Because of the large size of these "wholesale" transactions, very few people ever buy futures contracts with the intention of actually using or
consuming the underlying commodity. There's just too much of it! The great majority of people who buy and sell futures do so only to profit
from price movements. They are called speculators and they are drawn to the futures market in search of high-yield investing opportunities.
All that you have to do is buy low and sell high.
So what are some of these futures? Well, the oldest and perhaps best known are the grains like corn and soybeans. Then there are the meats
such as live cattle and yes, pork bellies. There are futures contracts on the energies such as crude oil and unleaded gasoline, and on precious
metals such as gold and silver. The softs include cocoa, coffee, sugar, cotton and orange juice. Finally, there are futures on financial products
such as U.S. Treasury bonds, equity indices and foreign currency. The advantages arising from this great variety of markets are diversification
and opportunity: When some markets are rising, others may be falling. When some are moving sideways, others may be trending.
The Nature of a Futures Contract
How do you go about trading commodities like coffee, sugar or crude oil? If, for example, you think that the price will go up, do you have to buy
the physical product and store it in your basement? Well, you could but there are a few problems with this approach.
To begin, the transaction size in the physical commodity markets is large so if you buy the physical commodity, then you will have to pay the full
price and that will tie up a lot of cash. Then you will have to
find a place to safely store the commodity and this will cost money as will the insurance that you'll want to have in case the commodity suffers damage.
Finally, you´ll have to pay shipping and freight charges both to take possession of the commodity after purchasing it and then, when you´re ready to sell,
delivering the commodity to the point of sale. The costs associated with all of this will eat into any profit that you make on the physical
commodity transaction, but that is not the biggest drawback to trading the physical product. What do you do if you expect that the price of the
commodity will fall? How can you go about trading that price expectation with a physical transaction?
Because of the difficulties described above, few people who desire to profit from changing prices (called speculators) trade physical commodities.
Instead, they trade a financial instrument whose value moves essentially in step with the price of the physical commodity. These instruments are
generally referred to as derivative products since their value is derived from price movements of the underlying commodity. For retail traders wanting
to participate in the commodity markets, the most important derivative products are exchange-listed futures contracts and options on these futures contracts.
(More recently, online binary options on commodities have become popular which are usually based on the corresponding commodity futures contract.) Arbitrage as
well as the formula for the final settlement price calculation by the exchange help ensure that price movements of the futures contract closely
match those of the underlying commodity.
A futures contract is just a legally binding promise to acquire the physical commodity (if you bought the futures) or deliver the physical commodity
(if you sold the futures) at some point in the future when the contract expires and this may be weeks or months down the road. In other words, the
transaction is deferred and because of this, it has several advantages over a spot or physical transaction that requires immediate delivery. For example,
since there is no immediate exchange of physical commodity for cash, you do not need cash equivalent to the full market value of a futures contract to
buy the futures contract. You will, though, need a small portion of this value - usually less than 10% - to show your financial ability to handle the
risk of the trade and this cash is referred to as margin. This relatively small cash requirement creates financial leverage.
Leverage is a measure of the worth or market value of an investment relative to the money required to buy or sell the investment.
If you need to pay the full market value of an asset when you buy it, then there is no leverage. On the other hand, if you only need
to put up a small fraction of the value, then leverage is high.
For example, if a futures contract has a market value of $10,000 but you only need
to deposit $1,000 to trade it, then the margin is ten-to-one. If the market value of the futures contract rises by 2 percent to $10,200
that represents an increase of $200/$1,000 = 20% of your cash, a ten-fold increase on a percentage basis.
Leverage makes trading futures risky since a gain or loss, even a relatively modest one, can quickly become significant
relevant to your initial cash deposit. This can, in turn, make you very rich or very poor in a short space of time even
to the point of depleting all of your deposited cash and further incurring a financial liability.
Just because an asset is leveraged doesn't mean that you should automatically avoid it. Indeed, without leverage, many
retail investors would not have access to markets such as crude oil or gold because the minimum financial investment would be
otherwise prohibitively high. But it does mean that you should first determine if this type of investing is appropriate for you.
