Futures Basics

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Futures Basics

Postby PebbleTrader » Tue Mar 19, 2013 5:19 pm

What is a Futures Contract?

A futures contract is a legally binding agreement to buy or sell a commodity or financial instrument
sometime in the future at a price agreed upon at the time of the trade. While actual physical
delivery of the underlying commodity seldom takes place, futures contracts are nonetheless
standardized according to delivery specifications, including the quality, quantity, and time and
location. The only variable is price, which is discovered through the trading process. As an
example, when a trader purchases a December CBOT mini-sized silver contract he is agreeing
to purchase 1,000 troy ounces of silver for delivery during the month of December. The quality
of the product is standardized so that all December CBOT mini-sized silver futures contracts
represent the same underlying product.
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Postby PebbleTrader » Tue Mar 19, 2013 5:19 pm

Offset

Only about 3% of all futures contracts actually
result in physical delivery or cash settlement of
the commodity. The other 97% are simply offset.
That means that the majority of participants
close out their positions prior to the contract's
delivery date (sellers buy back the futures they
sold, and buyers sell back the futures they bought).

The standardization of futures contracts
affords tremendous flexibility. Because futures
contracts are standardized, sellers and buyers
can exchange one contract for another and
"offset" their obligation to take delivery on
a commodity or instrument underlying the
futures contract. Offset in the futures market
means taking another futures position
opposite or equal to one's initial futures
transaction. For example, if a trader bought
one December CBOT mini-sized silver
contract, he must sell one December CBOT
mini-sized silver contract before the contracts
call for delivery.
Last edited by PebbleTrader on Tue Mar 19, 2013 7:33 pm, edited 1 time in total.
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Postby PebbleTrader » Tue Mar 19, 2013 5:33 pm

Delivery

Traders sometimes joke about having a
truckload of soybeans dumped in their front
yard as a result of a futures trade. While the
potential for delivery is vital to linking cash and
futures prices, in reality, very few futures trades
result in delivery and as a result of the formal
delivery process and facilities, you never have
to worry about taking delivery of the soybeans
in your front yard.

Delivery on futures positions begins on the first
business day of the contract month. Typically,
the oldest outstanding long (buy position) is
selected to match a short's (sell position)
intention to deliver. Some futures contracts
have a cash-settlement process rather than
physical delivery. For instance, if you held
a position in the Dow futures contract until
expiration, you would simply receive (or pay)
the final gains (or losses) on the contract
based on the difference between the entry
price and final settlement price.

While most futures traders offset their
contracts, if a futures contract is not offset,
the trader must be ready to accept delivery of
the underlying commodity. Futures contracts
for most physical commodities, such as
grains, require market participants holding
contracts at expiration to either take or make
delivery of the underlying contract. It's this
responsibility to make or take delivery that
forces futures prices to reflect the actual cash
value of the commodity.
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Postby PebbleTrader » Tue Mar 19, 2013 5:34 pm

Long or Short

With futures, the trader can profit under a
number of different circumstances. When the
trader initially purchases a futures contract he
is said to be "long," and will profit when the
market moves higher. When a trader initially
sells a futures contract he is said to be "short"
and will profit when the market moves lower.
Going short in a futures market is much easier
than going short in other markets. Other
markets sometimes require the trader to
actually own the item he is shorting, while this
is not the case with futures. Like most other
markets, a profit is obtained if you initially buy
low and later sell high or initially sell high and
later buy low.
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Postby PebbleTrader » Tue Mar 19, 2013 5:34 pm

Leverage

One of the key benefits of trading in the
futures markets is that it offers the trader
financial leverage. Leverage is the ability of
a trader to control large dollar amounts of a
commodity with a comparatively small amount
of capital. As such, leverage magnifies both
gains and losses in the futures market. For
example, if a trader buys one soybean
contract (5,000 bushels) at $6.50 per bushel
($32,500 per contract), the required amount
to trade, known as "margin," might be
approximately $1,400 (approximately 4
percent of the contract value), or about 28
cents per bushel. So for $1,400 the trader
can purchase a contract that has a delivery
value of $32,500.

The benefit of leverage is available because
of the margin concept. When you buy a
stock, the amount of money required is equal
to the price of the stock. However, unlike
trading a stock, a futures contract transaction
requires both the buyer and seller to post a
performance bond margin. To provide another
example, the margin required for a T-bond
contract worth $100,000 may be as little as
$2,400. As you can see, minimum margin
requirements represent a very small
percentage of a contract's total value.

