading to increased accessibility, lower commissions, and sophisticated trade routing. This shift to electronic trading has attracted more participants to the futures market, thereby increasing the liquidity of each contract.
Trading hours differ between pit traders and retail online traders, with online trading available 24/7 while pit sessions have specific opening and closing times. Despite changes in the way trades are conducted, the fundamental purpose of the futures market remains the same. Whether on the trading floor or through electronic markets, futures remain a valuable contract for trading and managing risk.
What is Volume?
The volume of futures contracts is reported by counting the number of contracts bought and sold within a given time frame, such as daily or intraday. Any transaction involving a futures contract adds to its volume. Traders often use changes in volume to make informed trading decisions, as volume can provide insight into price levels that are of interest to traders, indicate when to switch to the front month futures contract during a roll, and identify the most liquid trading periods.
However, volume alone cannot reveal whether traders are buying or selling, opening or closing positions, or indicate the direction of the market. For example, an increase in volume could be caused by traders opening new long positions at support levels, which may indicate a bullish sentiment, or by the liquidation of existing long positions or opening of new short positions, which could be bearish.
Traders may use different methods to interpret volume and make trading decisions, but volume remains an important factor in understanding market activity. Volume data is easily accessible and reported for each futures contract and the market as a whole.
Open interest refers to the total number of futures contracts that are held by market participants at the end of a trading day. This number can vary from day to day as new trades are opened and closed. Unlike the total number of issued shares of a company, the number of outstanding futures contracts changes regularly.
Open interest is an important indicator for understanding market sentiment and the strength behind price trends. Traders use it to confirm the strength of a trend, as increasing open interest is generally seen as a confirmation of the trend, while decreasing open interest can indicate that the trend is losing strength.
Open interest is related to, but different from, trading volume. While trading volume counts all contracts that have been traded, open interest only looks at the total number of contracts that remain open in the market.
Open interest data is published daily, and a report called the Commitment of Traders is released every Friday afternoon. This report breaks down open interest data by different classes of market participants and whether they are holding a long or short position. This information can be used by traders to gain valuable insights into what various participants are doing in the market.
Overall, open interest is an important variable that futures traders use in their analysis of the markets, and it can be used in conjunction with other analysis to support trade decisions. Large changes in open interest can be an indicator of when certain participants are entering or leaving the market and may provide clues to market direction.