And then you need to learn how to control leverage so as to manage the
risk of loss. Lack of control of leverage is the single leading cause of financial death among beginning futures traders.
A drop in the E-mini S&P 500 futures price from 904.00 to 895.00 is equal to just one percent yet represents a dollar change of
$450 per futures contract (9 points x $50 per point). A trader with a $2000 account who is long one E-mini will see
their account value drop to $1550, a decline of over 22%. This magnification of percentage changes is a result of leverage.
Since a commodity futures is a deferred contract, it is a simple matter to sell a commodity that you do not own, say, in case you expect the price to drop.
This is referred to as selling short and can be done because, with a futures, you don´t need to have the commodity in your possession upon sale of the
futures contract. But don´t you have to acquire the physical product at some point in order to satisfy delivery of the short futures position? Yes,
but only if you intend to hold the short futures position to contract expiration. For a retail trader who is just looking to profit from price changes,
you will not do this. Instead, you will close the short futures position by simply buying a futures contract on the same commodity and having the same
expiration. Upon doing so, you will have closed the futures position and there will be no further obligation on your part to deliver the commodity.
And if prices have fallen in the interim so that you buy back at a lower price, then you have made money!
Trading futures is much more efficient than trading the physical product. In fact, in many cases, trading activity or dollar volume is higher in the
futures market than in the physical market itself and the futures contract, even though it is a derivative product, actually provides the price
discovery function for the commodity itself. Crude oil is an example of this.
On-Line or Electronic Trading
In the traditional days of open outcry, a futures contract could only be bought or sold in one place: in the designated trading pit of the
respective futures exchange that lists the futures contract for trading. So, a client wishing to trade futures had one of two choices:
(1) physically stand in the trading pit or (2) have a communication line to someone who was in the pit.
With regard to the first choice, the privilege of standing in the pit is extended only to exchange members so such traders had to spend money - at times a
considerable amount of money - to either buy or lease an exchange membership. The physical presence requirement plus high entry fee meant
that few people could trade futures this way. Consequently, the second choice was the predominant means by which retail investors could trade
futures. A customer would open an account with a futures broker who has one or several employees stationed in the trading
pit. To buy or sell a futures, you would call (on the telephone) the trading desk of your broker. The trading desk would then
relay your order to the floor broker by telephone. The floor broker would execute the order in the trading pit and then relay the fill information
to the trading desk who, in turn, would relay the information to you. For market orders in liquid markets, this could usually be done while
you waited but it was not uncommon for delays to appear, and in some cases, significant delays.
All of this changed with the movement of exchanges to an electronic order matching platform - the beginning of electronic trading. This electronic
platform serves as a virtual exchange trading pit where orders are accepted, stored and, if possible, matched and disseminated all electronically, in
other words, without human intervention. By connecting to
the exchange order matching platform - such an electronic interface is provided by the broker - a retail trader literally anywhere in the world
can both receive real-time market bids and offers on electronically traded contracts and execute buy and sell orders with great speed and reliability.
In addition to the convenience, electronic execution opened a new door to investors: day trading from home or the office.
The original intent of the exchange electronic order matching platform was to enable trading in contracts during the hours outside of the
open outcry session. In other words, it was a supplement to the traditional way of trading. However, popularity of electronic trading encouraged
the exchanges to expand the electronic session so that now, most futures contracts are available for electronic trading practically around the clock,
from Sunday evening until the Friday close. Electronic execution is by far more popular than open outcry, accounting for 98% of total futures trading
volume on CME Group, and some contracts like the popular E-mini contracts can only be traded electronically.
THE RISK OF LOSS IN TRADING COMMODITY CONTRACTS, OPTION CONTRACTS, FOREX AND LEVERAGED INVESTMENT VEHICLES IN GENERAL
CAN BE SUBSTANTIAL. YOU SHOULD, THEREFORE, CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR
FINANCIAL CONDITION. TRADING IN FUTURES, OPTIONS AND/OR FOREX IS NOT SUITABLE FOR EVERYONE.