FUTURES

Traders have been using futures in America for almost two centuries; in Europe, the ancestors of futures have been known at least since the 17th century; but the first-ever rules for such contracts were written in the Code of the Babylonian King Hammurabi. Futures contract is a well-established and reputable, but much less known, instrument than stocks.

Why is this the case? Because most beginners (let alone people who don’t have anything to do with trading) have more trouble comprehending the essence of this financial instrument and the way it works than understanding the point of the «blue chips». It is very difficult to depict how to make money using futures and what they are made of in a novel – and even more so in a movie. A simpler solution for authors and screenwriters would be to make their characters trade stocks — at least this word is on everyone’s lips.

Is it possible to explain the point of futures in such a way that it would be clear even to a first-grader? Or at least to a 5th or 7th grader? The topic may seem complicated at first glance, and novice traders break their teeth left and right trying to crack this tricky nut. But fear not the derivatives (oh, what a word!): a few simple examples can explain what they are made of and how to use them.

 

In this article:

 

Why you need to know what futures are

8 questions about futures that may puzzle you

Part 1. The history of futures

1.1 Sorting out the terms

1.2 Why were forwards and futures made up

1.3 The futures of King Hammurabi

1.4 The ingenious Thales and the Tulip Mania

1.5 The first futures exchange

1.6 Chicago — the classics of futures trading

Part 2. Modern futures

2.1 «But I don’t want to trade grain. How do I make money by trading futures then?»

2.2 Modern futures contracts

2.3 Delivery date

2.4 Bushels and barrels

2.5 What to trade?

2.6 Asset price and a contract price

2.7 What kinds of margins are there?

Part 3.  The mechanism of futures trading

3.1 Common, let’s go buy something!

3.2 Not selling, but offsetting

3.3 Are you in the black or in the red?

3.4 Hi, I am a Margin Call…

3.5 Short trades: when samurai cry

3.6 Samurai strikes back

3.7 Attention! Leverage!

3.8 How much money does one need to trade futures?

3.9 From pocket to pocket

3.10 How to join the 5% of successful traders?

 

 

Why you need to know what futures are

Why you need to know what futures are

Futures trading is one of the most promising areas in trading. Futures contracts are actively used as financial instruments at the world’s largest mercantile exchanges, including Chicago’s CME. Traders enter into millions of contracts here every year, using a wide range of assets: oil, grain, gold, currency pairs, stock indices… This area has major advantages that have made futures contracts one of the traders’ favorite instruments.

  • First of all, the futures market shows high volatility (price movement), which means that it is relatively unusual for the market to freeze in limbo and that traders can make nice profits from fluctuations.
  • Secondly, a futures contract has built-in leverage that allows traders to increase trading volumes up to tenfold (and sometimes even more) compared to initial deposit capabilities. In other words, you can sign contracts worth $150,000-300,000 at just $1,000. So, there is a chance to make a lot of money very quickly — which is a very tempting idea. However, you can also waste this deposit if you ignore risk management rules.
  • Thirdly, the introduction of micro futures at the Chicago Mercantile Exchange has started a new era of trading for beginners. It is now possible to enter the global market — for example, the CME (one of the largest commodity exchanges in the world) — with the same amounts as used in the Forex market (no more than $1,000-2,000).
  • Fourthly, you can trade US futures practically around the clock. It is very convenient because you can trade in sync with your biorhythms. No matter what time zone you live in, no matter when you usually wake up, the CME will always welcome you. Moreover, virtually round-the-clock trading (there are Asian, European and American sessions, and trading is available 23 hours every day, excluding weekends) allows you to create charts without gaps, which increases the number of trading signals and their accuracy. There’s also another advantage: if you trade your favorite futures every day, you can study them thoroughly and increase the effectiveness of your trading. Honing the tool, you improve your skills.

So, the pros of the futures market are obvious: good volatility, built-in leverage, micro futures, and virtually round-the-clock trading. But if you don’t know what this futures thing is all about, all these pros will pass you by!

What are the typical questions a novice trader may ask when confronted with futures contracts?

 

8 questions about futures that may puzzle you

8 questions about futures that may puzzle you

Many beginners start to feel like they are losing their marbles when trying to figure out what a futures contract is by themselves. Here are the most common problems one might encounter while learning about futures:

  1. Derivative instruments, derivative contracts, derivatives — can’t people make more sense? If it goes on like this, there is no making head or tail of it…
  2. Some forwards and options are always hanging out with the futures. And forwards and futures seem to be the same thing, but not really.
  3. When starting conversations about futures, all authors mention that they were created for reducing risks. And after a while, it turns out that the risks of dealing with futures are so high that you can waste your entire deposit in several transactions. How come? (The poor beginner confuses two types of risks — hedged and personal risks; this is a common misconception, by the way.)
  4. Then after everything is sorted out with the variation margin – the intraday, initial and maintenance margins come to the picture. «Uh-oh!»— the trader’s face looks blank again. But it’s the same word for all of them. (Oh, the poor brain.)
  5. A futures contract has a beginning and an end. But what happens if you don’t sell it before the delivery date? (A typical beginner’s question.)
  6. Speaking of deliveries, everything seems to be clear when it comes to grain or oil futures. But what is delivered to the buyer under contracts that have currency pairs as the underlying asset? Suitcases full of dollars and euros? And what if it is a stock index futures contract? Will the buyer get a handful of numbers? This is something like one hand clapping. If your brain doesn’t explode, Zen is yours.
  7. Then it gets even trickier. Theoretically, the futures contract price reflects the market price of an asset, like corn, oil or gold. And in reality, the asset price and the contract price are intertwining like snakes on the chart. A beginner, pretty much worn down by mental struggles by that time, is facing some new terms then: contango and backwardation.
  8. And lastly, we have another bump on the way to understanding the essence of futures trading, which is the built-in leverage. Almost every other beginner scratches his or her head, trying to understand: how come after a 20% price increase you can make a 500% return on your deposit or lose it entirely while cooking some meatballs?

Most likely, you’ve asked yourself at least 2 or 3 of these questions, and, perhaps, you still haven’t found clear answers. Well, let’s analyze the futures on a molecular level — so that even a school kid can understand what they are!

