How Futures Contracts Are Bought and Sold
By: Don Dawson | June 13, 2019
Trading Futures on public Exchanges has been around for over 200 years. Futures markets were created so commercial traders (entities that own or will need to own the actual physical commodity) could offset price risk by buying or selling futures contracts. However, individual traders and investors can trade futures contracts as well.
Why Buy Futures Contracts?
Imagine if you owned some gold with the intention of selling it in the future. Would you want the price to go up or down before you sold it? Most likely you said, UP! Now, imagine if the U.S. Dollar were to get stronger before you sold your gold. In most cases, this event would cause the price of gold to drop. Can you see how owning the physical gold put you at a price risk?
Now imagine a Central Bank or gold miner who has millions of ounces of gold in their possession. They are subject to price risk just like you except on a much larger scale. If the price of gold drops, the value of their inventory will decrease, potentially causing substantial losses due to the inventory size. To protect themselves, they use Futures contracts to protect against adverse price moves of their physical gold inventory – this is known as hedging. To hedge, these commercial traders will sell Futures contracts which give them insurance against lower prices of the physical gold while they hold it in inventory.
Their intention is to lock in a favorable price by selling Futures contracts and being long cash (physical) gold. This way, if price goes up their long cash position will make money, and if price goes down their short Futures position will make money. The commercial trader is now protected against price risk.
What is a Futures Contract?
Futures contracts are written by the Exchange the product trades on. These are standardized contracts that reflect how many units of the commodity are in the contract, the trading hours the market is open, the minimum price movement and the associated dollar value of that minimum movement, price limits or circuit breakers, etc.
Buying and selling Futures contracts requires a skill set that can be learned with the right education. Let’s look at an example of buying and selling Futures contracts.
Futures tend to be used by investors seeking an income generating asset, as opposed to a Stock which some investors tend to hold much longer and can be considered a wealth generating asset. This is because all Futures contracts will expire at some point, so when someone enters a trade as a buyer or seller they must then also close out the position before the contract expires. Staying in the trade past the expiration could result in physical delivery of the commodity. Fortunately, most brokerage firms will monitor trading positions to ensure trades are closed out before the expiration. That said, goods are actually delivered on only about 2% of all Futures contracts.
How Futures Contracts are Bought
Buying a Futures contract simply means a trader has done their research/analysis and has decided at some point in the future the price will be higher. For this buyer to buy a futures contract at the specific price of their choice, there must be a willing seller of a Futures contract at the same price. The trader then can place the buy order either by calling their broker or using the broker’s electronic order platform.
Each platform has different bells and whistles, but in general, when placing a trade on a trading platform, the trader would :
- Open her trading platform and enter the Futures symbol, month of expiration and year of expiration
- Indicate that she wants to buy a futures contract.
- Enter the trade using her pre-determined Limit, Market or Stop Market Order type.
- Attach her protective stop and profit target to her order
- Click on Submit
How to Futures Contracts are Sold
When someone is selling Futures, they feel price will be much lower in the future. Once they locate a willing buyer, they can then place the sell order either by calling their broker or using the brokers electronic order platform.
Again, each platform has different bells and whistles, but placing an order to sell a futures contract follows pretty much the same steps as buying a futures contract with one exception, the trader is selling instead of buying.
- Open platform and enter the Futures symbol, month of expiration and year of expiration
- Indicate that he wants to sell a futures contract
- Enter the trade using his pre-determined Limit, Market or Stop Market Order type.
- Attach his protective stop and profit target to his order
- Clicks on Submit
Depending on his choice of order types the order will either be sent to his broker or the relevant Futures Exchange
Whether buying or selling futures, after the trade is made there are two possible outcomes:
- Price Goes Up - The Buyer will be making money as the price goes higher. Depending on the exit strategy of the Buyer, at some point she will elect to exit her trade and have the profits put into her trading account. The Seller who sold the contract to the Buyer has been losing money if price has been going higher. Most traders will have a protective stop so as not to lose all of their trading capital when they are incorrect about the market direction. The Seller in this situation must exit his position at a loss.
- Price Goes Down – The Seller will be making money as the price goes lower. Depending on the exit strategy of the Seller, at some point he will elect to exit his trade and have the profits put into his trading account. The Buyer who bought the contract from the Seller has been losing money if price has been going lower. Most traders will have a protective stop so as not to lose all of their trading capital when they are incorrect about the market direction. The Buyer in this situation must exit her position at a loss.
Benefits of Trading Futures
Futures Trading Hours
We all know that speculation comes with risk as well as rewards. When trading stocks, one of the biggest risks of trading is something called Gap Risk. Gap Risk occurs because there is potential for a stock price to fluctuate when the markets are closed and to open much further away from the previous close the next session. This can result in slippage (losing more capital than the trader intended) if the price Gaps through a protective stop during non-trading hours. The reason for so many Gaps in the stock market is stocks only trade for approximately 7 hours per day.
In contrast, most Futures markets trade for 23 hours per day starting Sunday evening until Friday evening. All Futures are closed Friday and Saturday nights. Because of these long hours and the short one hour close each day, there is rarely a Gap risk to the Futures trader during the week. The biggest Gap risk for a Futures trader is the Sunday night open since it has been closed since Friday night.
Futures Trading Can Offer More Leverage
The capital required to buy or sell Futures is approximately 5-10 % of the contract value of the market you are trading. In Stocks, that same transaction would require 50% of the value of the transaction. Because of the smaller capital requirements in Futures than Stocks there is a higher amount of leverage (small amount of capital controlling a much larger contract) for Futures traders.
Lower Commission on Futures Trades
Futures brokers charge a commission but it is usually much less than Stock commissions. Futures commissions are paid only once per buy and sell of the same Futures contract. Stocks charge you a commission to buy the Stock then another commission to sell the same Stock.
As we have learned, the Futures markets are used primarily by commercial traders to Hedge price risk of the physical commodity they own or will need to own. We, as speculators, participate in the Futures markets in an attempt to capitalize on being correct on price direction. If we think Futures prices are going higher we buy Futures contracts. If we think Futures prices are going lower we sell Futures contracts. To do this we need to have a Commodity Futures trading account that is funded with capital. Then we use the broker’s electronic trading platform or call them directly on the phone to place orders if we wish to participate in the Futures markets.
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