Futures Trading for Beginners: Basics of Futures Markets
- Futures were developed for farmers to manage risk and reduce uncertainty through risk management.
- Futures contracts allow producers and consumers of a commodity to manage risk surrounding price uncertainty.
- There are two major market participants in the futures market: risk makers (hedgers) and risk takers (speculators).
- Hedgers use futures to reduce or offset risk, while speculators aim to profit from trading the contract.
- Investors can speculate with futures by going long (buy) or short (sell) an asset, but it is vastly different from other asset classes, like stocks, in many ways.
Futures Trading for Beginners
Are you looking to get into futures trading but need help knowing where to start? Well, you've come to the right place. Admittedly, there are many moving pieces to futures trading, and feeling overwhelmed is a natural response. So, rather than get lost in endless web searches or posting questions on an internet forum, we've detailed the basics to help anyone looking to learn more about futures.
The act of trading futures is like any other asset where investors can either go long (buy) or short (sell). However, that's pretty much where its similarities to other asset classes end. Before we dive into the nuts and bolts of futures trading, let's cover some background information on futures and why they exist in the first place.
Why do futures exist? A Brief Intro to Risk Management
Agricultural commodities such as corn, wheat, and soybeans are usually the first things that come to mind when a new investor thinks about a futures contract. One reason for the development of futures was for farmers to manage risk and reduce uncertainty—also known as risk management.
In business, there are price makers and price takers. Price makers can set what they will charge for a product or service. Normally this is the case when a company is selling something unique, without a competitor. Price takers must buy or sell something at a price that is determined by a broader market of other transactions because their product is not unique and has competitors. As an example, farmers are price takers since the market determines the price they receive. Farmers have a unique business model because they will not know what the market price of their crop will be until it is ready to be sold. Since the market determines the price farmers can receive for their crop, they cannot be a price maker. The same risk applies to other commodity producers since it takes time for other commodities like wheat, gold, oil, or livestock to grow, mine, drill, or be ready for market.
Using the example of a farmer, the market price of corn at the time of planting may be $4 a bushel. At the time of harvest it could have decreased to $3.75 a bushel. Sure $0.25 may seem like a small amount, but farmers usually sell thousands of bushels of corn at harvest. A $0.25 difference over thousands of bushels could be the deciding factor for a profitable harvest.
Futures allow farmers and other producers to mitigate the risk of falling prices and price uncertainty at the time of delivery. They can lock in a selling price by selling a futures contract against their crop, promising to deliver it at a later date. This notion of locking in a price for a future delivery date is where futures get their name. We illustrate this in The Role of a Hedger section later on.
Additionally, futures also allow consumers of a commodity to lock in the purchase price for delivery at a future date. Continuing the corn farmer example, a cereal maker that produces cornflakes with concerns about rising corn prices in the future can lock in the price of corn by buying a futures contract for delivery at a future date.
All in all, futures are designed to help producers and consumers manage risk surrounding price uncertainty. However, you don't have to be a farmer, a commodity producer, or a manufacturer to use futures contracts to manage and mitigate risk.
The Role of a Hedger
There are two types of hedgers in the futures market: bona fide hedgers and hedgers.
Bona fide hedgers refer to commodity producers and consumers. Producers include wheat farmers or oil drillers that use futures to lock in a sale price and intend to deliver the commodity to a buyer of the respective futures contract. Buyers of futures contracts include consumers or manufacturers that use a commodity as a business input, like a cereal maker or oil refiner.
Producers may use futures to lock in a sale price when they are concerned about falling prices of the commodity they produce at the time of delivery. Conversely, consumers may use them to lock in a future purchase price if they are concerned about rising prices. Futures also allow for better stability in forecasting future profits and losses since a futures contract locks in prices.
Although a producer could lock in a price early to offset price uncertainty, it is not without risks. At the time of delivery, the commodity could be trading at a much higher spot price, and since a futures contract is binding, the producer could end up selling at a much lower price than they would have if they had not hedged. However, if the commodity's spot price is lower at the time of delivery, then the producer has protected itself by using futures to lock in a higher sale price than they otherwise would have been able to get.
The table below illustrates how hedging can help offset price uncertainty for producers, using a corn farmer as an example. Although some hedging could be unfavorable at the time of delivery, when bona fide hedgers sell futures, they eliminate price uncertainty at the time of delivery.
Examples of bona fide hedgers using futures include:
- Farmers hedge against crops like corn, wheat, and soybeans
- Ranchers hedge against livestock
- Miners hedge against precious metals, like gold or silver, and copper
- Drillers hedge against crude oil or natural gas
It's important to note that tastytrade does not support bona fide hedging futures accounts since we do not support physical delivery.
You don't have to be a farmer, miner, oil driller, or other commodity producer to use futures as a hedging tool. For example, investors seeking protection against a portfolio of long stocks can use equity index futures to help offset or potentially reduce losses.
