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Futures Trading Tutorial: Learn How to Trade Futures
Given the increased traffic in
commodity speculation, the most direct way to
invest is trading futures contracts. As
a speculator you can profit from either an increase
(going long) or decrease (going short) in the
price of a certain commodity.
For new investors,
confusion may arise when informed that you are
able to initially sell something in which you
do not currently own. Consider the futures
market a zero-sum game, for every buyer there
is a seller. Aside from the price of a commodity,
there are six pieces of information you need to
be aware of before opening a position (long or
short), and these are always listed in our
contract
specifications.
- Contract Size
– shows the quantity of the commodity
a futures contract represents.
- Tick Size –
shows the denomination in which the price of
the commodity fluctuates.
- Tick Value
– shows the $ value each tick represents.
- Last Trading Day
– shows the expiration date of the contract.
You need to liquidate your position prior to
this date to prevent delivery. We will
give you a courtesy call to confirm your awareness
of this date, going into expiration.
- Initial Margin
– the amount of funds needed in your futures
trading account to open a position. Margin
is subject to change without notice, and is
correlated with market volatility. The
more volatile a market, the higher the margin
requirement.
- Maintenance Margin
– You must maintain your account balance
above this level to prevent a margin
call.
Now that you have the information needed to proceed, lets put what we know into practice. |
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Futures Trading Example #1:
John believes the price of Crude Oil will rise over the next couple months, while contrarily Sarah believes the price of Crude Oil will fall over the next couple months. Lets assume the current date is January 15th and the contract price for a March Crude Oil futures contract is $100 (keep in mind, one futures contract of oil represents 1,000 barrels). John would enter a buy order for one March Crude Oil futures contract at a price of $100 with his broker. And Sarah would enter a sell order for one March Crude Oil futures contract at a price of $100 with her broker. Both of these orders will be routed directly to the futures exchange which handles Crude Oil. Both orders will be paired and executed, obligating both parties to the terms of the futures contract. In essence, upon the March expiration date of the futures contract John must purchase 1,000 barrels of Crude Oil at a price of $100, and Sarah is obligated to sell 1,000 barrels of Crude Oil at a price of $100 regardless of the price at expiration. If the price of Crude Oil is $85 at expiration, Sarah has made a profitable trade worth $15 per 1,000 barrels ($15,000) , while inversely John has a loss of $15 per 1,000 barrels ($15,000).
If either parties were to hold their Crude Oil futures contract through expiration they would technically be required to deliver or be delivered upon with 1,000 barrels of Crude Oil to their front door. But since the purpose of our investment is purely speculative we must offset our futures contract before the expiration date to prevent the retendering process. Thus, before the March expiration date, John would put in an order to sell one March Crude Oil futures at $85, and Sarah would enter a buy order for one March Crude Oil futures at $85. The orders would then be sent to the appropriate exchange, the orders would be paired and executed, relieving both parties of their obligation to deliver or be delivered upon. Sarah has now locked in the profit of $15 per 1,000 barrels ($15,000) at the expense of John.
It is not required for you to hold your futures contract into expiration, you have the ability to liquidate your position at any time you desire before expiration. Let’s alter the example and say that after the initial transaction, the price of Crude Oil rose to $110 after 1 week. John has a potential profit of $10 per 1,000 barrels ($10,000) if he were to liquidate the futures contract, while Sarah is at a current loss of $10 per 1,000 barrels ($10,000) if she were to liquidate. Now let’s say John is happy with the $10 per 1,000 barrels ($10,000) profit and enters an order to sell one March Crude Oil futures at a price of $110, while Sarah believes the rise in the price of Crude Oil is only temporary and wishes to hold her position. The order from John would be routed to the appropriate exchange and matched with an offsetting order, and executed. John is now free from any obligation in regards to a Crude Oil futures contract, and has profited $10 per 1,000 barrels ($10,000) in 1 week. Sarah is still holding a short (sell) position, and continues to hold into March where the price has now fallen to $85. Sarah then enters an order to buy one March Crude Oil futures contract at $85, at which point the order is routed to the exchange and paired with an offsetting order. Sarah is now free from any obligation regarding a Crude Oil futures contract and has made a profit of $15 per 1,000 barrels ($15,000), even though she was temporarily at a loss of $10 per 1,000 barrels ($10,000) at the time John took his profit.
So what have we learned from this example?
- Margin represents the funds needed to open a position.
- Each contract represents a specific size of the underlying commodity.
- Futures contracts are highly leveraged.
- We must be familiar with the tick size and tick value of each given commodity to evaluate potential profit/loss.
In reference to margin, you must be aware of the ‘initial margin’ and ‘maintenance margin.’ Going back to our previous examples, the initial margin for one Crude Oil contract is $8,000. For examples sake, lets say the maintenance margin is $5,500 (keep in mind, maintenance margin is also subject to change without notice). What does this mean? Your maintenance margin value is the point in which you would receive a ‘margin call’ from your broker. A margin call simply states two options for you as a trader: 1. exit your current position, or 2. make an immediate deposit to replenish your account to the initial margin required. Depending on the severity of the margin call, it may be possible for your broker to liquidate your position without notice. For self-directed accounts, if at any point you feel you will fall below margin, it is important you communicate your thoughts and possible actions with your broker to avoid unnecessary liquidation.
For example: If you were to enter one long Crude Oil futures contract at $100.00 with an initial margin of $8,000, and before expiration of the contract the price of oil has declined 250 ticks to $97.50 (250 ticks = $2.50/barrel = $2,500), your net liquidating value would be $5,500 ($8,000 - $2,500). When your net liquidating value is beneath your maintenance margin, you will receive a margin call asking you to either liquidate or add funds to your account.
So to recap:
After opening a position, we must maintain a net liquidating value above the maintenance margin to avoid receiving a margin call, and possible liquidation.
*Note: All examples used did not account for commission and brokerage fees. Costs are associated with all transactions, and should be accounted for.
So now that you know ‘how’ to trade, it leaves us with the question of ‘when’ to trade. Expo Futures provides free up to the minute news, and daily research to all of its clients.
If you’re still uncertain about trading on your own, we welcome you to speak to any one of our qualified brokers to help you assess your trading goals and strategies.
Need more information before you sign up for your futures trading account?
* The information provided here is purely educational, Expo Futures will not be held responsible for either its accuracy or completeness. There is a risk of loss in trading futures. Trading futures is not suitable for everyone. Past performance is not indicative of future results.
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