Futures Simplified

Futures trading evolved from a contractual practice among farmers known as Forward Agreements. Buyers and sellers of corn, wheat and other agricultural products would agree to a price based on the delivery of the product to the buyer at a future point in time. Upon delivery the buyer of the goods would have to pay the price agreed upon in the Forward Agreement. The lapse between the Forward Agreement and the time of delivery of the product may have seen a change in market price for the actual product. A myriad of factors could have caused a change in price including climate change, demand for the product, seasonal trends and so on. The potential for profit on price fluctuations mixed with the need for a centralized location for buyers and sellers resulted in the opening of a futures exchange in Chicago.

In 1848 the Board of Trade in Chicago (CBOT) was established where buyers and sellers of agricultural products would meet to exchange in Forward Agreements. The Forward Agreement soon evolved into a Futures contract that had a standardized quantity of product to be bought or sold and standardized rules for taking delivery of the product by the buyer. Any investor could buy and sell in this new standardized contract but the transaction would have to be made exclusively at the futures exchange in Chicago. Both farmers and speculators would bet daily on the price of future delivery of agricultural products. If they projected the market price of wheat was to increase in the future they would buy a futures contract. If sentiment was that the market will drop in price they would sell the futures contract and go short the wheat market.

Short selling is a term used to bet the market down and profit from a drop in price. A Short sell in futures must be offset by buying the contract back in the market before expiration of the futures contract. The difference between the price the contract was sold short and the price it was bought back will be either a profit or a loss. So if a wheat trader sold short a futures contract for wheat at $4.05 per bushel and he bought the contract back at $3.95 per bushel, he then made 10 cents in profit on the contract. He capitalized on the spread between where he bought or offset his position and where he originally sold Short.

When a futures trader purchases a futures contract he in actuality has committed himself to either take delivery of the underlying product if he has gone long the market or make delivery of the product if he has gone short the market. Taking a long position means the investor is betting the market to go higher in price. The only way to release his commitment to delivery is to offset his position before expiration of the contract. In futures trading the price of the futures contract must be aligned with the cash price of the underlying product as time moves closer and closer to delivery date because once the futures contract expires the value of the futures contract will be based on the cash market price of the underlying product. The cash market is the actual market where the product is bought and sold. Here are two classic examples. A mill decides to buy one futures contract of wheat at $3.95 a bushel at the CBOT and decides to exercise the contract and take delivery of the physical wheat in 6 months. The mill will not offset its Long position in the futures market but will hold on to its position and take delivery of the wheat. Once the contract expires the mill will await for delivery of the wheat at a warehouse at the exchange or in the city of Chicago. After loading up its truck it can take the wheat to market and sell the wheat at the cash price offered in the cash wheat market. If the cash price is trading at $4.20 the mill would stand to make 25 cents a bushel if it turns around and sells the actual wheat on the open cash market. The other scenario is that a farmer at the same moment chooses to sell Short one futures contract at $3.95 and decides to make delivery in 6 months. He never offsets his Short position by buying the contract back in the futures market but instead holds on to his position and decides to deliver 5,000 bushels of wheat to a specified warehouse in Chicago. The standard quantity for the wheat futures contract is 5,000 bushels. The wheat will be inspected by the exchange for quality and grade. Upon delivery he receives his $3.95 per bushel, the price he sold the wheat when going short the futures contract. At the end of day he actually lost 25 cents on the deal per bushel because he was forced to deliver his bundle of wheat 25 cents under the present cash market price for the product.