Investors using futures to safeguard a portfolio are generally large investors or institutional investors like a pension fund due to the sizeable notional value of each futures contract. Investors that use futures to protect a portfolio of treasuries or stocks may use interest rate futures or equity index futures as hedging vehicles. Banks or financial institutions looking to manage their currency risk or overnight lending rates may also turn to currency or Secured Overnight Financing Rate (SOFR) futures.
Investors at tastytrade can also use futures as a hedge to protect their portfolio. However, investors will want to consider their portfolio's size when determining which contract size to use, such as an E-Mini or E-Micro futures contract. Please visit the tastytrade Help Center to view a complete list of available futures contracts for trading at tastytrade.
All in all, bona fide hedgers and hedgers trade futures to reduce or offset risk and are known as risk makers.
The Role of a Speculator
Unlike hedgers that use futures to protect their investments or business interests, speculators have no intention of delivering or taking delivery of the asset the future tracks. For example, a speculator can take a long or short position on corn, gold, natural gas, or any other physically delivered futures contract without any intention to deliver or take delivery of the commodity. Instead, speculators only aim to profit from trading the contract.
Assumption: Rising prices
Opening trade: Buy to open
Closing trade: Sell to close
Profits occur: Sell or close the contract above the purchase price
Losses occur: Sell or close the contract below the purchase price
Assumption: Falling prices
Opening trade: Sell to open
Closing trade: Buy to close
Profits occur: Cover or close the contract below the sale price
Losses occur: Cover or close the contract above the sale price
Speculators play a vital role in the futures marketplace by providing liquidity and price stability. Like any other market, liquidity increases as the number of market participants increases, leading to more price stability. As a result of speculators, prices can go up or down to reflect current events or market conditions and provide a more accurate market price for a specific asset. Investors could benefit from rising or falling prices by taking a long or short position bias on a futures contract.
The tastytrade trading platform empowers investors that wish to speculate in futures with a wide array of trading tools and features, such as a wide range of charting tools to locate an opportunity and multiple trading interfaces based on your trading style. Futures traders can put their ideas to work and execute trades using the Active Trader Interface, which provides a visually intuitive interface to enter, adjust, and manage trades rapidly. The Grid Mode also allows investors to combine technical analysis with trade entry by allowing traders to place trades on a chart.
The tastytrade trading platform also has built-in watchlists listing all available futures contracts, including micro-sized contracts. Please visit the tastytrade Help Center to learn more!
Settlement Method at Expiration
Since a futures contract promises an asset's future delivery at a specified price, the contract will expire at some point. That said, not every futures contract settles into the asset it tracks. There are two settlement methods for holding a futures contract to expiration. The settlement method will determine the last trading date when investors at tastytrade must close their futures position.
To view a complete list of available futures at tastytrade, including their settlement method, please visit the tastytrade Help Center. One last thing worth noting is that expiration times and settlement methods are not uniform amongst different asset classes.
Physical Delivery and First Notice
As its name suggests, physical delivery refers to a futures contract type that will settle into the physical asset or commodity the future tracks. The seller of a futures contract is obligated to deliver and sell. The buyer of a futures contract is obligated to take delivery and buy.
For example, if you purchased a corn future and hold it to expiration, you will be obligated to buy 5,000 bushels of corn at the price you established in the contract. Five thousand bushels of corn is about the size of a railcar to provide some context behind the size of a single futures contract.
Conversely, an investor that sold a corn future and held it to expiration will be obligated to sell and deliver 5,000 bushels of corn to a buyer of the contract at the contract's established price.
Available Futures at tastytrade Subject to Physical Delivery
- Energy (non-micro)
- Treasuries/Interest Rates (non-micro)
One thing worth noting is that tastytrade does not allow for physical delivery of outright futures contracts, so investors at tastytrade will not have to worry about truckloads of corn or 1,000 barrels of crude oil appearing at your front door. However, physically delivered futures contracts are subject to a "first notice" or the date the long or short holder of the contract can request delivery. To avoid physical delivery, the tastytrade risk team will inform investors holding any futures contract subject to first notice dates or last trade dates so investors can close their contract and avoid physical delivery. To learn more about first notice and how it affects futures subject to physical delivery, please visit the tastytrade help center.
Financially settled is a term for a futures contract that settles to cash when held to expiration. Financially settled futures are also commonly referred to as cash-settled futures. A final settlement number published by the futures exchange at expiration will determine the amount of money that will be credited or debited from your account based on the gain or loss on the contract, respectively. Unlike physically settled futures contracts, there is no first notice date, and investors can hold them to expiration.
The table below illustrates holding a financially settled futures contract to expiration and the cash effect after the exchange publishes a settlement price.
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.