Understanding Futures Trading Basics

Futures trading is concerned with trading Futures Contracts. What is a Futures Contract? A Futures Contract or "Forward" Contract (often called cash forward sale) is a contract between a seller to supply a commodity at a given date for a specified price to a buyer. This is a formal agreement (obligation). No money changes hands until the date of delivery. Futures Trading is considered to be a zero sum game, that is, for every dollar made, someone else loses a dollar. If prices are too high or too low, the buyer or the seller will profit, but at the expense of the other. For example, if wheat prices rise, the farmers benefits but the bread manufacturer suffers. If wheat prices fall, the farmer suffers, but the bread manufacturer benefits.

Futures trading occurs on the floor of the trade exchange, such as the Chicago Mercantile Exchange (CME), where trading occurs in the open outcry pit. Futures trading also occurs "electronically," over the internet from desktop platforms, with customers submitting their buy or sell orders.

Futures traders are divided into two groups, hedgers and speculators. Hedgers are farmers, manufacturers, and exporters. Hedgers create futures positions for the purpose of reducing the risk that the price of their commodity may fall. For example, a wheat farmer knows his crop will be harvested in September. He sells wheat futures prior to the harvest at the current price in June for delivery in September. In June the price of wheat is high. This way should the price of wheat fall in September because of a bumper crop, his price is already protected. Mind you, the farmer is taking a risk. It could be that there is no bumper crop in September and the price of wheat rises even further.

Speculators are trading Futures for the purpose of earning a profit. Speculators make up the majority of traders in most markets. Speculators assume risk in the hope by buying low and selling high (going long), or by selling high and later buying back low (going short). Speculators provide needed liquidity to the Futures market. Without speculators, there would be no one to take the other side of the hedgers contract. As in the example above, the farmer sells the wheat to the speculator in June for the current price. The speculator is assuming risk. He is hoping that by September, the delivery date, the price of wheat has risen and he can make a profit at the farmer's expense. What he hopes doesn't happen is in September, the price of wheat has gone down and he over paid.

Before organized Futures exchanges, such as the CME, Futures trading was even more risky. Individual contracts between one farmer and one speculator were signed where the farmers happened to be selling their produce, like farmers markets. But there were significant problems with individual forward contracts. Either the farmer or the speculator could default on the contract. Who would oversee payment? Since contracts were between individuals, the speculator could not sell his contract to another speculator because the contract was specifically drawn up for that one speculator. Who would certify the quality of the delivery? Farmers could fulfill their end of the contract with inedible product.

With the advent of organized exchanges, it was the responsibility of the exchange to certify delivery and payment. Exchanges required good-faith money be deposited with a third party to ensure the contract performance,thereby reducing contract defaults. Exchanges also standardized contracts, stipulating contract terms, such as commodity grade and dates.

Futures trading has evolved beyond just buying and selling commodity contracts. Today, futures contracts are available across many different asset classes, including equities, currencies and energies. Futures are known as "derivatives." A security whose price is derived from one or more underlying assets is a Future. For example, the S&P 500 Futures Contract is based upon the underlying asset -- the S&P 500 Index traded on the NYSE. The S&P 500 Index is, by far and away, one of the most heavily monitored stock indexs worldwide. The index is a combination of the top 500 stocks traded on the New York Stock Exchange (NYSE). The stocks that make up the S&P 500 are the most well recognized companies. Here's the problem, however...you cannot trade an Index. The Chicago Mercantile Exchange (CME), created an S&P 500 Futures Contract that you can trade. In the case of the S&P 500 Futures Contract, when the value of the S&P 500 Index goes up, the S&P 500 Futures Contract goes up with it and vice versa.

Futures can also be based upon currencies. For individual investors, the Currency Futures Market is tailored to the small number of contracts that individual investors intend to trade. With Currency Futures, individual investors can trade the same currencies that are traded in the Forex market, but trade on the Chicago Mercantile Exchange. Check out Currency Trading for more information.

Shadowtraders specializes in training investors in the art of Futures Trading. While other Futures trading education companies concentrate on the S&P 500 Futures Contract, and in particular the Emini version of that designed for individual traders. Shadowtraders is more interested in introducing its clients to many different Futures, equities, currencies, energies, treasuries, etc. We trade instruments that have volatility and liquidity. We know the days of the week that an instrument trades, the times of day, whether you can or can't trade that instrument, etc. That is our specialty.

If you are tired of just trading the S&P 500 Emini and want to expand your trading style, or you are new to Futures trading and want to find out what is available to trade, attend a Shadowtraders Webinaron Monday nights.

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