Before entering the world of futures trading, investors must take the time to understand how contracts in the sector work and how they differ from trading in other, more mainstream asset classes, such as stocks and bonds.
Let’s begin with a simple definition of a futures contract. The contract legally obligates a buyer to acquire an asset, or a seller to sell an underlying asset, at a predetermined date and price in the future. The asset involved can be anything from physical commodities — gold, oil, corn, etc. — to financial instruments, such as stock indices, interest rates and currencies.
Now before entering into a futures contract — known as taking a position — an investor should be aware of the four main elements of a futures contract. These instruments are much different from buying shares in companies on stock exchanges. In that type of trade, an investor immediately takes ownership of the underlying asset.
The four elements in a futures contract are:
The contract will specify the asset that underlies the contract, which is crucial in measuring the value of the trade. Some of the most highly traded assets in futures trading include energy products, agricultural commodities, precious metals, equities indices, and forex.
The quantity explains the size of the contract, which typically outlines the specific number of the units being bought or sold. For example, one contract in WTI crude oil futures gives the holder the right to acquire 1,000 barrels of oil. If trading gold futures, one contract would give a market player the right to buy 100 troy ounces of gold.
Futures contracts must have an end date — an expiration on a set day in the future. The expiry date is the final day the contract can be traded. After that date, the contract must be settled under the terms of the agreement.
The price of a contract is ultimately determined by the open market, reflecting the value of the asset involved. A futures contract, however, will contain a specific price, usually tied to the spot or cash price of the underlying commodity. The contract will also make clear what currency is being used in the contract, such as whether the asset is priced in U.S. dollars or another denomination.
There are details involved in futures contracts, including delivery terms. Although most futures contracts are closed out before expiration, it’s still important to know the contract’s delivery terms. This involves knowing whether delivery will be in the physical commodity or will involve a cash settlement. Trading in gold, soybeans or oil often means a physical delivery, while other instruments, such as contracts based on S&P 500 Futures, are settled in cash.
Another key factor about futures contracts is that they are standardized, so they can be traded on exchanges, such as the exchanges owned by the CME Group, Chicago Board Options Exchange, or the Intercontinental Exchange. The Commodity Futures Trading Commission regulates the trading of futures contracts in the United States.
If you’re considering investing in futures, you should understand the intricacies of futures contracts and whether such investments fit the risk profile of the investor. To fully understand the pros and cons of investing in futures, investors should consult a qualified broker, such as Daniels Trading. If you’re ready to speak with a licensed futures broker, schedule your consultation now!