Futures traders can either be hedgers or speculators. Hedgers deal in the actual product either as a supplier of the product (seller) or as a consumer or distributor of the actual product (buyer). The futures market can be used by a farmer to hedge against a change in price that may affect the value of the underlying product. If he is a producer and let’s say he stores wheat, he may want to sell short a futures contract to hedge his product against a drop in market price. He will profit should the price fall in the futures market but lose in the cash market as the cash price also drops in price. Should the price increase he will potentially gain in the cash market and thus commensurately lose on his Short position in the futures market. A manufacturer planning to buy a commodity in 6 months could consider going long the futures contract. Should futures prices rise a gain will result from the higher price in the futures market but will be offset by a higher cash price to buy the underlying product, and if the price drops the manufacturer will take a loss on the futures contract but buy the underlying product at a lower price in the cash market. Whether the market goes up or down a hedger is usually safeguarded against price fluctuation when using futures to hedge inventory supply. The speculator on the other hand attempts to only profit from a change in price of the underlying product by buying and selling futures contracts. The speculator bets on the change in price and will close his position before delivery date and thus liquidate any commitment to take or deliver the product.

When an investor decides to take delivery of the underlying product he will need to post the balance of the contract that is outstanding. On his initial investment all he needed to post was 10% margin. Any decision to take delivery will require posting the balance owed on the contract in order to receive delivery of the product. Clearly leverage offered in futures outweighs stocks and bonds. In futures the only demand to add more than 10% of the investment to your futures account is when a decision is made by the owner of the futures contract to take actual delivery of the underlying product. This 10% requirement is called Initial Margin.
  
A futures investor must liquidate his position before delivery or be required to accept or make delivery. This being said his window of opportunity narrows as time closes in on the delivery date. Time restraint in futures trading makes this type of investment a much riskier proposition than stocks or bonds because the trader is forced in time to let go of his position or take or make delivery.

In 1919 the Chicago Mercantile Exchange (CME) was founded. Beginning in the 1970s the CBOT and the CME began trading also in non-agricultural futures contracts like the US Treasury Bond contract, world currencies, and stock indices like the S&P 500, the NASDAQ 100 and the DJIA. The crude oil contract traded at NYMEX in New York is one of the most widely traded futures contracts in the world. Gold and silver futures are also traded in New York on the COMEX exchange. The same standardized principles that apply to trading futures in agricultural products are now offered for financial instruments, currencies, metals, stock indices and other products. As futures trading began to expand in volume a decision was made by the US government to regulate the industry. The Commodity Futures Trading Commission and the National Futures Association are two agencies that currently regulate the commodity futures industry in the United States.

A clearer perspective on how futures are traded can better be explained by reviewing the details of an intraday session. Let’s focus on the closing prices for Wheat traded at the CBOT and the S & P 500 Stock Index traded at the CME for August 4, 2006. Trading in futures is now much more than just trading in basic agricultural products. The S & P 500 Stock Index futures contract is a prime example of one of many financial instruments that have been introduced in the last 35 years as a hedging tool. Wheat and the stock index are now futures contracts even though one is not a physical commodity. They share the same general trading rules and are bought and sold based on the expiration of delivery dates and the cash price of the underlying product. Let us now look at the price activity of these two futures contracts to simplify how they are traded. 

Here are the closing numbers for the Wheat contract traded at the CBOT for the near month delivery contract for August 4, 2006. The near month delivery is September delivery and the futures contract closed at end of session at $3.96 per bushel. The market opened at $4.00 with an intraday high of $4.02 and an intraday low of $3.95 and ¼. The volume was 181,920 and open interest was 177,560. The 52 week High is $4.45 and ½ and the 52 week Low is $3.51. The cash price settled at end of session at $3.29 ½.  The symbol for September delivery is WU. The quantity standard for delivery for the contract is 5,000 bushels times the price per bushel. The contract trades in ¼ and each increment/tick is $12.50.

Here are the closing numbers for the S & P 500 futures contract traded at the CME for the near month delivery contract for August 4, 2006. The near month delivery is September delivery and the futures contract closed at end of session at 1286.00. The market opened at 1287.20 with an intraday high of 1298.00 and an intraday low of 1278.00. The volume was 29,335 and open interest was 608,680. The 52 week High is 1342.50 and the 52 week Low is 1229.20. The cash price settled at end of session at 1279.36. The symbol for September delivery is SPU. The quantity standard for delivery for the contract is $250 times the index. The contract trades in 10ths and each increment/tick value is $25.

