What Are Futures

Understanding Futures Contracts

Definition of Futures Contracts

A futures contract is a standardized agreement between two parties to buy or sell a specific asset at a predetermined price on a future date. Unlike many other financial instruments, futures contracts are traded on regulated exchanges, ensuring transparency and reducing counterparty risk. The standardized terms include the quantity, quality, and delivery time of the underlying asset, which can range from commodities to indices and various other financial instruments.

Key Features and Standardized Terms

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  Standardization

  Futures contracts are standardized to facilitate liquidity and ease of trading. For instance, a single oil futures contract represents 100 barrels of oil. So, if the price of oil is $80 per barrel, then each futures contract is worth $8000. This standardization enhances liquidity.

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  Margin and Leverage

  Trading futures involves using margin, i.e. a fraction of the contract’s total value must be put down to enter a trade. This provides capital efficiency for futures traders. However, leverage is a double-edged sword because it magnifies both potential gains and losses.

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  Mark-to-Market (MTM)

  Futures positions are mark-to-market daily, meaning profits and losses are calculated each day based on the contract’s closing price.

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Mechanics of Futures Contracts

How Futures Are Traded

Futures contracts are traded on futures exchanges such as the Chicago Mercantile Exchange (CME). These exchanges operate electronically and provide a centralized marketplace for buyers and sellers. Traders can enter or exit positions during specified futures trading hours.

Roles and Obligations of Buyers and Sellers

What Does This Mean for Retail Futures Traders?

For most retail futures traders, buying or selling a futures contract does not mean you have to take delivery of, or physically deliver, the underlying asset.

Retail traders can open and close futures positions during market trading hours.

For example:

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  If you buy (go long) a futures contract, you can sell the same contract, at any time, before expiry to close your position.

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  If you sell (go short) a futures contract, you can buy the same contract back, at any time, before expiry to close your position.

Most retail futures trading therefore involves trading the price movement of the futures contract rather than taking or making physical delivery of the underlying commodity.

The obligation to take or make delivery generally only becomes relevant for physically settled futures contracts that are held close to, or through, their relevant delivery or expiry deadlines.

Brokers will normally have specific rules requiring retail traders to close or roll these positions before this point.

Cash-settled futures, such as many equity index futures, are settled financially and do not involve physical delivery.

At Orion Capital we do not take any products to expiry or do any settlement of any product.

The Concept of Margin and Leverage

Margin is the capital amount that you must put forward as a deposit when purchasing a futures contract. The margin amount is determined by the exchange and is calculated depending on market volatility, the greater the uncertainty the higher the margin.

Brokers have the discretion to offer their clients intraday margin which reduces the need to deposit the full exchange margin amount which allows traders leverage up to trade larger position with less margin requirements which makes trading capital efficient.

Leverage is the concept of controlling a larger position in the market using margin capital. It is usually expressed as a ratio. For instance, a leverage of 1:10 means that with a capital of $1000, you can control a market position worth $10000.

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Regulatory Environment

Overview of Regulatory Bodies

In the United States, the Commodity Futures Trading Commission (CFTC) regulates futures markets, ensuring market integrity and protecting against fraudulent activities. Similar regulatory bodies exist globally, maintaining standardized and fair trading practices.

Importance of Regulation in Maintaining Market Integrity

Regulation is crucial in maintaining the integrity and stability of futures markets. It ensures transparency, prevents market manipulation, and protects the interests of all participants.

Check out the full list of regulatory licenses Orion Capital holds here.

Pros and Cons of Futures Trading

Benefits of Trading Futures

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  Leverage

  Amplifies potential returns with a smaller initial investment.

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  Liquidity

  High liquidity ensures ease of entry and exit from positions.

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  Hedging

  Effective tool for managing risk and protecting against adverse price movements.

Potential Drawbacks and Risks

Trading futures offers powerful strategic advantages, but long-term success relies on smart risk management. Here is how you can proactively manage and mitigate the core challenges of the market:

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  Leverage

  • The Risk: While leverage maximizes your buying power, it can also amplify losses if the market moves against you.
  • The Mitigation: Always practice disciplined position sizing and utilize automated stop-loss orders to strictly control your exposure and protect your capital.

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  Complexity

  • The Risk: The structural intricacies of futures require a solid foundational understanding to trade effectively.
  • The Mitigation: Accelerate your learning curve by taking advantage of step-by-step educational resources or practicing your strategies risk-free in a demo account.

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  Volatility

  • The Risk: Fast-moving markets can lead to sudden price swings and rapid shifts in position value.
  • The Mitigation: Stick to a well-defined trading plan and monitor key economic calendars so you can anticipate and navigate market movements with confidence.