What are futures and how does futures trading work?
What are futures?
Futures are standardized contracts that represent an agreement between two parties, a buyer and a seller, to trade a particular asset at a set price before a certain expiration date, called the expiry. Regardless of what the underlying asset’s market price is at the time of the exchange, the price will remain fixed as per the contract.
Assets that can be traded in this way include baskets of company stocks, commodities, interest rates, cryptocurrency, and currencies. The quantity of the underlying will be specified in the futures contract.
Sign, sealed… but rarely delivered. Whatever the quantity, you probably won’t need to clear up your basement. Futures are financial derivatives that enable you to speculate on the price of an asset without ever owning it. Only a tiny percentage of futures contracts end in a physical delivery as most positions are closed before the expiration.
In cases of physically deliverable futures, a ‘first notice date’ applies. This date refers to the first day a delivery of an underlying asset can be made. To avoid delivery, tastytrade sends a first notice date email a few days before the actual day, detailing when the contract can be closed or rolled into the next cycle. Agriculture, metals, and interest rates futures contracts are subject to first notice; while the same three plus currency and energy (excluding E-mini) can be physically delivered.1
How do futures work?
Futures work by locking in the current market price and setting it as the fixed price at which an underlying asset will be exchanged later on. At the future date – on or before expiry of the contract – the market price, likely, will be different. The agreed-upon price would then be either higher or lower than the new market price.
If the new market price is higher than the futures contract price, the buyer benefits as they’ll pay less for the underlying asset. Whereas, if the new market price is lower than in the agreement, the seller benefits because they’ll be paid more than the current price per quantity of the asset. Of course, where the one party benefits, the other loses out.
There are three main types of future traders:
- Speculators take a position on the direction of an asset’s price movement – most retail traders fall under this future trader type
- Producers (hedgers) aim to limit their risk by locking in prices of expected production (goods they manufacture such as oil, gold and wheat)
- Position holders keep their trades open for a long period of time (could be anything between weeks and years)
The definition and workings of futures fly in the face of a popular assumption that it’s all about predicting what’s to come on the financial markets. As nice as that would be, you’re still speculating on upcoming price movements and there’s potential for profit if all goes well.
Buying vs Selling Futures
The basic notion of buying and then selling is a widely known concept in the world of trading. On the back of this, you can buy futures contracts (or go long on them) with hopes that the underlying asset it covers appreciates, so that you can sell it at a higher price to make a profit. However, you can also sell futures contracts if you think the underlying asset will depreciate – also known as going short. You’d then buy it back (or cover it) at a lower price to earn a profit.
A common question among those new to the concept of shorting is, ‘how can you sell something you do not own?’ When you are the seller of a futures contract, you agree to sell the underlying asset at a later date, at the futures contract price.
In summary, when going long, you hope to profit by selling the asset at a higher price. You’d close a long position to sell it. Conversely, you hope to profit by closing your short position at a lower price when going short. To close a short position, you must buy (or cover) it.
Futures Contracts Standardization
Liquidity is ensured in futures contracts through standardization – setting a precise benchmark on a variety of factors based on the underlying asset.
This is done by outlining specifications such as:
- The underlying asset: the exact asset, e.g. basket of stocks, commodities
- Settlement type: cash settlement or physical delivery
- Contract unit: the quantity of the underlying asset covered in one contract, e.g. 1,000 barrels of crude oil
- Currency: the currency of the futures contract’s price quotation
- Quality: the grade of the underlying asset
- Date of delivery: when the final cash settlement, or the delivery, will be made
- Last trading date: the day before the expiry date of the contract
- Tick size and value: the increments by which prices can fluctuate and its worth, e.g. the tick size for crude oil is 0.01 and the tick value is $10
- Maximum price fluctuation permitted: price limit that’s allowed within a trading session
Futures Contract Example
A futures contract includes some key information as outlined in the below example. This includes:
- Product: the type of underlying asset, e.g. crude oil is a commodity
- Expiration: the day on which the contract ends
- Quantity: contract unit, e.g. 1,000
- Price: the agreed upon price of the futures contract
Mark-To-Market In Futures
Futures and options on futures are marked-to-market on a daily basis according to the trading day’s settlement price. Therefore, the IRS refers to these as a Section 1256 products.
Mark-to-market is a finance term – so, it isn’t exclusive to trading. With regards to futures contracts, marking-to-market is a procedure of valuing assets at the end of each trading day, when profits and losses are settled between long and short positions.