 

Part 1. The history of futures

The history of futures

1.1 Sorting out the terms

Let’s simplify the problem right away by sorting out some terms. We’re not learning them to pass an economics exam, we are doing it to start trading. So let’s cut to the chase: derivative instruments, derivative contracts, and derivatives are the same thing.

Most often futures are called «derivative financial instruments» or simply «derivatives».

Financial instruments, in general, are any financial documents that can be sold and turned into money. These include stocks, bonds, futures, etc. There’s a category that stands out among these instruments called derivatives — the instruments that obligate the parties to do something (to buy, sell, deliver, etc). You can say it’s «securities for securities». Derivative financial instruments, i.e. derivatives, include forwards and futures (our main topic), their cousins — options — and about a dozen other instruments.

 

1.2 Why were forwards and futures made up

To understand why humanity needed derivatives — forwards and futures specifically — imagine that you are…

  • an owner of a date garden or a merchant living during the King Hammurabi’s reign;
  • an olive grove or press owner in Ancient Greece;
  • a rice farmer or an innkeeper in medieval Japan;
  • a breeder of new tulip hybrids or a flower enthusiast in the 17th century Netherlands;
  • a grain farmer or a cattle-farmer in the 19th century USA.

What do these people have in common? The fear that the future may considerably change prices on products they are interested in.

  • «What if the price drops and I won’t be able to even recover my expenses?» — thinks the seller.
  • «What if the price rises and I’ll have to pay too much?» — worries the buyer.

So they make a deal: the seller guarantees that he will sell the goods (which are not produced, not grown yet) on a certain date and at a certain price — for example, at 100 coins. He is happy with the price because it will cover his expenses and ensure the profit. If dates or wheat drop in price, this drop will pose no threat to the producer.

The buyer thinks like this: 100 coins is a normal price, it suits me. If the goods go up in price, I have nothing to fear.

Such contracts are called forwards. They are not futures contracts yet, they are their forerunners. This type of trading doesn’t involve mercantile exchanges yet, but the derivative principle is already here: the contract revolves around an obligation.

Do you know when people figured out how to reduce risks this way? 4000 years ago! Or maybe even earlier, but there’s no record of it.

 

1.3 The futures of King Hammurabi

The first forwards appeared in Babylon — one of the greatest capitals in the Ancient World. This rich city attracted flows of goods from different countries. Babylon was a city of merchants and a city of money. In the middle of the 18th century BC, almost 4000 years ago, the first code of laws known to mankind was introduced in Babylon — the Code of King Hammurabi. This is where historians found the first known record of forward contracts.

It turns out that even back then, in those ancient times, counterparties agreed on future deliveries at a negotiated price. For example, I grow dates or grain, and you want to buy them — so we make a deal that in 4000 years will be called a forward contract. To ensure that suppliers and buyers did not have disputes concerning changes in market prices, Hammurabi ordered to conclude such contracts in writing and in front of witnesses. According to some historians, these contracts written on cuneiform tablets could even be resold, just like today’s contracts.

 

1.4 The ingenious Thales and the Tulip Mania

At first, business partners used forward contracts only to protect themselves against risks. But gradually clever traders realized that it was possible to make money off such contracts without buying and selling specific goods: based on market forecasting and speculation. And now we are getting closer to the futures — exchange forward contracts. Let’s see how it all happened.

According to Aristotle, such future obligation contracts helped a certain Thales of Miletus from Ancient Greece to strike it rich. He was a poor philosopher who risked his small fortune and considerably boosted it. Thales accurately predicted that olive harvest would be abundant the following year and signed contracts with olive press owners: they assumed the obligation to press oil only for him. They did not know whether they would have enough work (because olive press loading depends on the harvest), so they agreed to insure themselves against downtime. And Thales benefited from his accurate prediction. Since the olive harvest, that year was very generous and everyone was in need of presses to extract the oil, Thales managed to sell the contracts profitably.

Note that Thales had no presses or olive groves of his own. He didn’t plan on growing crops or producing oil. He was almost a trader in his own right!

In Europe, exchanges were introduced in the 16th century.  And in 1636-1637, the first exchange boom happened, during which the extensive use of futures contracts began. The boom was associated with the growing demand for tulip bulbs of premium varieties.  The hype called Tulip mania attracted people of various occupations to the exchanges that traded tulip bulbs. No wonder why: some bulbs could be exchanged for an entire stone house!  Or vice versa — people could sell a house or a farm to buy a few precious bulbs hoping for a price rise in the future.

The demand was so high that speculators started buying bulbs that were yet to be grown by the breeders.  And then these contracts — that’s right — ended up at an exchange! The contemporaries were so fascinated by this situation that they kept notes (some of which survived to this day) about the unusual economic phenomenon: whoever heard of people who had no bulbs, but sold them to those who had no intention of growing tulips!

In the end, though, prices collapsed, thus bursting the world’s first asset bubble; but the most quick-witted traders, who sold their assets before it was too late, deserve our respect: they made some good profits. And many people, who made fortunes during this period, never held a tulip bulb in their hands.

 

1.5 The first futures exchange

Where were the first specialized futures exchanges established? In Japan. The Dojima Rice Exchange that traded future crops was established in Osaka in 1697. Rice was considered the second currency in Japan, and it was actively traded for money. The economy was on the rise, and this fact played its role too: after all, the more sellers and buyers there are, the more active is the exchange trade.

1710 is considered the dawn of the history of modern futures exchanges. What’s interesting is that exchange traders in Osaka had a direct impact on pricing. We will return to this topic later when we talk about short trades at modern exchanges.

 

1.6 Chicago — the classics of futures trading

As you can see, forward contracts could be spotted in different parts of the world at different times, which is the evidence of the importance of this financial instrument. First, people used these derivatives to protect themselves against price fluctuations, and then they began to make money by reselling their liabilities.

Well then, let’s get closer to our days.  The foundation for modern futures trading was laid by an agricultural exchange in Chicago. Modern futures trading and trading during the 1850s in Chicago have a lot in common.

Why did Chicago become a key pillar in futures trading in the United States?

