Futures Fundamentals Tutorial - Investopedia

 

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In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. Intermarket Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. The Double-Edged Sword In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital. DoorstepForex provides foreign currency at best exchange rates delivered free to your doorstep. Introduction 2 Futures Fundamentals:

Futures Fundamentals Tutorial - Investopedia

A futures contract is an agreement to buy or sell an underlying financial instrument or commodity at a specified future date and price. Each futures contract represents a specific amount of a.

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Trading in futures originated in Japan during the 18th century and was primarily used for the trading of rice and silk. It wasn't until the s that the U.

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.

If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. That is why futures are used as financial instruments by not only producers and consumers but also speculators. The futures market is extremely liquid, risky and complex by nature, but it can be understood if we break down how it functions. While futures are not for the risk-averse, they are useful for a wide range of people.

In this tutorial, you'll learn how the futures market works, who uses futures and which strategies will make you a successful trader on the futures market.

A Brief History Before the North American futures market originated some years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed and unpurchased crops were left to rot in the streets!

Conversely, when a given commodity - wheat, for instance - was out of season, the goods made from it became very expensive because the crop was no longer available.

In the midth century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery spot trading or for forward delivery. The latter contracts - forward contracts - were the forerunners to today's futures contracts.

In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season. Today's futures market is a global marketplace for not only agricultural goods, but also for currencies and financial instruments such as Treasury bonds and securities securities futures. It's a diverse meeting place of farmers, exporters, importers, manufacturers and speculators. Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas farmer can match a bid from a buyer in Europe.

How the Market Works The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry system, or bids and offers can be matched electronically.

The futures contract will state the price that will be paid and the date of delivery. But don't worry, as we mentioned earlier, almost all futures contracts end without the actual physical delivery of the commodity. This tutorial can be found at: What Exactly Is a Futures Contract? Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a specific number of cable channels at a certain price every month for the next year.

This contract made with the cable company is similar to a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for now and the next year - even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of higher prices.

That's how the futures market works. Except instead of a cable TV provider, a producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.

So, a futures contract is an agreement between two parties: In the above scenario, the farmer would be the holder of the short position agreeing to sell while the bread maker would be the holder of the long agreeing to buy. We will talk more about the outlooks of the long and short positions in the section on strategies, but for now it's important to know that every contract involves both positions.

In every futures contract, everything is specified: Profit And Loss - Cash Settlement The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis. As the market moves every day, these kinds of adjustments are made accordingly.

Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day.

In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position.

As the accounts of the parties in futures contracts are adjusted every day, most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. So on the date either party decides to close out their futures position, the contract will be settled.

In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market - this is referred to as hedging. Now that you see that a futures contract is really more like a financial position, you can also see that the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker.

In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires. Economic Importance of the Futures Market Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators.

Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity.

This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer because with less risk there is less of a chance that manufacturers will jack up prices to make up for profit losses in the cash market.

The Players The players in the futures market fall into two categories: Hedgers Farmers, manufacturers, importers and exporters can all be hedgers.

A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks. The holders of the long position in futures contracts the buyers of the commodity , are trying to secure as low a price as possible.

The short holders of the contract the sellers of the commodity will want to secure as high a price as possible. The futures contract, however, provides a definite price certainty for both parties, which reduces the risks associated with price volatility. Hedging by means of futures contracts can also be used as a means to lock in an acceptable price margin between the cost of the raw material and the retail cost of the final product sold.

A silversmith must secure a certain amount of silver in six months time for earrings and bracelets that have already This tutorial can be found at: But what if the price of silver goes up over the next six months?

Because the prices of the earrings and bracelets are already set, the extra cost of the silver can't be passed on to the retail buyer, meaning it would be passed on to the silversmith. The silversmith needs to hedge, or minimize her risk against a possible price increase in silver. Had the price of silver declined in the cash market, the silversmith would, in the end, have been better off without the futures contract. At the same time, however, because the silver market is very volatile, the silver maker was still sheltering himself from risk by entering into the futures contract.

So that's basically what hedging is: Someone going long in a securities future contract now can hedge against rising equity prices in three months. If at the time of the contract's expiration the equity price has risen, the investor's contract can be closed out at the higher price.

The opposite could happen as well: A potato farmer would hedge against lower French fry prices, while a fast food chain would hedge against higher potato prices. A company in need of a loan in six months could hedge against rising interest rates in the future, while a coffee beanery could hedge against rising coffee bean prices next year.

Speculators Other market participants, however, do not aim to minimize risk but rather to benefit from the inherently risky nature of the futures market. These are the speculators, and they aim to profit from the very price change that hedgers are protecting themselves against.

Hedgers want to minimize their risk no matter what they're investing in, while speculators want to increase their risk and This tutorial can be found at: In the futures market, a speculator buying a contract low in order to sell high in the future would most likely be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future. Unlike the hedger, the speculator does not actually seek to own the commodity in question.

Rather, he or she will enter the market seeking profits by offsetting rising and declining prices through the buying and selling of contracts. Short Secure a price The now to protect Hedger against future declining prices Secure a price The now in Speculator anticipation of declining prices Long Secure a price now to protect against future rising prices Secure a price now in anticipation of rising prices In a fast-paced market into which information is continuously being fed, speculators and hedgers bounce off of - and benefit from - each other.

The closer it gets to the time of the contract's expiration, the more solid the information entering the market will be regarding the commodity in question. Thus, all can expect a more accurate reflection of supply and demand and the corresponding price.

Regulatory Bodies The U. Congress and subject to CFTC supervision. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange.

It is imperative for investors wanting to enter the futures market to understand these regulations and make sure that the brokers, traders or companies acting on their behalf are licensed by the CFTC.

Know your rights as an investor! Characteristics Given the nature of the futures market, the calculation of profit and loss will be slightly different than on a normal stock exchange. Let's take a look at the main concepts: Margins In the futures market, margin has a definition distinct from its definition in the stock market, where margin is the use of borrowed money to purchase securities.

In the futures market, margin refers to the initial deposit of "good faith" made into an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses. When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account.

This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. In other words, the amount in your margin account changes daily as the market fluctuates in relation to your futures contract. These predetermined initial margin amounts are continuously under review: The initial margin is the minimum amount required to enter into a new futures contract, but the maintenance margin is the lowest amount an account can reach before needing to be replenished.

For example, if your margin account drops to a certain level because of a series of daily losses, brokers are required to make a margin call and request that you make an additional deposit into your account to bring the margin back up to the initial amount. Word to the wise: If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have This tutorial can be found at: The Double-Edged Sword In the futures market, leverage refers to having control over large cash amounts of commodities with comparatively small levels of capital.

In other words, with a relatively small amount of cash, you can enter into a futures contract that is worth much more than you initially have to pay deposit into your margin account. It is said that in the futures market, more than any other form of investment, price changes are highly leveraged, meaning a small change in a futures price can translate into a huge gain or loss.

Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question which is part of the reason why the futures market is useful but also very risky. The smaller the margin in relation to the cash value of the futures contract, the higher the leverage.

You already know that the futures market can be extremely risky and,therefore, not for the faint of heart. This should become more obvious once you understand the arithmetic of leverage. Highly leveraged investments can produce two results: As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain will be large in comparison to the initial margin.

However, if the price just inches downwards, that same high leverage will yield huge losses in comparison to the initial margin deposit. Consequently, while the value of a commodity or a financial instrument may not exhibit very much price volatility, the same percentage gains and losses are much more dramatic in This tutorial can be found at: Pricing and Limits As we mentioned before, contracts in the futures market are a result of competitive price discovery.