Futures Education

The Contract

Futures are simply contracts, or obligations, to buy or sell an underlying product, or commodity, at some point in the future at a price agreed upon today. As time passes, the value of a futures contract increases or decreases relative to the cash price of the underlying commodity.

The early days of the futures industry were quite inefficient and chaotic. The problem was the lack of structure to the forward contracts that were bought and sold. If it were that way today, you would find lawyers and appraisers sitting along the sides of the exchange. The lawyers would carefully review every contract to determine what was being bought or sold, how much, and when delivery was to take place. In general, the attorney would make sure the contract was legitimate. After getting through the attorneys, the contract would then have to go to an appraiser to put a value to the contract. The appraiser would have a list of all the contracts that had been bought or sold in the past, and would find a similar one to provide an appraisal of the contract. Then you could take the contract and try to find a buyer or seller, who would take the opposite side.

Fortunately, those days are in the past and we have a wonderful system of standardization that makes futures trading much simpler! Standardization is to futures as traffic laws are to roads, providing structure and rules so we can quickly and efficiently navigate the industry. Standardization makes futures contracts easy to trade. Trading futures is like exchanging apples for apples. They are standardized as to terms of the contract such as the quantity and grade of commodity that is acceptable and when and where it can be delivered.

Let's go through some general points of a futures contract.

Obligation to Buy or Sell

Similar to stock options, there are two parties associated with each contract: the buyer and the seller. Unlike stock options, however, where the seller has an obligation and the buyer does NOT, futures contracts obligate both the buyer and the seller. The seller has an obligation to deliver a specific amount of product at a set time in the future. The buyer has an obligation to take delivery and pay for the product. The key word is "obligation."

Nobody likes the word obligation, and chances are you have now toned down your enthusiasm. However, these obligations kick in only when you don't close out, or offset, your position before expiration. Long before the truckloads of pork bellies are delivered to your doorstep, speculators, like you and I, will offset the position. This simply means that if you bought one contract of pork bellies, you "offset" your position by selling one contract of pork bellies. In math terms it looks like this: +1 -1 = 0. No delivery - as long as you do it before expiration!

At this point everyone asks, "What happens if I forget and don't offset before expiration, will I get a truckload of pork bellies?" The answer is always no! First of all, no one is going to deliver commodities without a whole lot of paperwork and mutual consent. Second, your broker has systems in place to avoid such predicaments. Your broker will simply "roll" you over into the next expiration - this is done by selling your expiring contract and buying a new longer-term contract. Or, your broker may just offset your position, leaving you flat. This is one of those "fine print" points you will want to follow up on with your broker. Less than 2% of all futures contracts are actually delivered - and 99% of those are for commercial use!

The Underlying Product or Commodity

The word commodity is defined very broadly to include underlying products such as physical commodities, financial instruments, foreign currencies or stock indexes. As mentioned before, commodities are standardized in two ways: the quantity and grade or quality.

Every futures contract specifies a certain quantity of the commodity. For example, one CME Euro FX contract represents 125,000 Euro. CBOT Soybean contracts are for 5,000 bushels of soybeans. The COMEX gold contract represents 100 troy ounces. This type of standardization makes it possible for buyers and sellers to know exactly how much of a commodity they are trading.

Another aspect of commodity futures contracts that is standardized is the quality of the underlying commodity. For example, silver contracts represent 5,000 troy ounces of 99.99% pure silver in ingot form. Crude Oil traded on the New York Mercantile is 1,000 barrels of light sweet crude (a specific grade of U.S. oil). There is also a Brent sweet crude contract which is an entirely different grade of oil.

Whether it's a silver or currency futures contract, you know exactly how much and what grade of commodity you are trading.

Price

Price is the only variable when it comes to futures contracts. When you buy a futures contract, you agree to buy the underlying commodity at a price traded today for future delivery. By putting money down on the contract, you lock in the price.

This will be better understood with an example.

Suppose you own a small regional airplane business. You are afraid that oil prices will skyrocket in the near future. You are currently paying $2.00 a gallon for gas, a by-product of crude oil, and it would sure be nice to lock in that price for the next six months.

You can - sort of. You go to the futures market and buy a crude oil futures contract that expires in six months. The price you pay for the crude oil futures contract will be at or very near today's crude oil price of $60 a barrel.

Over time it turns out you were correct in your speculation of oil prices. In three months, oil has increased to over $70 a barrel. The price you are paying at the pump to fill your plane has increased from $2 to $2.50, so you are losing money every time you fill the airplane. However, the value of your futures contract has increased and now you can sell it for $70 a barrel - making over $10 on 1,000 barrels of oil! With the profits made in the oil futures, you more than covered the increase in the price of gasoline.