In the 19th century, the Midwest became the agricultural center of the country.  Construction of railways and the invention of the mechanical reaper by Cyrus McCormick spurred the development of this industry. And Chicago had a particularly favorable location — at the crossroads of transport routes. The city had become the center of transportation, logistics, and trade of agricultural products. (Note that this situation is identical to the one that happened in Babylon, Osaka and the Netherlands before!) A new class of dealers started buying grain and other products in Chicago; they played a huge role in the development of forward contracts.

For example, a farmer could promise a dealer that he would hold the grain until winter when it could be transported on ice, but with one condition: the dealer would pay the current price, even if it dropped by winter.

Another condition for the development of derivatives was the fact that Chicago depended on crops: growing prices guaranteed prosperity and dropping prices slowed down the economics.  Many farmers and businessmen were interested in hedging (protecting) against their risks.

In 1848, the flourishing Chicago welcomed a grain exchange — the Board of Trade of the City of Chicago (CBOT) — one of the ancestors of the CME. Trading intensified. And then it was a stone’s throw away from a revolutionary decision: why not start trading forward contracts at the exchange?

On March 13, 1851, the first futures contract was entered into at the CBOT. The seller undertook to deliver 3,000 bushels of corn (about 75 tons).  This event marked a new milestone in the history of the exchange economy.

Forward contracts still exist today, but they are relatively narrow in scope. Forwards always require two parties — either individuals or legal entities. And in order to trade futures, it’s enough to register at an exchange that trades them — for example, at the CME.

Another big plus is that it has become easier to trade after the standardization of futures. Futures for a particular asset at the exchange are like two peas in a pod.

And finally, the development of this trading area has pushed the asset itself into the background. Just like Thales of Miletus, many traders started trading something they don’t have and don’t really need.

So, just to recap on the definition: futures are standardized exchange forwards. We will talk about them next.

 

Part 2. Modern futures

Modern futures

2.1 «But I don’t want to trade grain. How do I make money by trading futures then?»

Ok, the reader might say, I get the point of these forwards and futures now.  What is the good of it? I don’t grow any wheat, or corn, or dates, or rice, or olives, or tulips. I’m not planning on buying them either. I don’t need to insure myself against risks.  What place do I have among these suppliers and buyers?

Well, it’s time to move on to the question of what opportunities trading offers to people who want to make money off futures without ever laying their eyes on all these bushels of grain and baskets of olives (or bales of cotton, or metal ingots, or barrels of oil).

 

2.2 Modern futures contracts

So you decided to trade. What does a standardized futures contract at the CME look like?

This contract specifies:

  • the underlying asset;
  • the quantity of the underlying asset;
  • the delivery date;
  • the type of the contract (deliverable or cash settled);
  • the lifespan;
  • the minimum price movement;
  • tick (minimum step) volume.

The conditions are listed in the futures contract specifications, which is a special document approved by the exchange.

Each futures has a code represented by a certain set of letters and numbers. The first part is the name of the asset. For example:  ZC — Corn Futures, LE — Live Cattle Futures, GC  —  Gold Futures, ZS — Soybean Futures, NG — Henry Hub Natural Gas Futures, CL — Crude Oil Futures (Light Sweet Crude Oil), 6E — Euro FX Futures, ES — E-mini S&P 500 Futures, and so on.

All these symbols can be easily found on the Internet.

The second part is the month of delivery.  It is also indicated with letters: January — F, February — G, March — H, April — J, May — K, June — M, July — N, August — Q, September — U, October — V, November — X, December — Z.

The third part is the year. The year is indicated with its last number. For example, futures with a delivery date set in 2019 will contain the number «9», 2020 — «0», and 2021 — «1».

 

2.3 Delivery date

As you can see, the delivery date (date of supply, or expiration date) is obvious from the name of the asset. And the beginner looks at it warily. What happens when it comes? It’s ok if an oil tank is delivered at my doorstep… But what if someone brings a herd of bulls there?!

And vice versa: what if I buy a contract with the obligation to deliver coffee and will be obliged to deliver these 37,500 pounds — 17 tons! — to the States?! Am I some sort of an Asian palm civet that can «produce» coffee?

It’s not actually that bad. The exchange is well aware that it is unlikely that you plan to grow cotton or buy aluminum. Futures that end in actual deliveries constitute only two percent of the CME’s transactions at most. And the London Metal Exchange has the annual turnover of futures that is 40 times higher than the world’s metal production! The Internet era has brought many people living thousands of miles from financial centers to trading; the share of virtual transactions is constantly increasing and will likely continue to do so.

The implication here is that the vast majority of traders will sell futures before the delivery date. The exchange will fine the most forgetful traders $25 for automatic liquidation of the position, and if the situation happens again, the fine will be $50. If the trader doesn’t take the second «hint» either, his or her intraday margin may one sad day go up to the exchange level (we will talk more about different margins later).

That means that «the disruption in delivery» may actually have repercussions. But there’s no need to dramatize the issue:

  • first of all, the contracts won’t expire for several months;
  • secondly, it’s unlikely that you will be trading more than 2 or 3 assets at a time, so you won’t get confused;
  • and thirdly, it is not easy to forget something, when your money is at stake.

You are not planning on going on a long bender, are you?

Besides, it is possible to hold on to a futures contract for six months or more. The thing is that there can be several identical futures circulating at the exchange at the same time, but their expiration dates may differ by six months. Most traders operate the ones with closer delivery dates (their liquidity and volatility are higher and the pricing is more reasonable). As the expiration date approaches, traders start to gradually close expiring contracts and buy new ones — with the same asset, but with a more distant delivery date. When the moment of closing comes, the chart of the contract in the terminal may be «spliced together» with the chart of the next one (the action is optional, though).

So, no one can stop you from getting a contract with a distant expiration date as opposed to the most active one. For example, you want to purchase a contract in April. You can buy an active contract that will expire in June. Or you can buy a December futures contract and forget about it until the end of the year.

Moreover, futures for some assets are now only cash settled (meaning these assets are not physically delivered). This, by the way, answers the question of how you deliver a stock index to the buyer: you simply don’t. Usually, when a contract is a cash-settled one, it expires automatically — in other words, the exchange simply does not give you a chance to screw up.