This way of measuring fair value according to market price means that, with the change in value of the contract each day, a settlement will be made to reflect this.
Let’s put this into context…
Mark-To-Market In Futures Trading Example
Since a buyer is essentially bullish and a seller is bearish, a lower price at the end of the day would mean a loss for the long position and a gain for the short position. The buyer and seller’s accounts are updated daily (cumulative gain or loss) based on this until the expiration, or when the position is closed.
The change in value from the futures price, as well as the direction, determines gains and losses. The party with the position that matches direction of the change in value will collect the difference in value (from the futures price) at the end of each day, while the other makes a loss equivalent to the change in value. However, unrealized losses will only be factored in once the position has been closed.
Why Trade Futures
Transparent Pricing & Fees
Budget for your positions accurately ahead of time and open a position with low commissions
Capital Efficiency
Take your capital further, with higher potential returns, using leverage
Near Round-The-Clock Monitoring
Experience flexibility – 23 hours availability each day means you can plan futures trading around your life
Broad Range Of Markets
Explore our futures product range and take a pick - you can access the right opportunities for you
Go Long or Short
Speculate on both rising and falling prices – because sometimes ‘the only way to go is up’ is just an option
High Liquidity
Enjoy greater efficiency with tight spreads and many contracts on both sides of the market
Types Of Futures
| Type | Futures products you can trade with tastytrade |
|---|---|
EQUITY INDEX FUTURESCollections of stocks in an equity index offer an indication of how a sector, exchange or an economy is performing. Therefore, equity index futures can give you broad exposure. |
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INTEREST RATE FUTURESFluctuations in interest rate, the fee for borrowing, can be caused by a variety of factors. You can speculate on these movements on specific debt instruments. |
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FOREIGN CURRENCY FUTURESThe value of one currency against another is ever-changing. With strong influences that come into play, e.g. binary events, geopolitics, and international relations, you can back your speculation up with some real-life action and historical data. |
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VOLATILITY FUTURESIncreased relative movement of market prices comes with more opportunities for success. Volatility futures enable you to take positions based on a basket of stocks’ expected explosiveness in price. |
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CRYPTOCURRENCY FUTURESCryptocurrency has taken the Information Age by storm, with invaluable contributions in digital finance. You can trade Bitcoin futures with tastytrade, but more are coming soon. |
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COMMODITY FUTURESHard and soft commodities have been a bedrock of ways of living across centuries throughout the world. You can take a position on these natural resources that have seen bygone times come and go. Agricultural
Energy
Metals
Livestock
| |
What Is Futures Trading And How Does It Work?
Futures trading is making a commitment to take a position by a future date, either buying or selling a specific underlying asset, at a predetermined, fixed price. It works by having a futures contract in place that’s entered into by a buyer and a seller, who both have an obligation to hold up their end of the deal.
Learn more about futures trading
While a futures contract can protect you from negative price changes, you also run the risk of missing out on a better price. It’s not exactly all or nothing, or a win-win situation – but somewhere in-between.
Let’s have a closer look at this when put into context.
Notional Value And Leverage In Futures Trading
Notional value is the total worth of the underlying asset that is controlled in a derivatives trade, i.e. the amount you stand to lose. It doesn’t include additional fees such as commission and margin relief.
Buying power can fluctuate based on the position and market volatility. That’s why you don’t only need your initial margin amount, which is used to open your futures position, but you also need maintenance margin. This is the minimum amount needed in your account at any given time. A margin call occurs if the amount in your account is less than the maintenance margin.
Notional value is calculated by multiplying the spot price with the futures contract size, or number of units of the underlying asset. Let’s continue with our example of a 1,000 crude oil barrels futures contract at a price of $75.72 per barrel ($75.72 x 1,000). The notional value at risk in this case is $75,720.00.
Market value differs from the notional value – it’s the spot price of the underlying asset per unit, or the futures contract price. As per the example, the market value of crude oil is $75.72.
Further, leverage has a big impact on your trading. It means that you only have to commit a certain percentage of the full value of the trade upfront. Despite putting forth less initially, your risk remains the same for long positions – the notional value. If you went short on a futures contract, however, your risk isn’t capped.
Futures Contract Tick Size
In derivatives trading, a contract’s tick size is the smallest increment by which prices of the underlying asset can fluctuate. An exchange sets the tick size for an instrument. On the Chicago Mercantile Exchange (CME), the tick size for crude oil is 0.01 and each point is worth $1,000. Multiplying these two values gives you the tick value – which, in this case is $10 (ticks to a point).