There is often confusion when it comes to the differences between futures and equity options. Both are contractual agreements between a buyer and seller. Both define the quantity of the underlying product. The difference comes in how they specify price. Option contracts lock in a future price for delivery; in other words, you determine what price you want to pay in the future and pay a premium today for the right to buy the product in the future at the strike (pre-determined) price. Futures are different. Futures lock in today's price for future delivery.

Let's go back to our example of the airline company.

There is a difference between how options and futures traders would structure the same objective. The options trader would say, "I want to buy crude oil in the future at $58 a barrel." The options trader would choose an option that expires in 6 months with a $58 strike price, and pay a premium of $4 for the contract. If the price of crude oil goes up to $70, the option would be worth $12 minus the original premium of $4. In other words, the option would be worth $8 a barrel.

One big difference between options and futures, however, is how the contracts are valued at expiration. If, at expiration, the option is at or out of the money, there is no value left in the option. If a futures contract is lower than your original price, however, there is still value in the contract.

Back to the airline example:

What happens if crude oil dropped to $57 a barrel? The options trader's position is completely worthless - the option is out of the money.

The futures contract, on the other hand, still has value - albeit a loss. If the price of the contract is $57 a barrel and the futures trader paid $60 a barrel, the futures trader is losing $3 a barrel on a 1,000-barrel futures contract.

The only similarity between a futures contract and an options contract is that they both have an expiration date. But a futures contract does not "waste away" like an options contract.

The futures markets exist for the purposes of price discovery (speculation) and the transference of risk (hedging.) They are an excellent way to express your own opinion about where the price of a commodity is heading.

Expiration

Like options, futures contracts expire at a certain date in the future. For example, a June 2009 futures contract will expire sometime during the month of June in 2009 (depending on exchange rules). As with other elements of the contract, a standardized expiration date makes it easier for investors to focus solely on price discovery.

The Underlying Commodity

The futures market is growing in popularity as a financial instrument, as well as in the number of products offered. More than just a wheat and barley market, futures now include underlying products such as interest rates, energy, currencies, equity indexes, metals and more.

Due to the incredible growth, and in an attempt to keep the industry organized, the futures industry has divided futures into three broad categories: Commodities (including Ags and Metals), Financial, and Equities. These broad classifications are broken down into subgroups in much the same way the equities market breaks industries like retail down to industry groups like apparel.

In this section we cover the three broad classifications of futures and break them down into their smaller subgroups.

Commodity Futures

The term commodity can be confusing to new futures traders. The futures market is often referred to as a commodities market. The underlying product can also be generically referred to as a commodity. For example, "commodity trading advisor" is used to define an individual or firm who operates a managed futures program, even though many of them trade exclusively in the financial futures markets such as interest rates or stock indexes.

More specifically, commodities are known as physical assets. They include natural resources, chemicals and physical products you can touch, taste, smell, grow, mine, consume or deliver. Corn, gold, crude oil and coffee are all commodities.

The most popular commodity futures can be broken down into several subgroups: metals, energy, grains, livestock, and food and fiber.

Metals As one of the most fundamental building blocks of an economy, metals are used in myriad ways to support many different industries, from construction to production and financial to retail. The major metals futures contracts include copper, gold, platinum, palladium and silver. Many factors, including supply and demand, geopolitical and economic policy, affect the price of metals. As a general rule, metals are listed primarily on the New York Mercantile Exchange and through the Globex electronic exchange.

Energy

Given the world's appetite for oil, energy futures can be an exciting place to trade. The most popular energy futures include crude oil, RBOB gasoline, heating oil and natural gas. These natural resource markets have become one of the most important gauges of world economic and political developments, and are therefore heavily influenced by disruptions in energy-producing nations. Energy futures are also traded on the New York Mercantile Exchange and Globex.

Grains

Grains and soybeans are essential to food and feed supplies. The major futures contracts in this category are corn, soybeans, soybean oil, soybean meal and wheat. Grain prices are especially sensitive to weather conditions in growing areas at key times during a crop's development, as well as economic conditions that affect demand. Reports from the U.S. Department of Agriculture are closely watched, summarizing key factors influencing supply and demand including current production and carryover supply from the prior season. Grain commodities are generally traded on the Chicago Board of Trade, Kansas City Board of Trade, and Minneapolis Grain Exchange.

Livestock

Commodity futures on live cattle, feeder cattle, lean hogs and pork bellies are another class of commodities. Their prices are affected by consumer demand, competing protein sources, price of feed, and factors that influence the number of animals born and sent to market, such as disease and weather. Livestock futures are generally traded on the Chicago Mercantile Exchange.