There are also deliverable contracts used by actual suppliers and buyers. You can trade such futures contract without much concern for what will happen on the delivery date — they will have to figure everything out on their own because you will sell the contract by that time. Or, if you don’t, you’ll just pay a fine, which is usually not particularly heavy, so there’s nothing to be afraid of.

Besides, most traders close positions within a day to avoid paying the full initial margin (this way they pay only intraday margin). So they couldn’t care less about the delivery date. They do care about the end of the trading session though.

Does the expiration date affect trading? Yes, it does, to a point. The closer the date, the less predictable the price behavior because there are fewer and fewer traders, and some major players may even hike or drive down the prices for personal purposes. That’s why sometimes during the expiration, exchanges discard the results from one or even several previous trading days.

 

2.4 Bushels and barrels

As you can see, the delivery date is not as scary as it may seem at first glance. The units, in which the goods are measured, are even less scary. It is well-known that the US still uses old units of measurement alongside the metric system. That’s why you can see all these bushels and barrels everywhere. Google can tell you, how much they are in pounds or kilos. You can look it up, though there’s no actual need for it. If you trade futures without the intention to buy or sell physical commodities, you can safely ignore the quantities.

The thing is the quantity of the asset to be delivered is stated in the standards of exchange (in the futures contract specifications). And it remains unaltered. That’s why all futures contracts for a certain asset are identical in terms of the number of barrels or bushels.

You trade contracts, not something else. It makes things easier, doesn’t it?

 

2.5 What to trade?

As we’ve already established, the main trading unit for a trader is a contract. Therefore, the assets are virtual to some extent: it is highly unlikely that you will ever touch or smell oat and oil you bought at the CME. However,  you should not ignore the concept of an asset (as opposed to the units, in which it is measured). It affects such important matters as liquidity and diversification.

Despite the virtualization of futures trades, futures are always tied to their underlying assets. Every derivative has one. You can’t trade something that doesn’t exist — like skins of emerald jerboas. You can’t trade something that is not a trading asset either — you can’t trade air, for example. Sure, theoretically, you can imagine interplanetary exchanges that trade oxygen futures, but hopefully, they are still a long way in the future.

However, there are also some rather exotic assets that tempt you to say: «What are these if not air?!» For example, the CME allows you to trade futures… for weather conditions. But these are, of course, not air, but a tool for hedging against weather risks — a good third of the world’s business depends on the weather.

As a general rule, exchanges open futures for assets that are internationally liquid. For example, there are no futures contracts for Krasnodar tomatoes or Sicilian oranges (but there are, indeed, futures for orange juice). Wheat and rice have them, rye and buckwheat — don’t.  You won’t find derivatives for British kittens either.

How do assets come to exchanges? An exchange acts as an underwriter — it introduces new futures and sets standards for them. Market makers — asset suppliers — assist the exchange in this task. While the market is taking its time to adjust to a new asset, market makers get things moving.

But if it is the exchange that introduces new futures, why can’t it create futures for anything it fancies? The answer is simple: it won’t make any sense.   Futures are introduced for goods that are expected to be popular with traders: after all, to ensure continuous trading and good volatility, you need a lot of willing traders. The history of the CME is illustrative in this regard: at first, it traded only grain, then it introduced futures for metals, oil, currency, stock indices and swaps (for example, interest rates). In 2017, the cryptocurrency proved to be a strong global asset — hence, futures for bitcoins were introduced.

A number of exchanges also offer stock futures. Traders even created special strategies that are essentially a combination of stock and stock futures trading.

So, what to trade?  The Chicago Mercantile Exchange offers traders over 70 assets. Your choice depends on your strategy, but usually, the most active trading involves the most liquid assets. And that’s where a beginner may mistakenly think that it is difficult to sell a futures contract for a low liquid asset — that it will take a lot of time to find a buyer for it. Our further analysis of the futures trading mechanism will show you that it is literally impossible. Illiquidity, in this case, means that a relatively small number of traders operates this asset, so the market is less volatile, and trading will require a different strategy (but this does not mean that you cannot make money).

Let’s also address the asset diversification. To hedge against personal risks, traders are advised to trade assets from several market segments. For example, you can select one liquid asset from the commodity, currency and, say, index section.

 

2.6 An asset price and a contract price

Before moving on to the trading mechanism, let’s look into another matter: the relationship between the futures contract price and the underlying asset price. At first glance, it seems that the prices should be identical since the futures are tied to a particular asset. But in fact, for a number of reasons, the price charts for assets and contracts look like some sort of «braid» with two curves going side by side and interlacing from time to time.

When the futures price is higher than the underlying asset price (spot price), the situation is called contango. This means contracts are trading at a premium to the spot price. If the opposite happens — the situation is called backwardation, i.e. a discount.

This difference may be used to make profits — such a process is called arbitrage. But it requires either very large investments (and only large pension and investment funds can afford them), or very sophisticated calculations and predictions of the market behavior (which can be made by arbitrage bots today). If you are interested in this topic — you are free to learn more about it. A regular trader does not really need to delve into such nuances.

 

2.7 What kinds of margins are there?

Now it’s time to look into margins; as you remember, there are several types of margins:

  1. Initial Margin is the margin that must be in the trader’s account to open and hold a position after the first closing time, according to the exchange requirements. I want to make it clear that it must be available for every contract.

The amount of collateral for different assets varies at different exchanges. As a rule, it is no more than 10% of the total contract price.  Sometimes the initial margin is only a couple of percent. Why isn’t there a hundred percent collateral? Let’s go back in time to the era when exchanges have only started to attract forward contract counterparties and offer them futures contracts. What would’ve happened if some exchange had asked a farmer who didn’t have his crops yet for a 100% insurance coverage? He would’ve made a cuckoo sign. What would’ve been the point of such a deal? He hadn’t made that much money yet! As practice shows, when hedging, the parties of the transaction are not ready to deposit an over 20% collateral. This is how futures trading developed an exchange margin — based on the actual interests of the forward transaction parties.

The amount of the initial margin depends on various factors, such as volatility of the underlying asset price. This means an exchange can change the margin amount requirement, so you should always monitor the information.

  1. Maintenance Margin is the amount of money that must be in your account in case you decide to keep a position open after the next closing time.
  2. Intraday Margin, or intra-session collateral, is the minimum amount of funds that allows you to trade within a trading day. Most traders trade within a day, closing positions at the end of a session. In this case, it is enough to deposit the intraday margin. Usually, it is significantly lower than the initial margin (however, sometimes they may be equal).