Points are on the left side of the decimal point of a price and ticks are on the right.
If the price of crude oil moves up 25 ticks (0.01 x 25) from the spot price in the example ($75.72), it would then become $75.97. That might seem insignificant – but multiplied by the tick size ($10), it accounts for a $250 change in your profit or loss.
This means you stand to gain $250 if you went long, or lose $250 if you took a short position. If you took a position on multiple futures contracts, you’d multiply this value by the number of contracts.
Futures Trading Example
Futures trading spans from the time the contract is entered (also known as ‘opened’) to the time the position is exited (also known as ‘closed’), or when this happens by default at expiration. If the market price is higher when the exchange is made, you’d benefit if you took a long position (buying), and the seller would lose out.
On the other hand, when the market price is lower than the futures contract predetermined set price would benefit the seller and the buyer would lose out.
Suppose you buy a crude oil futures contract and you’ve agreed to purchasing 1,000 barrels of it at a price of $75.72 by September 22nd.
If the price of crude oil drops and stays low after you enter the agreement, you’ll incur a loss if this is still the case at expiration. But if it rises and stays above the futures price, you’d make a profit.
Either way, you still have a chance to try to lock in profits or limit losses before the expiry date. If the market moves against your position, you can open and close it anytime – there are no pattern day trading (PDT) rules for futures, as they aren’t securities. This is useful when you want to change your directional assumption in a particular futures product.
Futures Vs Options: What Are The Differences?
Futures and options differ in several ways. You might ask yourself which is better between futures and options. These include:
| FUTURES | OPTIONS |
|---|---|
Obligation to buy or sell | Right when buying, obligation when selling |
No premium and probability of profit is fifty-fifty (linear payoff) – depends on direction only | A premium applies (buyers pay and sellers collect) and exposure is non-linear |
Options and futures might be apples and oranges, but they are also similar in some ways, e.g. both are financial derivatives that can be used for hedging. Both also enable a trade to be made at a future price and by a certain date.
Options On Futures: What Are They And How Do They Work?
Unlike their equity option counterpart, which is tied to 100 shares of stock, options on futures are options that are tied to a single futures contract. It’s a derivative of a derivative. Similarly, the value of the option adheres to each futures contract tick value.
Similar to their equity option counterpart, buyers of options on futures give the right to buy or sell the underlying futures contract at the strike; and sellers of options on futures have the obligation to buy or sell the underlying future at the strike price.
Details that are typically included in an option on futures contract are the product, the future’s contract month, and the set price to buy or sell the futures contract.
How To Start Trading Futures
- Do your research to get an understanding of how futures trading works
- Create an account or log in
- Choose your preferred market and asset
- Create a trading plan and manage your risk
- Open your futures position and monitor it
- Close your position if you want to do so before the contract expires1
FAQs
In any type of trading activity, risk is a factor and should be given due consideration. That’s why it’s important to build a rock solid foundation of knowledge on all the moving parts in futures trading, e.g. the impacts of leverage, before getting started so that you can manage your risk accordingly.
You can buy stock index futures with tastytrade by following our steps on how to trade futures.
Some differences between futures and stocks include:
| Futures | Stocks |
| Financial derivative contract that allows you to buy stocks and other assets | Financial instrument that you can trade via futures and other derivatives |
| Obligation to buy or sell in the future at a predetermined price | Can buy and sell (with no obligation) at whatever the market price is |
| The exchange must happen on or before the contract expiration | No time limit – can take your position in 10 years’ time or not at all |
| Less risk of insider trading | A single stock is prone to leaking of information |
| Not subject to PDT rules since futures aren’t securities (requires a margin account) | Subject to PDT rules, as stocks are securities |
The question of which is better between futures and options has no particular correct answer. It depends on how you want to get exposure, what your risk appetite is, and the trading time horizon. Upon doing a deep dive on both futures and options, you’d be better poised to make a decision based on your needs.
With tastytrade there’s no minimum account balance to trade CME futures in a margin account.
But if you’re trading using an IRA account, start-of-day net liquidation must be $25,000 for standard CME futures contracts and options on futures; and $5,000 for CME micro e-mini futures and CME options on micro e-mini futures.
Whichever account you use, you need to ensure that overnight requirements are met.
All investments involve risk of loss. Please carefully consider the risks associated with your investments and if such trading is suitable for you before deciding to trade certain products or strategies. You are solely responsible for making your investment and trading decisions and for evaluating the risks associated with your investments.