Futures Trading: The Risks and Rewards | Understanding The Risk Management of Derivatives

Futures Trading: The Risks & Rewards  | Understanding The Risk Management of Derivatives

What is a futures contract? 

A futures contract is an obligation to buy or sell a commodity at some time in the future, at a set price agreed upon today. The contracts themselves are interchangeable. They are standardized as to terms such as the grade of commodity that is acceptable and when and where it can be delivered. The definition of a commodity is defined very broadly to include physical commodities, financial instruments, forex, and stock indexes.

 

Futures contracts are traded on an organized and regulated futures exchange so that buyers and sellers can easily find each other. The exchange clearinghouse is an intermediary to every trade, which not only reduces credit risk in futures trading but also makes it easy for position holders to exit whenever they wish.

 

More importantly, a futures contract is an obligation, not a right like an option. That obligation must be fulfilled. In most cases it is fulfilled by simply making an offsetting trade that takes you out of your original position (sold if one has bought; bought if one has sold). But strictly speaking, you 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.

 

The word "margin" here means something different in futures trading than it does in stocks. In stocks it means that you're borrowing money and paying interest to hold a position. In futures, it refers to the amount of money that you need to have in your account should the margin be called.

 

Futures margins refer to the minimum required balances to place a trade. You certainly are free to maintain a much higher balance – or even the full contract value (100%) – in your commodity trading account. Once your position is established, you are required to keep a "maintenance margin” amount in your account per each contract you hold or risk having your commodity broker close your position.

 

Futures contracts are settled daily and 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. 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 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. Every trader can have confidence knowing that the other side of his trade will be made good. Clearing member firms at the clearinghouse, and ultimately the futures exchanges themselves, guarantee that each trade will be honored.

 

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

 

The process of trading futures is also known as commodities trading. Unlike buying stocks, when  trading a futures contract you do not actually own anything. All you are doing is speculating on the future direction of the price of the commodity. In other words you are betting that the price will either go up (if you are a buyer), or it will go down (if you are a seller).

 

Three types of futures traders 

There are basically three types of people who trade in futures: hedgers, speculators, and floor traders. A hedge trader is an individual or company which trades in the futures market so they can establish a known price level to satisfy a future need to buy or sell the underlying commodity. They do this in an effort to protect themselves against the risk of an unfavorable price change when it comes time to fulfill their need.

 

The second type of trader, the speculator, is more like a stock trader. These are individuals or companies which try to make a profit from the price fluctuations of the underlying commodity. Whenever someone speculates in a futures trade, there is always someone who is taking the opposite position, or betting against the speculator.

 

The third type of futures trader is known as the floor trader. These are people who buy and sell for their own accounts directly on the trading floors of the exchanges. These are a very elite group of traders, not unlike Day Traders in the equities market. They are credited with giving the futures market the liquidity that it needs in order to function.

 

Of the three types of traders found in the futures trading, most people who enter this market looking solely for a profit fall under the second category of the speculator. This is an extremely risky market to trade in, and one must be armed with the right kind of knowledge in order to be successful.