Margin amounts for each instrument are listed in the futures contract specifications. These amounts can be calculated using some formulas, but I’m not gonna puzzle you with such problems now. It’s easier to look here.

The money deposited in the account on top of the margin is usually called free capital. Please note that futures always involve the entire free capital, which means that all of it is at risk.

So, are we done with all the margins? Not yet.

There is another one — variation margin, or variable margin, which is a financial difference between contractual obligations. It is fundamentally different from the first three margins. All three of those, despite their differences, refer to the collateral you are required to have in the account, however, the variation margin is the financial result of trading.

Of course, it is not very convenient that there are several margins in trading terminology. It’s the same with the word «spring»: sometimes it means a time of the year, and sometimes it is synonymous with the words «source» or «jump». Just don’t overthink it. Simply try to remember:

  • Initial, intraday and maintenance margins are types of collateral.
  • Variation margin is all about profit (or loss).

Now let’s see how futures trading works.

 

Part 3.  The mechanism of futures trading

The mechanism of futures trading

3.1 Common, let’s go buy something!

To make calculations simpler and demonstrate the process of futures trading as clearly as possible, let’s consider a hypothetical example with nice round numbers. Imagine that you are a trader in the 19th century and you are interested in corn…

So you are making a deposit of $1,000 (hypothetically).  Let’s assume that the current market price of corn is $100. You believe that the market will grow, and you want to make a profit on the price rise. This type of trade is called a long trade. Sometimes traders call it «entering into a long position».  Or — «opening a long position».

How many hypothetical corn contracts can we buy with our $1,000? Let’s see.

The thing is that the concepts of buying and selling futures are used for simplification. In fact (think back to the meaning of forwards and futures) we are talking about entering into contracts with obligations to buy and sell. In other words, you don’t buy any corn at the moment. You place a contract with the obligation to buy a certain amount of bushels of corn on day X.

Well, since you are not buying anything, you don’t need to pay for corn yet, right? And you actually don’t pay anything! (For corn.) But the exchange that acts as a counterparty requires you to confirm that your intentions are serious — what if you decide to flee the market at the first hint of trouble? Or, what if you enter into contracts worth millions without a penny in your pocket? To prove that you have serious intentions, you need to deposit a collateral (security deposit) for each contract.

So, let’s get in the time machine and go trading our corn. Suppose the exchange expects you to pay a $20 collateral for one corn delivery contract.

How many contracts you want to open is your decision. In this example, we will go big and spend half of the deposit. So, we’re opening 25 contracts.

Why not take fifty, while we can? Why don’t we spend $1,000, instead of only $500? Because risking all your capital is just crazy. One slight price movement in an unfavorable direction may force the exchange to immediately close your position. (It does not necessarily mean that this will be done immediately, but it’s not unlikely.) Of course, you can spend the entire deposit on contracts and manage to «accelerate» it if the price moves favorably. But it’s too risky because you can’t expect the price to constantly move in the right direction.

Since we don’t know where the price will go, let’s add a buffer (its role will be explained when we talk about losses and margin calls).

What now? Now we wait! The price is moving, and let’s say our prediction turns out to be correct: corn is getting more expensive, and after a while, its market price reaches $120. We are not going to be greedy and wait for the market to turn, we will sell the futures!

Again, selling here is a simplified concept. In fact, we’ll be… offsetting the contracts.

 

3.2 Not selling, but offsetting

Why do I put emphasis on this, instead of just saying «we buy and we sell»? Understanding the mechanism of the exchange allows us to answer questions related to futures trading. Beginners often ask: will there be enough futures for a certain asset if many traders decide to buy them at the same time? Another popular question: what happens if no one wants to buy a contract when I try to sell it at a favorable price?

You don’t have to worry about that for two reasons. First, the logic behind exchange trading implies that if there are too many people willing to buy an asset, the price will be going up until the market is satisfied, and if there are none, the price will be dropping until the asset finds its buyer. Secondly, the futures are not technically sold or bought. At the time of purchase, you create (place at the exchange) a contract with certain obligations. In our case, it goes like this: «I, Bill Stern the trader, hereby undertake to purchase 1,000 bushels of corn at $100, in confirmation whereof I deposit a $20 collateral.»

Entering into a non-exchange forward contract requires two parties: let’s say, they are Mr. Bill Stern and Mr. Ben Kim who want to enter into a deal. (First, Bill needs to find someone who can sell him the coveted corn.) But no Mr. Ben Kim is needed to enter into a futures contract. The counterparty is the exchange.

And now let’s see what happens at the time of sale. We place another 25 contracts, but this time using the reverse wording and taking into account the new underlying asset price: «I, Bill Stern the trader, undertake to sell 1,000 bushels of corn at $120.» (And there are twenty-five similar contracts.) This time, the exchange will not demand a collateral one, later it will become clear why.

— Are you kidding me?! — exclaims the novice trader. — Where do I get all this corn?!  And why on earth would I promise to buy something I don’t need and sell something I don’t have?!

The situation is paradoxical. The exchange gets the following at the same time:

  • 25 Bill Stern’s contracts with the obligation to buy corn at $100 on day X;
  • 25 Bill Stern’s contracts with the obligation to sell corn at $120 on day X.

The exchange sees mutual obligation contracts, in which you represent both parties. The exchange judges that after the obligations are fulfilled you will still have no corn (25,000 bushels were bought under 25 contracts — and 25,000 bushels were sold). So why wait? And here comes the offsetting!

Obligations are canceled the moment the offsetting contracts are placed. The collateral for the first contracts is returned (the funds in the account are immediately unlocked). The offsetting contracts are not charged with collaterals at all because they would have to be immediately returned. Asset obligations are canceled (we don’t have to buy or sell anything). But keep in mind that the asset price has changed! We bought them at $100 and sold at $120.

This means, our variation margin (profit) per contract is $120 minus $100.  We made $20 off every contract. And since there were 25 of them, the trade has generated a $500 profit.