Joe is not too familiar with futures but he is beginning to learn steadily on how futures work. A friend of his recommends a reputable futures discount broker and Joe decides to open an account with that same company and deposits $50,000 into his new account. All the forms have been signed and he is ready to trade futures. After reviewing the wheat market he decides to possibly take a position in wheat. The wheat contract traded at the CBOT requires 5,000 times the cost per bushel to hold a position overnight. At close on August 4, 2006 the September wheat contract closes at $3.96 per bushel. The total value of the contract is 5,000 times $3.96 which is $19,800. To hold a wheat position his broker will demand that 10% of the value of the contract be in the account, or $1,980. The account is funded with $50,000 so there is more than enough money to cover the margin requirement for taking a 1 Lot (one contract) position in the wheat market. Joe also has a good feeling that the stock market will rise in the upcoming weeks. The margin requirement will be 10% of $250 times the current index price. The closing price on August 4, 2006 for the index is 1286.00 which valued in dollars is $321,500 ($250 times 1286.00). The 10% Initial Margin rule requires that he has $32,150 in the account for this trade on a 1 Lot. Entering the market in wheat and the S & P 500 will require an aggregate total Initial Margin of $34,130 in his futures account which will cover both positions. Margin requirements may vary depending on the brokerage house but in most cases the 10% margin rule is standard in the industry.  

Before placing his trade Joe decides to evaluate the intraday movement, volume, open interest and 52-week range for both futures contracts. Since he is interested in investing in the near month delivery he also decides to pay close attention to the cash price for the underlying product. Friday morning August 4 the wheat market opens at $4.00 and slowly heads higher to $4.02 then retraces back to $3.95 ¼ for the low and then settles at $3.96 on the session. The volume reached 181,920 contracts which changed hands over the session. The Open Interest is estimated at 177,560. This figure is a measurement of the number of outstanding contracts still open in the market for this delivery month that have yet to be closed. Many buyers have not sold their position and many Short sellers have not bought back their short position but continue to keep their positions open. He also notes the delivery months for the wheat contract which are September, December, March, May and July. The current and closest delivery month is September delivery also known as the near month delivery. The most volume and open interest is usually found in the near month delivery being closest to expiration and therefore trading virtually in tandem with the cash market price as delivery date approaches. Note is also taken with regards to the 52-week low at $3.51 and the 52-week high at $4.45 ½. The market is now trading near the mid-point of the 52-week range at $3.96 per bushel. The cash market price is trading at $3.29 1/2 per bushel which is almost 67 cents below the current futures price for near month delivery.

Joe also follows the stock market averages. The Standard & Poor’s 500 Stock Index futures contract for September delivery begins its day of trading on August 4 at 1285.60. After optimistic government news the market rallies in the morning and hits a high of 1298.00. Soon the market loses its momentum and heads down as low as 1278.00 and closes the session at 1286.00. The intraday volume is moderate at only 29,335 contracts changing hands. Open Interest is strong with 608,680 contracts still being held as open positions. The cash market is just slightly at a discount to the near month futures price selling at 1279.36. The 52-week range in the September contract is 1342.50 for the high and 1229.20 for the 52-week low. Like wheat, the index is currently trading at a mid-point of the 52-week range spectrum when it settled at 1286.00. For the S & P 500 contract the months scheduled for delivery are September, December, March and June.

What will Joe decide after reviewing the numbers and market trends for these two futures markets? Will he take a long-term or short-term position? Is the Options market on futures something he should investigate before making a final decision on his investment? Should he delay his investing or jump in with full confidence? No matter how he approaches the market he will need discipline and good information to succeed. Reverse Motion allows an investor to sit back and let the system trade without manual input. The trading system buys and sells and closes its positions automatically by end of intraday session. Many of the above trading decisions that need to be made by an investor are answered with ease when using Reverse Motion.

This was a very brief summary of futures trading as it applies to the Reverse Motion system. There are many other facets of futures trading like Options trading, Arbitrage trading, Spread trading to name a few, that are not used in the Reverse Motion system but are a part of the futures trading spectrum. To learn more about futures we suggest going online or visiting your local library to find out more about the dynamic world of futures trading.