An Introduction to Futures Trading For Beginners

Table of Contents

Introduction

Futures trading has been around since the 1700s, originally designed for hedging commodity exposures, it is now gaining increasing popularity among speculative retail traders. It provides a wide range of opportunities to capitalize on the future price of various asset classes such as equities, commodities, and currencies. Futures are typically traded on secure, regulated exchanges with the exception of recent crypto venues such as FTX – and we all know what happened there!

This introduction to futures trading will explain the fundamentals of futures trading, including derivative assets, leverage, margin requirements, and several trading strategies. After reading this guide you will have had an introduction to futures contract specifications, and you ought to have a solid grasp of the basics of futures trading and be ready to take the next step in your trading journey.

Understanding Futures

The underlying market where securities or commodities can be bought and sold for immediate delivery is known as the ‘spot‘ market. In other words the underlying ‘cash’ market price right now, and this is the starting point that other tradable instruments are derived from (derivatives), with futures being one type of derivative. So first and foremost let’s begin with an introduction to futures contract components, starting with their classic definition:

A future is a legally binding CONTRACT which is an OBLIGATION to deliver / take delivery of a fixed QUALITY and QUANTITY of an underlying asset at a fixed price on a SPECIFIED DATE in the future.

It should be noted that this obligation only exists if you hold the contract to its expiry date, there is nothing to stop you passing it onto anyone else in the market that wishes to trade it from you prior to that date. It should also be noted that at expiry, many futures contracts can be cash settled for equivalent cash value, rather than involving physical delivery, but by no means all.

Some examples of futures markets include:

Equity Index Futures e.g. S&P 500, Nasdaq 100, Russell 2000, Eurostoxx50, Dax, FTSE
Energy Futures e.g. ICE Brent Crude Oil, Nymex Crude Oil, Natural Gas, Gasoline
Precious Metal Futures e.g. Gold, Silver , Platinum, Palladium
Agricultural Futures (ags) e.g. Corn, Oats, Soybeans, Wheat, Cattle, Frozen Concentrated Orange Juice, Palm Oil
Softs e.g. Cocoa, Sugar, Coffee
Metals Futures e.g. Iron Ore, Aluminium, Copper, Zinc
Fixed Income e.g Government Bond futures, Interest Rate Futures
FX Futures e.g. EUR/USD, GBP/USD, USD/JPY Futures etc.

Many exchanges offer differing size variations of their standard futures contracts which may include, ‘mini’, ‘micro’ and even ‘nano’ versions specifically to cater towards retail trader interest (and the excitement of High Frequency Trading (HFT) firms wanting to market make them). These smaller contracts match the price of their larger counterparts nearly always but have smaller tick values and smaller margin requirements which reduces risk exposure.

Futures and Forwards

Futures contracts are very similar to forward contracts being that they both represent a pledge to carry out a specific transaction at a future date. Although futures differ from forwards in that they:

Trade on a regulated futures exchange.
Are guaranteed by clearing houses.
Have a margin requirement to be settled on a daily basis i.e. they are ‘marked to market’.
Are standardised

Standardisation of Futures

The standardisation of futures contracts involves various elements:

What the underlying asset or instrument is (such as barrels of oil or interest rates).
Whether the settlement of the contract results in actual physical delivery of a product or cash settlement to the same value.
The amount and units of the underlying asset per contract.
The currency in which the futures contract is quoted.
The grade of the deliverable. eg NYMEX Light Sweet Crude Oil contract specifies sulphur content and API specific gravity, as well as the pricing point – the location where delivery must be made.
The delivery month and last trading date.
Other details such as the tick value – the minimum permissible price fluctuation.

A generic commodity futures contract will therefore have its:

Units of trading, such as bushels (wheat), barrels (oil), the quantity of them per contract and any composition (quality) requirement.
Delivery months e.g. March, June, Sep, Dec if looking at something like T-notes or equity indices with good quarterly volume expiries.
Standard of delivery – cash or physical and required delivery location.
Quotation per unit e.g. dollars and cents for oil.
Minimum price movement e.g. for CL Nymex oil – $10 per tick (1 cent x 1000) where the CL contract represents 1000 barrels of oil per contract. So if you buy a 1 lot at $85.30 and sell it at $85.31 would would have made $10 before deducting the cost of the trade.