The exchange immediately recalculates the variation margin. It takes seconds for the exchange to process the actions we’ve described here. Simply put, we sell 25 contracts — and voila, our account is immediately refilled!

And what about corn? We’ve never set our eyes on it.

If we traded corn for real, the purchase of 25 corn contracts with a 20% asset growth would make us much more money today. The intraday margin would be $25,000, and to hold a 25 contract position overnight, we would need to have over $20,000 in our account (exchange margins for corn are lower than the intra-session margin). But I wouldn’t want to go into calculations and describe the ins and outs of margins and clearing — because my task here is to explain to the beginners how the trading mechanism works in the simplest terms. Besides, usually, only trading can help a trader to understand all the nuances: one day of practice is worth a month of theory.

Once again, I would like to emphasize that I tried to adjust this article as much as possible, I wanted to simplify the info about futures contracts and shed some (or maybe more than «some») light on the topic. That’s why, we used hypothetical numbers ($100, $20, a 20% price growth and so on).  But keep in mind: you shouldn’t actually spend half of your deposit on futures (we used these numbers for dramatic effect so that you could feel the magic of changes that certain decisions may bring to your account).

 

3.3 Are you in the black or in the red?

It is not always possible to predict market behavior, though. Let’s see what will happen if we make a wrong prediction and the price of corn falls (remember, we are considering only long trades for now).

Again, let’s take a $1,000 deposit and spend $500. (Don’t forget that we need a buffer, otherwise the marketplace can simply close our position if the price movement causes losses.)

Technically, everything goes the same way as in the first example. We place 25 contracts (we buy). But the price is creeping down… And now our corn is worth only $80. We place offsetting contracts (we sell). And the situation at the exchange is as follows:

  • 25 Bill Stern’s contracts with the obligation to buy corn at $100 on day X;
  • 25 Bill Stern’s contracts with the obligation to sell corn at $80 on day X.

If you buy higher and sell lower — you will obviously lose money. So the variation margin will be negative after the mutual obligations are canceled.  We’ve lost $20 per each contract. And since we had 25 of them, our total loss is $500.

The exchange takes this loss from our deposit, which, let me remind you, was $1,000. What do we see now? We’ve wasted half of the deposit! (Insert some foul language here.) Let me remind you that all available funds are at risk at all times, that is why only a large deposit can withstand high volatility in futures trading and it won’t be so easy to become an investor in this area, as opposed to stock trading. Within a few hours after the clearing break, you will receive a report that contains information on all trades and write-offs that happened during the day. And then, your account balance will be updated according to the clearing organization report.

 

3.4 Hi, I am a Margin Call…

Now let’s consider the situation when we don’t have enough money to continue trading.

Surely, a reasonable person will not allow something similar to our hypothetical drawdown to happen. You have to be completely nuts or extremely absent-minded to lose half of your money in one trade, having a deposit of $1,000. It would be like going to a casino.

But trading is a business, not a casino. Therefore, sensible people determine the maximum possible losses they are ready for and put a restrictive stop loss order. When they reach this level, the exchange receives the order to automatically close the trade. This helps traders to minimize their losses.

How much is the minimum loss in real trading (as opposed to our hypothetical cases)? It is equal to one tick. If you have forgotten, it is included in futures specifications. Once again: tick is the minimum price movement (tick size), tick volume is the value of one «step» of the price. It is different for each futures contract; it can be from $5 to $25, or 10 times lower for micro-contracts. This item is called Minimum Price Fluctuation in the specifications; the tick size for Corn Futures is 1/4 of one cent per bushel ($12.50 per contract). Each instrument has its own detailed specifications and you should read only the original source information.

Some fellas ignore the stop-loss orders on principle (but not for long, their deposits drain very quickly). Beginners repeatedly showed me insane trades, where the price dramatically dropped. The chart indicates it as a line that suddenly ends in a cliff and dives almost vertically into the precipice.

Margin Call

This is the case when a short trade (we’ll talk about it later) generates an amazing profit. And a long trade without a placed protective order guarantees the fall into the abyss of forced liquidation and then: game over.

So, we’ve come closer to the term Margin Call. This is a situation where losses have gotten out of hand and there is not enough collateral to continue trading.

Let’s turn to a hypothetical corn example once again. You’ve wasted half of your deposit. And you have $500 left. So you buy 15 contracts with $300 collateral. This means you have only $200 left to maneuver. You sit and wait for the price growth… but instead, it’s going down again! And here it is — the dreadful margin call.

If you have no free capital left and you are getting closer to the collateral threshold, the transaction is closed automatically.

And you are fined on top of it. The fine is not very heavy (usually it’s $25 for the first time, $50 for the second), but it’s still unsettling.

There’s another important nuance. If you do intraday trading and decide to hold a position overnight, you must have enough money in your account to cover the exchange margin at the time of the clearing break. If there is not enough money, the exchange will automatically close your position and set a fine that will be conveniently taken from your account. In case you have several contracts, you are obliged to see about closing the ones you are not able to provide for.

In any case, be careful and don’t allow your deposit to sink down to a dangerous level. When you are trading within a current session, carefully monitor whether you have enough money to hold the position, and always close unsecured contracts on time.

 

3.5 Short trades: when samurai cry

Ok, we’ve pretty much gotten a handle on a trading algorithm in the futures market. We could’ve just stopped here, adding that short trades are not fundamentally different from the long ones. Mirror them — and that’s it. However, as practice shows, short trades (short positions, i.e. bets on price reduction) often cause mental blocks aka stupors in the beginners. Well, let’s look at short trades under a microscope.

At the beginning of the 18th century, Japan saw a rise in agriculture. Rice production was growing every year and its price was going down. The poor were happy that the food was getting cheaper. But the samurai were growing gloomy: rice was the main currency for the military class. Dropping rice prices made the samurai poorer. How it all ended and what part traders from the Osaka’s exchange had in this story, we will learn later. In the meantime, let’s see how a trader can use this situation to make money.

So, you believe that the market will be falling and the samurai will be crying, but you are planning to make money out of it. You can call it market pessimism, coupled with personal optimism.

