Basic Features of Futures

What Are Futures? Lesson 1 of 7

A futures contract is an obligation to buy or sell a commodity at some time in the future, at a price agreed upon today.

• The contracts themselves are interchangeable. That is to say, they are standardized as to terms like what grade of commodity is acceptable and when and where it can be delivered.
• The word commodity is defined very broadly to include financial instruments and stock indexes.
• The contracts are traded on an organized and regulated futures exchange so that buyers and sellers can easily find each other.

Please Note: A futures contract is an obligation (not a right like an option) and that obligation must be fulfilled. In most cases it's fulfilled by simply making an offsetting trade that takes the trader out of his position (sold if one has bought; bought if one has sold). But strictly speaking, the trader can choose to carry the position all the way to the delivery date, when it?s fulfilled either by the exchange of the physical commodity or by a cash settlement.

Is A Futures Contract Similar To An Options Contract?

Lesson 2 of 7

The simple answer is no. The only thing that looks similar is that they both have an expiration date. But a futures contract is not a wasting asset like an options contract.

An options contract conveys the right, not the obligation, to assume a position in the underlying instrument at a specific (strike) price any time before the option expires. When you buy (go long) an option, your risk is limited to the premium you pay. The cost of the option is known as a premium (similar to insurance) and is based on time, volatility and the relative value of your strike price to the underlying market.

However, the value of a futures contract is ultimately tied to the underlying product or instrument (i.e. KL Composite Index, Crude Palm Oil, etc.) via each contract's specifications. You can either buy (go long) or sell (go short) any futures contract and your risk (or potential profit) is virtually unlimited.

Futures markets exist for the purposes of price discovery and the transference of risk. They can provide an excellent way to express your own opinion about where prices are heading. So if an option is a four-dimensional instrument, then a futures is simply a two-dimensional instrument. But they are very different from options.

Are the Margin Requirements for Futures Similar to Those for Stocks?

Lesson 3 of 7

Again, the answer is no. The word "margin" means something different in futures than it does in stocks. In stocks it means that you're borrowing money and paying interest. In futures it simply refers to the amount of money that you need to have in your account.

The margin required for a futures contract is better described as a performance bond or good faith money. The levels are set by the exchanges based on volatility (market conditions) and can be changed at any time.

Generally futures margins are much less than the 50% minimum required for leveraged stock trades. The performance bond (margin) requirements for most futures contracts range from 2% to 15% of the value of the contract with a majority in the 5% area.

Of course, futures margins refer to the minimum required balances to place a trade. A trader is certainly free to maintain a much higher balance - or even the full contract value (100%).

What is the Difference Between Initial Margin and Maintenance Margin?

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There are two types of margins in futures. They are:

• Initial Margin: the amount of funds that must be deposited by a customer when the positions are initially put on.
• Maintenance Margin: the minimum balance that must be maintained in a trading account to keep positions.

Don't make the common beginner's mistake of trying to add the two numbers together. Rather, think of maintenance margin as a subset of initial margin.

Maintenance margin is usually a smaller number than initial margin and really doesn't come into play unless the account balance is shrinking due to losses. If the value of the account balance falls below maintenance level then you?re required to get the account back into compliance (a margin call). You can do this by either sending more money (raising the balance back up to initial margin) or lightening up your position (lowering the initial margin back down to the balance).

How do I Determine the Value of a Futures Contract?

Lesson 5 of 7

It is very important that you understand the contract specifications before you trade any futures contract. These specs will allow you to calculate the value of any contract when you get a quote. Using the data from Lesson 4, here are the specs used to determine their values.

How and When Does the Value of my Account Change?

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All futures contracts are settled daily (assigned a final value price). Based on this settlement price, the value of all positions are "marked-to-the-market" each day after the official close; your account is either debited or credited based on how well your positions fared in that day's trading session. In other words, as long as your position(s) remains open, cash will either come into your account or leave your account based on the change in the settlement price from day to day.

This system gives futures trading a rock-solid reputation for credit-worthiness because losses are not allowed to accumulate without some response being required. It is this mechanism that brings integrity to the marketplace.

Or considered another way, every trader can have confidence knowing that the other side of his trade will be made good. In actual fact, the clearing member firms, and ultimately the futures exchanges themselves, guarantee that each trade will be honored. So as a trader, you need never give thought to the guy on the other side of your trade.

So, if your account falls below the maintenance margin level as described above, your broker will contact you for additional funds to replenish it to the initial margin level. On the other hand, if your position generates a gain, you can withdraw any excess funds (those funds above the required initial margin) or even use them to fund additional trades.

Conclusion

Lesson 7 of 7

This brings to a close our discussion on the ABCs of Futures. In this section we discussed what a futures contract is - and just as important, what it is not. We pointed out that a futures contract is an obligation to take or make delivery of a commodity at some future date, and that a commodity can be very broadly defined to include financial instruments.

You should understand at this point that, even though they both have an expiration date, futures are very different than options. While options retain a right and decay in value over time, futures incur an obligation that must be fulfilled at some point down the road.

Finally, you should now have a general understanding of how futures margins work and know that they are not the same as margins in stocks. We detailed the difference between initial margin and maintenance margin and explained how marked-to-market brings credit-worthiness to the marketplace.

If this was your first exposure to futures-related topics then you may wish to explore further in the links below.

Commodity & Futures Education