Grasping the Terminology

Any introduction to futures trading wouldn’t be complete without highlighting some of the terms and concepts:

Leverage: Futures trading enables you to control a substantial amount of the underlying asset with a relatively small amount of capital, known as leverage, which can amplify both gains and losses.
Margin requirements: Because of this leverage, to trade futures you must have enough money to open a position (initial margin) and maintain a certain amount of capital in your account thereafter, called the maintenance margin. If your account balance falls below the maintenance margin, you will receive a margin call and be required to deposit additional funds or have your position closed out.

Margin rates are listed on exchange websites such as CME (Chicago Mercantile Exchange), Eurex and ICE (Inter-continental exchange) and they vary from time to time depending on how volatile or illiquid the markets are, the greater the risk of movement the higher the margin required. If you only trade intraday, many retail brokers will give you reduced intra-day margin requirements, although if you deal with institutional providers many have recently been demanding even greater amounts than the exchange’s initial margin requirements.
Tick value: A tick represents the minimum price movement for a futures contract, and each tick has a monetary value, known as the tick value, which varies depending on the specific contract (see the oil example in the section above). These tick values can be found under the contract specifications on the exchanges’ websites.
Expiration date: Each futures contract has a predetermined expiration date, after which the contract ceases to exist. Traders must close i.e. trade out of, or ‘roll over‘ their positions (close out in the old expiry contract and open in the new expiry contract) before this date to avoid requirements around physical delivery or cash settlement. Most retail brokers will not let you trade or hold positions in contracts which are close to expiry as dealing with expired futures positions can be extremely costly, particularly in contracts which involve physical delivery.

Participants in Futures Markets

There are two main types of participants in futures markets: hedgers and speculators. Hedgers use futures contracts to protect against adverse price movements in the underlying assets, while speculators aim to profit from these price movements. Both types of participants play a crucial role in providing liquidity and facilitating price discovery in the futures markets.

As futures trading is a zero sum game i.e if you make money someone has to lose the same amount on the other side, you need to understand who you are trading against and what they are doing in the market. A large bond fund may unwind a massive position over a few days moving the market significantly, yet an intraday mean reversion spread trader will have a completely different short term agenda. Only if you get into the mindset of what are known as other timeframe participants compared to you, can you learn to be fluid around their actions and profit from them. Arbitrage algorithm firms such as Citadel or Jump might be interested in having a position for only milliseconds or less.

Settlement and Delivery

As mentioned, many futures contracts can be settled in two ways: physical delivery or cash settlement. Physical delivery involves the actual transfer of the underlying asset between the buyer and seller, while cash settlement involves a cash payment based on the difference between the contract price and the market value of the asset. Most individual traders prefer cash-settled contracts, as they do not require the handling of physical commodities or assets. Most speculators and almost certainly all retail speculators don’t hold physical delivery contracts to expiry, their FCMs or brokers tend to block this from happening.

If you are ‘long’ a futures contract you have bought the contract, which if held to expiry means you wish to take delivery of the underlying asset (in the classic sense of physically delivered commodities), whereas if you are ‘short’ a futures contract and hold it to expiry it means you are the one that will provide and deliver the asset. If you are short at expiry but don’t own the commodity i.e. you are not a producer then you have to go and find it in the market and buy the correct grade and quantity so as to deliver it.

Physical Hedging Example

As a simplified example imagine you are a coffee farmer in South America and bad frost is forecast at a critical time in your crop’s development. The price of coffee futures for the expiry around harvest time, several months away, spikes higher as speculators see the weather maps and take on long positions to profit on their prediction. They assume with more frost damage to the crop there will be less of it around come harvest time, so with no forecast drop in demand for coffee but a reduced supply, economics tells us prices will increase. Starbucks and Costa customers still want their coffee.

The frost comes and goes, you as the coffee farmer found your crop barely affected by the frost, the same as your neighbouring farmer friends, in fact you think you are still on track for a bumper harvest. So your opinion is that the price spike will be short lived and prices will come down hard. You can’t sell your coffee yet, as it’s not ready but you can open a short futures position for a number of contracts close to the amount of the coffee you will harvest. You might look up the C Coffee futures contract specs on ICE and see it’s 37,500lbs per contract, so you sell an offsetting amount compared to your production as a hedge. This has the effect of locking in this spike high sale price for your coffee – happy days. This leads to several scenarios.

