Understanding the Futures Markets

Stock traders are often initially intimidated by the futures markets. They soon learn, however, that trading futures involves the same principles and techniques as trading stocks (or any other investment, for that matter). There are three major differences between the stock and futures markets:

  1. the concept of leverage, made possible by the low margin rates that generally prevail in the futures markets;
  2. futures are traded in series of contract months that expire on a rotating basis, and
  3. you can sell futures short just as easily as buy them.

We’ll explain these concepts in detail shortly. First, let’s get a few definitions out of the way

What are futures?

When you buy shares of stock you become part owner of a company, participating in the company’s profits and losses through dividends and increases or decreases in the stock’s value. You also are entitled to certain voting rights regarding company policy.

By contrast, when you buy and sell futures, you don’t really own anything. You are, however, entering an agreement with the person you trade with–the reason futures are more precisely referred to as “futures contracts.” When you buy a futures contract, you are agreeing to buy a commodity or financial instrument (crude oil or Treasury bonds, for example) at a specific price by a certain date in the future. The person on the other side of the trade is obliged to sell you (“deliver”) that same commodity or financial instrument at the specified price by the specified date. However, if you sell your futures contract by a specific date, you offset your position with no further obligations and have either profited or lost on the trade.

Contract months


While the stock you bought five years ago is the same stock trading today, futures contracts have limited shelf lives, and are traded in a regular series of “contract months” (also referred to as “delivery months”) that vary from market to market. Ticker symbols for futures can vary depending on the source, but they typically consist of a two-letter market designation followed by a contract month designation (see Table 1) and a year designation. Thus, SPU9 represents the September 1999 S&P 500 futures contract while USZ9 is the ticker symbol for the December 1999 T-bond future.

All futures contracts have expiration dates after which no further trading is allowed; as a result, the wheat you traded last year is not the wheat you’ll trade this year. For example, the crude oil futures at the New York Mercantile Exchange (NYMEX) have contracts for every calendar month. If you trade the December 1999 crude oil contract, you are trading oil that is deliverable in December 1999; if you trade the May 2000 crude oil contract, you are trading crude oil deliverable in May 2000. The T-Bond futures at the Chicago Board of Trade and the S&P 500 stock index futures at the Chicago Mercantile Exchange both have contract months of March, June, September, and December (the common “quarterly cycle”). Many other financial contracts use these same months as well.

Many contracts in a market may trade simultaneously, sometimes several years into the future (though volume is generally lighter the further out in time you go). The current contract—that is, the one that will expire next–is called the “front month;” the other contracts are referred to as “back months.” In August of any year, the September S&P 500 futures contract would be the front month, while the December contract and the March and June contracts of the next year would be the back months.

When the current front month expires, the next month in the cycle becomes the new front month. In many (but not all!) markets, trading is most heavily concentrated in the front month and the first one or two back months. If you need to hold a longer-term position that spans more than one contract month, you have to liquidate your position in the current contract month and re-establish it in the next contract month in the cycle, a process called rollover. For example, if you bought December 1999 S&P 500 futures and wanted to hold your long position past the end of the year, you would simultaneously sell the December futures (before this contract expires) and buy the March 1999 futures. For shorter-term traders, rollover is not really an issue.

Contract settlement

The S&P 500 stock index futures are an example of a “cash-settled” futures contract, one that does not have a deliverable underlying commodity. Such futures are simply settled for a cash value on the last day of trading. If you have not liquidated your position by expiration day, the value of your position is set against the value of the closing price of the contract on expiration day, and you are credited or debited the difference. For example, if you were long the December S&P futures at 1300.0 at the close of trading on expiration day and the market closed at 1302.00, you would be credited a profit of 2.00 points ($500).

For deliverable futures (agricultural contracts like wheat, corn, soybeans, and some energy contracts), it is necessary to liquidate a position by a specified date to avoid having to make or take delivery on a physical commodity. These days and delivery periods vary from market to market, but are easy to verify with the TradingMarkets.com trading calendar or through the exchange where the futures are traded.

Contract sizes

The size of a futures contract is determined by the exchange, and may take the form of a specific measurement or amount (5,000 bushels for corn, wheat and soybeans, for example) or a nominal amount ($250 times the index in the case of the S&P futures). To determine the value of a futures contract, you simply multiply its price by the contract size. For example, the contract size of corn is 5000 bushels; if December corn is trading at 290.00 cents/bushel, the value of the contract is $14,500 (5000 * $2.90). The minimum tick in corn is 1/4 cent, or $12.50; each 1-cent move is $50 per contract. If the S&P futures are trading at 1300.00, the nominal value of the contract is $325,000 ($250 * 1000), the minimum tick (.10) is $25 and a 1.00-point move is worth $250.

While all the issues discussed above are important, you should also know they will have very little in practical impact in technical analysis and trading (other than knowing your contracts months and rollover dates). While you should always know the ins and outs of what you are trading, only the most negligent trader will find himself with an open position in a deliverable commodity after First Notice Day (the first day buyers can be notified they’re being assigned delivery of a physical commodity), for example.