If it were a real-life forward deal, we would have to enter into a rice delivery contract under the condition that in six months we will deliver 300 kokus of rice to Mr. Toyotomi Hideyoshi at the price of 100 kobans per consignment. However, we expect that the harvest will be even better this year, and the real asset price will be lower. Everyone will be selling rice at 80 kobans. That means, Toyotomi-san will overpay, and we will reap a benefit. Banzai! Ugh, I mean profit ))

* In case you are wondering, koku is the amount of rice enough to feed one person for a year. It’s about 180 liters. One gold koban (a large Japanese coin) could feed three people for a whole year in the Middle Ages.

The catch is that we haven’t met a real person that would want to enter into such a contract. Besides, we don’t have any rice and we do not actually intend to deliver it. But when it comes to selling futures, the concepts of buying and selling are also conditional. In fact, we place a contract with the obligation:  «I, Bill the trader, undertake to sell 300 kokus of rice at 100 kobans» (the wording is now opposite to the long trade’s wording). The terminal will indicate the following in the opened position: short and the price, at which you have entered into a sales contract.

As with long trades, the exchange demands a collateral one (let’s say, 20%), which is being blocked, not written off. And that is why with 100 kobans, we enter not into one, but five contracts.

We can say that with shorts we immediately sell contracts, but in fact we create them the same way as longs. Only we mirror them.

By the way, that is why it is impossible to ban shorts in futures trading, as was done at some stock exchanges.  Formally, a trader takes a loan there, when opening a short position, and the broker acts as a lender.  But if we trade futures, we borrow nothing — we create obligations for future sales.

So, futures delivery contracts are created (sold), and — hurrah! — our predictions were correct. The samurai are furious, the price goes down to 80, and what do we do at this level? That’s right, we repurchase our «short» rice futures position!

Minus five plus five equals zero. That’s offsetting.

In the context of futures agreements, it looks like this: first, we made a commitment to sell rice, and then we made a commitment to buy it. And we see the following situation at the exchange:

  • five Bill-san’s contracts with the obligation to sell rice at 100 kobans on day X;
  • five Bill-san’s contracts with the obligation to buy rice at 80 kobans on day X.

Obviously, if we sell 300 kokus of rice at 100 and buy 300 koku at 80 in real life, we will get back all our rice and an additional profit of 20 kobans.  But since its exchange trading, the agreements are mutually canceled (Bill-san, why don’t you make an agreement about your rice with yourself), the collateral is released, and the difference goes to our account.

In the end, each contract yielded us 20 oval gold coins with Japanese characters, and the whole trade brought us a whopping hundred coins. We politely bow to the outraged mister Toyotomi and scamper off to escape his katana.

That’s how a correct forecast can result in a profitable short trade.  Only in today’s world instead of gold kobans we would have to use traditional dollars.  But what if we make a mistake and the price of rice goes up?

 

3.6 Samurai strikes back

In the 1730s, when the landslide of rice prices became catastrophic, exchange traders in Osaka started holding on to the product: this resulted in a sort of collusion between the trading and noble elites. And this time, it was the commoners’ turn to be angry: rising prices did not sit well with them because they wanted to eat. This, by the way, was one of the first cases in history when exchange traders made a real impact on pricing. The crisis was so dramatic that a shogun had to get involved. Japan set minimum prices for rice to guarantee feudal lords a certain level of income (after all, they got rice as a due from peasants and vassals).

Imagine that we’ve decided to short once again, hoping that the price of rice will fall. And we placed the same contracts as last time. But the market turned against us, and rice prices, to the delight of the samurai, shot upward.  The time to deliver five consignments of rice to Mr. Toyotomi comes, and he pays 100 kobans for each, as agreed. The things is though, the market price of 300 koku is now 120 gold coins…

What do we see at the exchange?

  • five Bill-san’s contracts with the obligation to sell rice at 100 kobans on day X;
  • five Bill-san’s contracts with the obligation to buy rice at 120 kobans on day X;

It turns out that each contract resulted in a 20-coin loss. 100 kobans walked off into the sunset!

So, we’ve lost 100 kobans, and at this point, we are almost ready to commit hara-kiri.

It’s time to write beautiful poems, say goodbye to this cruel world and prepare the ritual tanto. (The «fly out the window» option is simpler, but not as dramatic.) There is also another, more practical solution: finding the strength to stand up after the fall and achieve success against all odds. It can’t hurt to think about what went wrong.

Have you guessed what?  That’s right. The risks were too high.

 

3.7 Attention! Leverage!

Careful risk estimation is very important in trading, especially in futures trading. The leverage effect in the futures market allows you to control a huge futures position having a relatively small collateral in your account. Leverage is inherent in futures trading.

The more contracts you buy (having the same deposit, and all other things being equal), the higher the risk level and, therefore, the greater the leverage.

Let’s take the E-mini S&P 500 futures as an example (note that this is no longer a hypothetical, but a real example from trading practice). The current total value of the contract (at the time of writing) is $143,300 (A-value), and the initial margin is $6,930 (B-value). How big is the leverage? We divide A by B and get 20. And this is the leverage (1:20).

The intraday margin for the same futures at the CME has a different value — $500. Divide the total contract value by $500. And it turns out that the maximum leverage that a trader can get when using the intraday margin is 1:286! Whoa!

It means if we trade the E-mini S&P 500 futures, the leverage will allow us to control a position 286 times larger than our deposited funds. A lever effect is at work here. (Remember Archimedes, who said: «Give me a lever long enough and a fulcrum on which to place it, and I shall move the world»?) But there is also a downside: the risks are very high, too…

Does it scare you? Well, no one is forcing you to squeeze the leverage dry. Act reasonably! It’s up to you what leverage size to use in a trade. For example, if you have a $10,000 deposit and you buy only 1 contract, the leverage will be much smaller: 1:14. And it’s effective in terms of risk.  Effective leverage used by a trader is the ratio of the futures position value in the market to the amount of cash collateral allocated to this position. If you use the maximum leverage within a day, more often than not a risk management system will liquidate the position. Therefore, the necessary intraday collateral should be viewed as minimum funds that must be in your account, unless otherwise instructed by the broker.

Leverage must not be ignored as it is an integral part of futures trading. Remember we said that the margin reflected the interests of forward contract counterparties that benefited from low collateral? In those days, they didn’t even imagine that this instrument would later be actively used in speculative trading and that it would popularize futures trading.