If the price continues higher, as the rest of the South American harvest was decimated by the frost and you just had a warm valley, you could sell your harvest for even more money but you will have lost money on your short futures position. So net-net you locked in the price you sold at overall.
If the price drops as you predict, because there’s little frost damage and lots of farmers sell a bumper crop at harvest time as you predicted, you will end up selling your harvest for less money than the spike price but you will have made money on your short futures position to compensate, so once again you locked in the high sale price effectively.

You could either deliver the coffee against the short futures contract by holding it to expiry or you could close out your futures hedge prior to expiry.

Many producers and significant purchasers hedge some of their exposure to price fluctuations in this manner, as it can provide some balance sheet stability and make planning easier for accountants as to what costs and revenues will be. However if you hedge you can lose out on preferable market moves in your favour and nobody has a crystal ball. A firm like Emirates Airlines does not hedge its aviation fuel purchases, it is fully exposed. This is a management decision, traders and forecasters are often wrong and in house traders or external hedging brokers bring their own costs and issues but the choice is there to be made.

Selecting a Broker

Choosing a trustworthy and reputable futures broker or Futures Commission Merchant (FCM) is essential for a successful trading experience. The broker should provide access to the necessary trading platforms, charting tools, and order types for your preferred trading strategies. Additionally, consider factors such as transaction costs, intraday margin requirements, and customer support when comparing them and do some research on their financial viability. Anyone you had an account with MFGlobal knows getting money back an take a long time.

I will discuss in another article the misconception that trading products such as CFDs with no transaction costs and only a being charged a bid/ask spread is somehow cheaper than paying exchange fees, regulatory fees and commissions in futures, as many CFD providers let you trade on the futures contract expiry month priced equivalents.

Developing a Trading Plan

Creating a robust trading plan is a crucial component of futures trading success and being successful at trading any other product. Your trading plan should outline your trading goals, risk management guidelines, and specific trading strategies. It should also include a comprehensive understanding of the market structure, technical analysis, and key factors that influence price movements.

Risk management: Effective risk management is vital to protect your trading capital, in addition to setting stop-loss parameters it should also consider appropriate leverage, times when you should or shouldn’t be in the market and psychology – both yours and the market’s. Even if you plan to automate you trading, fear and greed still drive markets and so psychology should always be a consideration when coding an algorithm. Some of the most panicked moves in the market are actually driven by fearful, badly coded algorithms which feed off each others’ actions like spooked cats.
Technical analysis: Technical analysis involves using charting tools, specifically indicators, to analyze historical price data to help predict future price movements but the term is bundled in with general charting which tends to focus more on patterns and volume. Common chart types used in futures trading include candlestick charts, volume profile charts, and market profile charts.

Market Profile (TPO-Time Price Opportunity) and Volume Profile are advanced charting techniques that display price and volume data in a unique format, helping traders visualize the market’s auction process, identify value areas, and locate the point of control (POC) – the price level with the highest trading activity.
Fundamental Analysis: Critical in knowing what is driving your market and protecting your account from surprise moves. We have a whole article on fundamental vs technical analysis that goes deep into strategy which I strongly recommend.
Order flow: Order flow refers to the real-time flow of buy and sell orders in the market. By analyzing order flow data, such as the Depth of Market (DOM), traders can gain insights into the market’s liquidity, supply and demand, and potential short term price movements.
Trading strategies: Various trading strategies are available to futures traders, including directional strategies such as momentum trading which focus on outright or flat price trades, spread trading where one position offsets another or mean reversion trades, and scalping also known as jobbing, which is high frequency trading for small profits involving analyzing order flow.

It is essential to choose a strategy that aligns with your risk tolerance, trading style, and market knowledge. The book, Enhancing Trader Performance by Brett Steenberger, gives extensive guidance on how to find your niche trading style.

Trading Sessions and Market Hours

Futures markets operate in different trading sessions, including overnight sessions and regular trading hours (which used to be pit sessions) although the trend is towards near 24hr trade, 5 days a week. It is crucial to be aware of the trading hours for your specific futures contracts, as market conditions and liquidity can vary significantly between sessions as well as the margin requirements demanded by your broker at different times. Additionally, understanding the concepts of balance and imbalance in the different sessions can help you identify potential trading opportunities based on auction theory.