Once you understand the instruments you want to trade and the idiosyncrasies in language and trading practice, the experience of analyzing and trading futures is much the same as that of stocks. Prices go up, prices go down, and it is your job to find the technical strategies that will allow you to profit from those moves.

Exchanges and markets

Futures are traded on a number of exchanges around the globe, and two exchanges may trade futures contracts on the same underlying instrument. The major U.S. exchanges are the Chicago Board of Trade, the Chicago Mercantile Exchange, and the New York Mercantile Exchange (there are several other smaller exchanges).

Futures markets are traditionally divided into several categories:

  • Financial futures (stock indexes like the S&P 500, interest rates like the T-bond and Eurodollar, currencies like the Japanese yen and German deutschemark, and more obscure contracts like insurance futures);
  • energy futures (crude oil, gasoline, natural gas, etc.);
  • metals (gold, silver, copper, etc);
  • grains (wheat, corn, and soybeans, among others);
  • “softs” (other agricultural commodities like coffee, sugar, and cocoa);
  • meats (cattle, hogs, pork bellies).

More financial futures are traded than any other kind. Energy futures are the second most popular group. In the United States, the most active futures in these groups are traded at the three exchanges listed at the beginning of this section.

The players

Some people find the purpose of futures confusing. Futures exchanges originated as vehicles for guarding against price fluctuations in agricultural commodities and to establish a method of price discovery for these items.

The classic example is a farmer seeking to protect the value of his crop. In a wildly fluctuating market, the farmer has no idea what the prevailing price for the crop he is planting in May will be in November. If the bottom fell out of the market for some reason, he would have nothing to show for his season of work. To lock in a profit (or buy insurance against a large price drop) a soybean farmer could sell November soybean futures, establishing the price at which he could sell his crop in the fall. If price dropped, he is protected by his futures contract. If prices rise, he loses money on his futures contract but makes money on his physical crop. This process is called hedging.

But commodity futures actually comprise a small portion of the total futures trading volume. Far more financial futures–interest rate futures, stock index futures, currencies–are traded around the globe. The philosophy at work, though, is the same as our soybean farmer example. Banks use T-Bond futures hedge interest rates fluctuations, stock portfolio managers sell S&P futures to protect the value of their portfolios, and oil companies use crude oil futures to hedge their holdings. (Individuals also could use such futures to hedge their own portfolios.)

Hedgers are only one part of the story. If markets consisted only of hedgers, trading could not continue very long. Speculators, those traders who are not hedging financial or commodity holdings but are rather buying and selling to profit on price moves, make up the other half of the futures equations. Futures traders range from fund managers trading billions of dollars in dozens of markets (much the same as their stock fund manager counterparts) to individual traders like you.

Futures attract traders for a number of reasons. The relatively small number of markets to trade (compared to individual stocks) makes monitoring and analyzing them much easier. Also, you can just as easily sell futures short as buy them, allowing you to take advantage of down moves–a much more difficult proposition in stocks, where regulations limit short selling. But most of all, traders are attracted by the leverage available in the futures markets, a concept you must thoroughly understand if you want to take advantage of the potential of futures and avoid their dangers.

Leverage and margin in the futures markets

When people hear stories of fortunes made and lost overnight in the futures markets (most of them untrue, actually), they imagine the futures markets as casino gambling, with few, if any, rules–and similar odds.

However, futures are for the most part no more or less volatile or risky than stocks. What makes the large returns (and large losses) you hear so much about possible is the use of leverage, which allows you to buy and sell more futures contracts using much less capital than you would have to commit to trade the same dollar amount of stocks. The high percentage returns this kind of leverage allows also creates an commensurate level of risk.

Margin in futures trading runs as low 3 percent (or even less) for some contracts, compared to the 50% minimum margin requirement for stocks. A $100,000 Treasury bond contract could be leveraged with margin of around $2700 in mid-1999, less than 3 percent. By comparison, you would need at least $50,000 to trade a similarly sized position in the stock market.

These low margins stem from the fact that futures are contracts rather than actual assets; you’re not exchanging anything, you’re merely agreeing to do so at some point in the future. Because almost all speculators will offset their positions to avoid taking delivery on physical commodities, the risk involved in futures positions is the price changes that may occur over the life of the position–not the underlying value of the contract.

Margin for hedgers is even lower than margin for speculators because a hedgers’ physical holdings (say, an oil refinery’s reserves or a grain processor’s wheat) function as collateral for their futures positions. Margin functions as a guarantee that you will be able to meet the financial obligations for your trades. Again, if your trade goes against you, you will be required to deposit more margin into your trading account.

Exchanges will change the margin they assess their clearing firm members (i.e., your brokerage) based on the volatility of particular markets, among other factors. Your brokerage may then require more margin from you even if the status of your position has not changed. There is no rule that says you have to use minimum margin, though. You could maintain 100% margin for all your futures positions, although the large size of many contracts can make this prohibitive.

It’s important to understand the disadvantages as well as the advantages of leverage. The leverage that can result in high-percentage returns can also lead to equally large losses. The key, as always, is to limit risk on your trades.