Futures Trading definition for beginners, Trading Futures for dummies explained by “ForexSQ” experts to know basics and strategies and make money online, Open free online account with the best futures trading brokers in the world.
Futures Trading Definition
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A futures contract (more colloquially, futures) is a standardized forward contract which can be easily traded between parties other than the two initial parties to the contract. The parties initially agree to buy and sell an asset for a price agreed upon today (the forward price), with delivery and payment occurring at a future point, the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.
Contracts are negotiated at futures exchanges, which act as a marketplace between buyers and sellers. The buyer of a contract is said to be long position holder, and the selling party is said to be short position holder. As both parties risk their counter-party walking away if the price goes against them, the contract may involve both parties lodging a margin of the value of the contract with a mutually trusted third party. For example, in gold futures trading, the margin varies between 2% and 20% depending on the volatility of the spot market.
The first futures contracts were negotiated for agricultural commodities, and later futures contracts were negotiated for natural resources such as oil. Financial futures were introduced in 1972, and in recent decades, currency futures, interest rate futures and stock market index futures have played an increasingly large role in the overall futures markets.
The original use of futures contracts was to mitigate the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions. This could be advantageous when (for example) a party expects to receive payment in foreign currency in the future, and wishes to guard against an unfavorable movement of the currency in the interval before payment is received.
However, futures contracts also offer opportunities for speculation in that a trader who predicts that the price of an asset will move in a particular direction can contract to buy or sell it in the future at a price which (if the prediction is correct) will yield a profit.
Risk of trading futures for dummies
Although futures contract are oriented towards a future time point, their main purpose is to mitigate risk of default by either party in the intervening period. In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. Margins, sometimes set as a percentage of the value of the futures contract, must be maintained throughout the life of the contract to guarantee the agreement, as over this time the price of the contract can vary as a function of supply and demand, causing one side of the exchange to lose money at the expense of the other.
To mitigate the risk of default, the product is marked to market on a daily basis where the difference between the initial agreed-upon price and the actual daily futures price is reevaluated daily. This is sometimes known as the variation margin, where the Futures Exchange will draw money out of the losing party’s margin account and put it into that of the other party, ensuring the correct loss or profit is reflected daily.
If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (i.e. the original value agreed upon, since any gain or loss has already been previously settled by marking to market). Upon marketing the strike price is often reached and creates lots of income for the “caller.”
Futures Trading Pricing
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist – for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) – the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.
Futures contracts and Forex exchanges
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There are many different kinds of futures contracts, reflecting the many different kinds of “tradable” assets about which the contract may be based such as commodities, securities (such as single-stock futures), currencies or intangibles such as interest rates and indexes. For information on futures markets in specific underlying commodity markets, follow the links. For a list of tradable commodities futures contracts, see List of traded commodities.
Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today’s exchange-traded futures contracts. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.
Trading Futures Exchanges
Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures and futures options exchanges worldwide trading to include:
- CME Group (formerly CBOT and CME) — Currencies, Various Interest Rate derivatives (including US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Indices (Dow Jones Industrial Average, NASDAQ Composite, S&P 500, etc.); Metals (Gold, Silver)
- Intercontinental Exchange (ICE Futures Europe) – formerly the International Petroleum Exchange trades energy including crude oil, heating oil, gas oil (diesel), refined petroleum products, electric power, coal, natural gas, and emissions
- NYSE Euronext – which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced ‘LIFE’) was merged. (LIFFE had taken over London Commodities Exchange (“LCE”) in 1996)- softs: grains and meats. Inactive market in Baltic Exchange shipping. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index.
- South African Futures Exchange – SAFEX
- Sydney Futures Exchange
- Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)
- Tokyo Commodity Exchange TOCOM
- Tokyo Financial Exchange – TFX – (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate Futures)
- Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures)
- London Metal Exchange – metals: copper, aluminium, lead, zinc, nickel, tin and steel
- Intercontinental Exchange (ICE Futures U.S.) – formerly New York Board of Trade – softs: cocoa, coffee, cotton, orange juice, sugar
New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium
- Dubai Mercantile Exchange
- JFX Jakarta Futures Exchange
- Montreal Exchange (MX) (owned by the TMX Group) also known in French as Bourse De Montreal: Interest Rate and Cash Derivatives: Canadian 90 Days Bankers’ Acceptance Futures, Canadian government bond futures, S&P/TSX 60 Index Futures, and various other Index Futures
- Korea Exchange – KRX
- Singapore Exchange – SGX – into which merged Singapore International Monetary Exchange (SIMEX)
- ROFEX – Rosario (Argentina) Futures Exchange
- NCDEX – National Commodity and Derivatives Exchange, India
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