Advantages of Futures Trading

Futures trading offers several advantages to traders and investors, including:

Leverage: The ability to control a large amount of the underlying asset with a small amount of capital, potentially amplifying returns.
The same price seen around the world: Unlike something like CFDs or other over the counter (OTC) products like cash forex, everyone trades on centralised regulated exchanges (ignoring non-regulated futures venues like the defunct FTX) and everyone knows exactly how many contracts traded at each price with the same high and low prices. CFD and FX providers rarely have the same high and low prices as their competitors particularly in times of panic such as the Swiss currency de-pegging where they were hundred of prices different to each other and several firms went bust.
No counterparty risk: unlike CFD, forex or spread bet providers, regulated futures exchanges use a clearing house model to guarantee the other side of your position even if your FCM fails.
Diversification: Access to a wide range of asset classes, including equities, commodities, and currencies, and short selling in them is as easy as going long (buying) allowing for portfolio diversification and hedging.
Short selling: The ability to profit from falling market prices by selling futures contracts short without calling a broker to borrow stock on your behalf, as is required when shorting individual stocks.
Tax benefits: Futures trading may offer favorable tax treatment compared to other investment vehicles, depending on your jurisdiction.
Lower transaction costs: Futures trading often involves lower transaction costs compared to trading the underlying assets directly but is also often cheaper than ‘commission free’ OTC providers when you do the maths.

Starting with Futures Trading

Learn the market: Educate yourself on the specific futures contracts you wish to trade, including their contract specifications, tick values, and margin requirements.
Develop a trading plan: Create a comprehensive trading plan that outlines your trading goals, risk management guidelines, and trading strategies.
Get yourself set up with a futures trading journal, it needn’t be anything fancy, just a notebook or excel sheet will do but there are fancier alternatives.
Practice with a demo account: Before risking real capital, practice trading with a demo account to build your skills and test your trading plan.
Open a brokerage account: Choose a reputable futures broker or FCM and open a brokerage account that meets your trading needs and capital requirements, only put in what you can afford to lose.
Start trading: Once you’ve given yourself an introduction to futures trading on a simulated account, feel confident in your trading abilities and have a solid understanding of futures trading concepts, you can begin trading with real money. Start very small and grow your confidence in your strategy before incrementally increasing the number of contracts you trade over time.

I began on a 1 lot clip (EUR12.50 per tick) in 2002 trading Euribor futures (3 month interest rates) after 3 months on the sim and within 5 years I was clipping 400 lots in the bund (10yr German Bond) as an intraday trader doing 20-30 trades a day, although the bid ask size used to be a few thousand lots at each price back then, whereas today it’s only a few hundred. With the introduction of micro and nano futures, you can start much smaller although I would recommend getting off these as soon as possible if actively day trading as they work out to be expensive in terms of costs relative to what you make per tick.

Conclusion

This introduction to futures trading has shown that trading these derivatives offers numerous opportunities for individual traders to profit from market movements across various asset classes but also has some unique advantages compared to other product types. By understanding the basics of futures trading, familiarizing yourself with the market structure, and developing a solid trading plan, you can position yourself for success in these exciting and potentially very lucrative markets. Keep learning, stay informed, and adapt your trading strategies as the markets evolve.

Key Takeaways

A futures contract is a legally binding agreement to deliver or take delivery of a fixed quality and quantity of an underlying asset at a predetermined price on a future date.
Futures contracts can be found in various markets, including equity indices, energy, precious metals, agriculture, and foreign exchange, among others.
Futures contracts are standardized, traded on regulated exchanges, and guaranteed by clearing houses. They have daily margin requirements to settle and are marked to market.
Two main participants in futures markets are hedgers, who use futures contracts to protect against adverse price movements, and speculators, who aim to profit from these price movements.
Futures contracts can be settled in two ways: physical delivery or cash settlement, with most individual traders preferring cash-settled contracts.
Selecting a trustworthy and reputable futures broker or Futures Commission Merchant (FCM) is crucial for a successful trading experience.
A robust trading plan that outlines trading goals, risk management guidelines, and specific trading strategies is a crucial component of futures trading success.
Futures markets operate in different trading sessions, including overnight sessions and regular trading hours, with different margin requirements and liquidity levels.
Futures trading offers several advantages including leverage, diversification, the ability to profit from falling prices (short selling), potential tax benefits, and lower transaction costs compared to trading underlying assets directly.
Getting started in futures trading involves educating oneself on the specific futures contracts, developing a trading plan, practicing with a demo account, opening a brokerage account, and gradually beginning to trade with real money.