Food and Fiber

If you've ever watched the movie "Trading Places" you'll be familiar with this class of commodities, which includes cocoa, coffee, cotton, sugar and the ever infamous frozen concentrated orange juice. In addition to global consumer demand, the usual growing factors such as disease, insects and drought affect prices for all of these commodities. International exchange rates affect all of these global products, as well as factors like tariffs and geopolitical events in producing nations. These markets are traded at the New York Mercantile Exchange and ICE.

Financial Futures

Financial futures are futures contracts where the underlying products are financial instruments such as interest rates or equity (stock) indexes. Like all futures markets, a financial futures contract specifies an exact quantity of the underlying financial instrument at a market-determined price that can be settled via cash or physical delivery, depending on the instrument.

Financial futures were developed amid a rapidly growing trend toward globalization in the world's economic landscape starting in the early 1970s. They were designed to meet new needs and risks that businesses, governments, and individuals faced amid changing capital flows. Even though they have a shorter history than agricultural futures, they now dominate the exchange-traded product offerings. Today, the majority of activity in futures globally takes place in contracts on financial investments, and futures exchanges are continually on the lookout for new successes in this category.

Financial futures fall into two subgroups: interest rates and equity indexes.

Interest Rates

As the hub of all economic and financial performance, interest rates have become an increasingly more important factor in the U.S. financial system. Interest rate futures products encompass a range of short-term instruments, such as the Federal funds rate (an overnight inter-bank lending rate), and long-term products, such as the 30-year U.S. Treasury bond.

Equity Indexes

Recent years have brought a surge of interest in equity index futures as an alternative investment choice to exchange traded funds, and equity index options. Stock index futures contracts were introduced in the United States in 1982, nine years after listed options investing began at the Chicago Board Options Exchange, the securities offshoot of the Chicago Board of Trade. Interestingly, the CBOT had come up with the idea of futures on stocks as a way to diversify its product line, although futures on individual stocks were many more years in coming. However, shortly thereafter, the Chicago Mercantile Exchange introduced the S&P 500 index, which quickly became the market leader and continues to dominate U.S. stock index futures trading today. A number of stock index futures and options contracts are now available to futures traders, covering all areas of the market. The most popular major index futures contracts include the S&P 500 Index, the Nasdaq 100 Index, the Dow Jones Industrial Average, ISE Sector Indexes, and Volatility futures.

Single Stock Futures

Single-stock futures combine the best elements of two popular and useful financial investments–futures trading and stock investing. SSF's can be used as speculative or hedging vehicles with unique characteristics and potential benefits, and provide an alternate method for financing equity transactions.

Currency Futures

When it comes to international investing, investment managers, corporations and private investors trade currency futures, also known as foreign exchange, forex or simply FX, to manage the risks and capture potential opportunities associated with forex rate fluctuations.

When trading currency you don't actually trade one currency, but a pair based on the relationship between the two. For example, if you wanted to buy Euro, then you would sell or give up your dollars and buy Euro. You would profit if the dollar weakens and the Euro strengthens. A number of factors go into determining the "strength" or "weakness" of a currency versus another, but it usually comes down to comparing the economy of one nation to that of another. Generally, expanding economies have stronger currencies, while recessionary economies have weaker currencies.

As you can see the futures market is enormous. Don't get overwhelmed though. There are more stocks than there are futures and you seem to get by just fine. Most futures traders will specialize in one area or another. The adage "Jack of all Trades, Master of None" isn't a description of a futures trader! One key to futures success is knowing as much as possible about the underlying commodity.

Symbols

In order to understand the futures markets, it is essential to become familiar with basic terminology and operations. While trading rules and procedures at each futures exchange vary slightly, terms tend to be used consistently by all U.S. exchanges - especially when it comes how each futures contract is identified.

All futures contracts are assigned a unique one or two-letter code that identifies the contract and the underlying commodity. This abbreviation, or ticker symbol, is used by the clearing platforms to process all transactions. For instance, the symbol for the Dow future is DJ, while the symbol for the mini-sized Dow future is YM. This symbol is important when you trade electronically because if you enter the wrong symbol, you could trade the wrong contract.

In addition to the contract code, you also need to know the expiration month and year code. For instance, the month code for March is H. So if you were trading the March Dow future in 2009 the code would be DJ H9.

To find a futures symbol take 1) commodity root 2) letter for month 3) last digit for year. Here is a list of the month codes for your convenience: (globex)

F = January	K = May	U(P) = September
G = February	M(I) = June	V = October
H(C) = March	N = July	X =November
J = April	Q = August	Z(T) = December

Before you trade, be sure to contact your broker to make sure you have the right symbols, since different platforms and brokerages may vary slightly in how to enter them into their computer systems.