FUTURES TRADING

By now it has been established that futures trade on exchanges, much in
the same way that stocks do. These exchanges are located throughout the
world and represent both pit and electronic trading.

Pit, or floor, trading is done on-site at the exchange. This is what most
people think of when they picture the futures market. The traders who op-
erate in these sometimes frantic arenas are the folks who actually execute
the transactions as the buyers and sellers. In the case of those who work
for brokers or other institutions, they trade based on the flow of orders
coming from their employer. There are also pit traders who are just there
trading for their own account. As noted before, they help the process by
providing liquidity.

Pit trading is the traditional operation, but it is one which is becoming in-
creasingly phased out in favor of electronic trading. This newer method
involves no human interaction, but rather is a system of order matching.
Incoming orders are matched up by computer. This speeds up the process
and provides a high degree of transparency.

As an individual trader you take positions via a broker. Your orders get
routed to the exchange where they are actually executed. Whether that is
through the pit or electronically depends on the market you are trading,
and possibly the time of day. Some markets feature floor trading during
the normal daytime market hours with electronic trading taking over in
the “after hours” timeframe. Other markets are either completely pit
traded or totally electronic.

Opening and Closing Futures Positions

Because trading futures does not result in the actual exchange of anything
(for most traders anyway), it has to be thought of a bit differently than
would be the case with stocks, for example. You aren’t actually buying or
selling anything. You are entering in to an agreement. As such, it is more
correct to say you are going long or going short rather than buying or sell-
ing, though in practice buy and sell are frequently used.

Going long means entering in to a futures contract position whereby you
would be the purchaser. Using our wheat example, the person who is long
that contract is the one who will be buying the wheat at the contract’s end.
Going short, naturally, is the other side of the equation. The short is the
one who is to be the seller at contract conclusion.

You can think of it this way. You are long if an increase in price benefits
you. If a decrease in price is to your benefit then you are short.
So when you initiate a long or short position you are entering into a fu-
tures contract. Now let’s take a look at exiting a position.
Since taking a futures position means entering in to a contract, it’s not as
each as just breaking the contract. What we actually do is enter in to an
offsetting contract.

Bringing Wheat back in to the picture, imagine that we’ve gone long a fu-
tures contract. Now we want to get out of that position. To do so, we enter
into a new futures position in which we are short. Those two positions ne-
gate each other, so you end up with no net positions.

You might be thinking “Yeah, but I have two contracts now.” No need to
worry. The exchange handles that. Because you offset your positions, you
have no more commitment. The exchange keeps track of all the open long
and short positions to make sure they match up those who are looking to
actually take delivery with those who are actually looking to provide it.
Profits and Losses

We make profits in futures positions by closing them out with an offset at a
better price than at which we entered the initial contract. If we are long,
that means at a higher price, while if we are short it’s a lower price. This is
where the value of the futures contract comes in.

Imagine that we have gone long a Wheat contract at the price of $5/bushel
Keep in mind that a futures contract is 5,000 bushels, so the value of this
contract is $25,000. Let’s say the price moves up to $6/bushel. Now the
value of a contract is $30,000. If we offset our long position by taking a
short futures position at the current price, we make $5,000.

To understand how this works, let’s take a look at what the mechanics of
the situation would be if there were no exchange.

First we have the long position. If we went all the way through the process
to delivery we would have to pay $25,000 to receive 5,000 bushels of
Wheat. Now in the case of the short position we would actually receive
$30,000 to deliver 5,000 bushels of Wheat. So the net result is that we
would buy the wheat from one person and sell it to another, making a
$5,000 profit because of the difference in the prices of the two contracts.
Can you imagine what a hassle it would be to take delivery on one side and
provide the product on the other side? That’s why we can be thankful for
the futures exchange. It eliminates that whole delivery flip-flop process,
and actually gets us our money right away rather than having to wait for
the end of the contract.

Now consider that if we had to put up 3% margin on our long position it
would have been $750 as compared to our profit of $5,000. That’s a very
nice return, isn’t it. Right there is why so many people eagerly trade the
futures market. It provides one with enormous leverage and the potential
for very high rates of return. Just keep in mind that the leverage works
both ways, though. The losses can happen just as quickly and dramatically
as the gains if you aren’t careful about your risk management.

Margin

One of the things which confuses many who first start looking at futures
trading is the concept of margin and how it works. It really is not all that
complicated, though. I’ll explain by first providing a general idea of mar-
gin and leverage.

Leverage is the use of borrowed money (generally from one’s broker/
dealer) to take on a position which is larger than one would be able to do
with strictly one’s own funds. The money the trader is required to deposit
as surety for those borrowed funds is referred to as margin.

Using a real-world example, think in terms of buying a house. Home buy-
ers generally do not pay 100% of the price in cash. In most cases the buyer
can pay a certain percentage, which is referred to as the down payment,
but must borrow the remainder. This is the application of leverage and the
down payment can be thought of as margin.

In the markets, leverage and margin
are used in one of two fashions. One
can put up margin and apply lever-
age to take control of a collection of
assets larger than they would have
been able to do so otherwise, as in
buying a house. Alternately, one de-
posit’s margin is applied as surety
for the future fulfillment of an agree-
ment to exchange assets (futures
contract).