To trade a futures contract, the amount you
must deposit in your account is called initial
margin. Based on the closing prices on each
day that you have that open position, your
account is either debited or credited daily for
you to maintain your position. For example,
assume you bought 1 CBOT corn futures
contract (5,000 bushels) at a price of $2.25
per bushel and posted initial margin. At the
end of the trading day, the market closed at
$2.30, resulting in a gain of 5 cents per bushel
or a total of $250 (5,000 bushels x $.05). This
amount will then be credited to your account
and is available for withdrawal. Losses, on the
other hand, will be debited. This process is
called market-to-market.

Subsequent to posting initial margin, you
must maintain a minimum margin level called
maintenance margin. If debits from market
losses reduce your account below the
maintenance level, you'll be asked to deposit
enough funds to bring your account back
up to the initial margin level. This request for
additional funds is known as a margin call.

Because margins represent a very small
portion of your total market exposure, futures
positions are considered highly leveraged.
Such "leverage," the ability to trade contracts
with large underlying values, is one reason
profits and losses in futures can be greater
than trading the underlying cash contract. This
can be an attractive feature of futures trading
because little capital is required to control
large positions. At the same time, a bad trade
can accrue losses very quickly. In fact, a trader
can lose more than his initial margin when
trading futures. This is why successful traders
must develop a sound trading plan and
exercise great discipline in their trading
activities.
Last edited by PebbleTrader on Tue Mar 19, 2013 5:38 pm, edited 1 time in total.
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Postby PebbleTrader » Tue Mar 19, 2013 5:35 pm

Liquidity

Another key benefit of futures trading is
liquidity. Liquidity is a characteristic of a
market to absorb large transactions without a
substantial change in the price. Liquid markets
easily match a buyer with a seller, enabling
traders to quickly transact their business at
a fair price. To view liquidity in action you can
visit the CBOT web site and view the live
"book." This shows all the bids (to buy) and
offers (to sell) on both sides of the CBOT
gold contract, for instance. You will notice that
within the first five price increments (known
as "ticks") there is typically an average of 300
contracts to either buy or sell. This is
considered a very liquid market, meaning
that for all practical purposes the trader can
buy or sell at a fair price.

Some traders often equate liquidity with
trading volume, concluding that only markets
with the highest actual number of contracts
traded are the most liquid. However, for some
contracts, the Chicago Board of Trade has
a market maker system in place to promote
liquidity. For contracts with a market maker, a
trader or firm designated as the market maker
then makes two-sided markets (both bids and
offers) for a specific quantity.
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Postby PebbleTrader » Tue Mar 19, 2013 5:35 pm

Transparency

Many futures markets such as those at the
CBOT are considered to be "transparent"
because the order flow is open and fair.
Everyone has an equal opportunity for the
trade. When an order enters the marketplace,
the order fills at the best price for the
customer, regardless of the size of the
order. With the advent of electronic trading,
transparency has reached new heights as
all transactions can be viewed online in real
time. In a very general sense, transparency
makes all market participants equal in terms
of market access.
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Postby PebbleTrader » Tue Mar 19, 2013 5:35 pm

Financial Integrity

When making an investment, it is important to
have confidence that the person on the other
end of the trade will acknowledge and accept
your transaction. Futures markets give you
this confidence through a clearing service
provider system that guarantees the integrity
of your trades. Clearing service providers, in
conjunction with their clearing member firms,
create a two-tiered guarantee system to
protect the integrity of futures and options
markets. One tier of the system is that the
clearing service provider acts as the
counterparty to futures and options trades?
acting as a buyer to every seller and a seller
to every buyer. The other tier is that clearing
firms extend their own guarantee to buyers
and sellers who are not clearing firms. All firms
and individuals who do not hold memberships
or ownership interests in the clearinghouse
must "clear" their trades through a clearing
firm, which then guarantees these trades
to the clearinghouse. This allows all
market participants to rest easier because
clearing firms will make good on the trades
they guarantee, even if the original
counterparty defaults.
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Postby PebbleTrader » Tue Mar 19, 2013 5:38 pm

-----------------------------------------------------------------------------------------
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Postby PebbleTrader » Tue Mar 19, 2013 5:41 pm

Market Mechanics and Terminology

In order to understand the futures markets,
it is essential to become familiar with basic
terminology and operations. While trading
rules and procedures of each futures
exchange vary slightly, these terms tend to
be used consistently by all U.S. exchanges.
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