But leverage is insidious: all these possibilities intoxicate the mind and trigger the greediness — one of the worst trader’s enemies. It’s the same as with a credit card: a bank provides a credit limit but does not force you to use all of it. Experience has shown that financially ignorant or simply greedy folks will happily max out their credit cards, without thinking of how they are going to make payments after. In the end, some credit card users dispose of bank funds wisely, making their payments during the grace period and receiving cashbacks, but others scold credit card companies for exorbitant interest rates: «Deceivers! Robbers!» But who else robbed you, if not you yourself?

The same is true for trading: stupidity, greed, inability to estimate risks (and difficulties with math in general) lead to ruin. Only a few traders are capable of realizing their mistakes and getting back up after a failure. But there are far too many of those who start to shout from the housetops after wasting their deposits: «Help! It’s a scam! I’ve been deceived!» As if they were forced to use leverage up to the limit at gunpoint…

It is important to understand that the more leverage opportunities you use, the riskier trading gets. However, leverage increases the chances of hitting the jackpot. What’s important here is not to succumb to greed. Traders have a saying: «Pigs get slaughtered». And «pig» is a trading slang for the greediest players. I think the above examples make it clear why such traders get slaughtered.

 

3.8 How much money does one need to trade futures?

In our examples, we used smaller numbers — for the sake of convenience. But you can’t trade futures with only $100 in your account. The average intraday margin for a contract is $500-1,000.

There is no point in trading with less than $5,000-15,000 at the CME. The exception is when you decide to jump at the opportunity to trade micro futures contracts. See the difference for yourself: $0.5 tick instead of $5 tick, $50 intraday margin and $600-800 in the account required for holding a position. In this case, you can try trading with $2,000-3,000 in your account: if you act wisely, «micros» won’t let you quickly waste this money.

I recommend you to have a $10,000 deposit for trading one contract and a $3,000 deposit for trading one micro contract.

Why is it better to use greater deposits? Trading strategies fall into three categories: aggressive (high-risk), medium-risk and conservative (low-risk) strategies. Aggressive strategies let you risk 5% or even 10% of the deposit in one trade. If luck is on your side, you will be quickly building up your capital. But keep in mind that 20 or even 10 failed trades in a row — or several more low-profit trades — may cause you to hit rock bottom. And this kind of a cold streak is quite possible.

It is best to use low-risk strategies for comfortable and steady trading; they involve small risks in several trades (1% or 2% maximum), which are easily covered by one profitable trade.

Calm and quiet trading entails 1-2% risk per trade. Per trade! If you trade five contracts at a time, the risk for each should be no more than 0.4% — even better if it’s only 0.2%. If your deposit is $10,000, the risk per trade must not exceed $200. Obviously, you shouldn’t place too many contracts… or else the risks will increase significantly.

Don’t forget about diversification in trading either. Various market segments behave differently, that’s why many risk management systems recommend traders to divide their capital between 2-3 segments. But if you have money barely enough to buy one asset, how would you divide it?

There’s an important psychological factor: the smaller your deposit is, the scarier it is to lose it. Even a trader who has strong nerves harbors an unconscious fear of losses. It stands in the way of rational trading, and after a long series of unsuccessful trades, it may spark panic, and then «all is lost». A larger deposit not only allows you to choose trading directions freely but also makes it easier to keep a cool head.

 

3.9 From pocket to pocket

Perhaps, an idea that futures trading is basically moving money from pocket to pocket has already crept into your mind. We’ve traded long corn positions and shorted rice. But we have set our eyes neither on corn nor on rice. We only created obligations that were subsequently liquidated. But at the same time, there was either a profit or a loss.

Where do they come from? From traders’ pockets. If you make money off the price rise, someone loses it. It is impossible to satisfy both a poor man who demands cheap rice and a samurai who is eager to increase the price. Of course, all these matters are a little more complicated, but I’m not going to describe here how a clearinghouse that allows you to exit a position at any time without being bound to a specific counterparty works and I won’t be touching upon other nuances of the exchange system.

If all traders were equally smart, then, according to probability theory, each trader would lose money 50% of the time, and make profits 50% of the time. In fact, 95% of traders («lemmings», «woodpeckers», «pigs») waste their deposits, and the «wolves» from the rest 5% scoop the profits from the whole market. By the way, that’s the explanation of the saying about losers that get slaughtered.

 

3.10 How to join the 5% of successful traders?

  • The most important thing in futures trading is to follow the rules of risk management. It is the alpha and omega of trading. There is a misconception among people who have peeked into trading: they say, farmers and buyers hedged against their risks (reduced them), and that’s exactly why a futures contract is profitable to a trader. No, no, and no.  The original principle of hedging, which is the foundation of forwards and futures, has nothing to do with your personal risks. Trading always entails risks, and leverage raises them even higher. Your primary objective is to learn how to distribute and use your money in such a way as to minimize these risks.
  • It is important to understand the nuances of the futures market, its analysis, and trading strategies. You need to learn. This article provides basic information about futures, but you don’t think that’s all there is to it, do you? There are tons of books on futures trading (including the ones about how the futures trading stands out from the stock exchange trading). For example, there is a book called «Technical Analysis of the Futures Markets: A Comprehensive Guide to Trading Methods and Applications» by John J. Murphy. You will benefit from reading the books in the ever-growing list on this website.
  • It is necessary to know what’s what in the exchange trading; you need to understand the strategies and the information shown on charts and indicators, and you should learn how to choose an entry or exit point and how to use orders.
  • But 80% of success is not in techniques, it’s in psychology. The ability to keep a cool head, not to give in to emotions and to act systematically and a high level of self-control and self-discipline are no less important than the knowledge of terminology and the understanding of strategies.
  • And there is nothing more important than practice. Without plunging into exchange trading with your own money (not with the demo account «candy wrappers»), you will not be able to learn how to trade futures. You can get good results combining practical trading with the analysis of successful professional trading.

If you want to see my trades regularly — subscribe to my Telegram-Channel @MonsterTraders. Anyone can access my trades in real time and even trade hand in hand with me.

And most importantly — do not be afraid to try new things, learn and improve yourself!  Futures, as you can see, are not as scary and complicated as they seem at first glance.