An example of how this works in the
first fashion can be seen the stock
market. As you may know, you can
purchase 100 shares of a $50 stock
by putting down only $2500 on de-
posit – 50% margin. Your broker
loans you the rest of the funds re-
quired to make the purchase, so you
are leveraging your $2500 to control
twice that much in assets. This is
similar to putting down 20% to pur-
chase a house with the bank loaning
you the rest.

In futures, however, you aren’t actu-
ally buying or selling anything right
away. You are entering in to an

agreement to do so later on. Therefore, there is no money changing hands
immediately.

In the futures market, however, you are required to put up margin as
surety against your failure to fulfill your end of the contract agreement.
This is where the idea of counter-party risk comes in—the counter-party
being the person on the other side of the contract.

At least that is how it would be in theory. In practical reality, as an indi-
vidual trader you are required to post margin as a protection against
changes in the value of the contract(s) you hold. It is partly your protec-
tion, but mostly it is to keep the system safe because in futures it is the ex-
change which is the counter-party on all contracts. In that way margin
serves the exact same purpose as it does in the stock market (as it does
when you buy a house).

Unlike in stocks, though, most of the time futures margin requirements
are 5% or less of the contracts’ value. What is that value? That’s pretty
easy to determine. Simply take the size of the contract and multiply it by
the contract price. Using our Wheat example from earlier, the contract
size is 5,000 bushels. If the contract price is $5/bushel, then the value of
the contract is $25,000 ($5 x 5,000). If the applicable margin rate is 3%,

you would be required to put up $750 as margin for each contract
( $25,000 x 0.03 ). This is where the leverage can really be seen. [Note:
The actual margin you are required to post for each contract is determined
by your broker based on certain exchange requirements.]

There’s another difference between futures margin and stock margin. In
the stock market, when you trade on margin you are borrowing from your
broker to do so. You get charged interest for that. In futures you don’t ac-
tually borrow any money because you don’t actually buy anything.

What’s more, in the stock market you take possession of shares and cash
leaves your account to do that. In futures, the money stays in your account
the whole time. That’s actually the requirement. The margin money must
be in your account. The result is that you can actually earn interest on that
money. Some brokers will pay interest on margin deposits.

Marked-to-Market

Something which differentiates futures from stocks is how accounts are
marked-to-market. In the stock market one’s account value with move up
and down with changes in the price of the stock(s) held therein. Any prof-
its made, however, cannot be withdrawn until the gains are realized by
selling the shares. This is not the case in futures.

The holder of a futures contract sees their account credited or debited each
day based on changes in futures prices. That is just like stocks, but unlike
in equities, these gains are considered realized and one could withdraw the
profits if so desired. This might seem a trivial point, but it isn’t.

Think about this example. You have $10,000 in your stock account. You
use that to buy $10,000 worth of XZY shares. If the price of that stock
doubles, your account value goes to $20,000. If you don’t sell the stock,
though, you can’t use that extra $10,000 to buy any more stock or to buy
shares in another company.

In futures, though, a $10,000 gain in the value of your positions does give
you additional free capital for further trades. You could take that money
and use it as margin to take on additional long or short positions, in the
same futures or other ones. This is a major advantage to futures trading
and one of the real attractions to it for many speculators.

Commissions

In the futures market brokerage commissions are generally charged on
what is referred to as a “round-turn” basis. That means you only pay the
commission when you close out a position. This contrasts with stocks
where most brokers charge you both when you enter and when you exit a
position. This is another reason why so many traders look on the futures
market so favorably.

Delivery

The delivery process is something that scares a lot of potential traders out
of the futures markets. They are concerned they’ll end up with a truckload
of something they most certainly don’t want ending up dropped off in their
driveway. This isn’t something which should prevent one from making use
of the futures markets to pursue your trading objectives, though.

Why?

Well, first of all, some of the more popular futures contracts—like the ones
for stock indices—are cash settled. That means no physical products of
any kind changes hands during the delivery process. In this situation, the
exchange just credits or debits the contract holders’ accounts as if they had
offset their position at the final price recorded when the contract was up.
For example, consider a futures contract in which the value of the contract
is 100 times the value of Index X. If one enters a long position at 100, the

value of the contract is thus $10,000. Now assume the index is at the 110
level when the contract matures. The contract value is then $11,000. The
long holder would then be credited with $1000 in profits at maturity.
Of course, most futures contracts do involve some kind of physical delivery
at maturity, at least in theory.

You see, a large majority of futures posi-
tions are not entered in to with delivery (or receipt of delivery) intended.
This is because much of the futures trading volume actually comes from
speculator and hedgers who are only looking to protect themselves from
price movements.

That said, delivery can and does happen. To avoid getting in to that kind
of situation when trading futures which feature physical delivery, simply
make sure to close/offset your open contract(s) prior to the deliver period.
The exchanges set the delivery dates and other terms for all contracts, and
that information is readily available either directly from them or through
any futures broker.