Table of Contents

1. What is a Futures Contract?
2. Trading Futures Contracts

1.General introduction:

What is a Futures Contract?

Forward and futures contracts let market players manage the risk of asset price changes over time. A futures contract differs from a forward contract in two key ways. First, it's a legally binding deal to buy or sell a standardized asset on a set date or within a specific month. Second, this deal happens through a futures exchange.

The standardization and exchange-traded nature of futures contracts make them essential for commodity producers, consumers, traders, and investors.

A Standardized Contract

An exchange-traded futures contract outlines the quality, quantity, delivery time, and location of the product. This could be an agricultural commodity like 5,000 bushels of corn for March delivery, or a financial asset like the U.S. dollar value of 62,500 pounds for December.

These specifications are the same for all participants, allowing easy transfer of contract ownership through trading. The only variable is price, determined by bidding and offering until a trade occurs.

Regulated exchanges create futures contracts and standardize their specifications.

Exchange-Traded

Exchanges also guarantee these contracts, eliminating counterparty risk. Every futures contract is centrally cleared, making the exchange the buyer to every seller and the seller to every buyer. This reduces the credit risk of a default.

Exchanges remove counterparty risk and, unlike forward contracts, offer anonymity to market participants. By bringing confident buyers and sellers together on the same platform, exchanges make futures markets highly liquid and optimal for price discovery.

Futures Contract Specifications

Every futures contract outlines key details: the underlying asset, quantity, delivery location, and delivery date.

Take, for instance, WTI Crude Oil contracts at CME Group is for 1,000 barrels of a grade of crude oil known as “light, sweet” which refers to the amount of hydrogen sulfide and carbon dioxide the crude oil contains.

By entering a futures contract, parties agree to exchange an asset at a set future date. This asset could be a physical commodity like crude oil or a financial product like foreign currency.

For physical commodities, the exchange defines acceptable grades to ensure quality. However , financial futures contracts are simpler, a contract might specify the U.S. dollar value of 100,000 Australian dollars.

Each contract also specifies the quantity delivered, known as contract size. Examples 5,000 bushels of corn, 1,000 barrels of crude oil, or Treasury bonds with a $100,000 face value.

Exchanges tailor contract sizes to suit market participants. For instance, those looking to speculate or hedge with S&P 500 futures but seeking lower exposure can opt for the E-mini S&P 500 futures contract.

The delivery location is another critical specification, particularly for physical commodities with significant transportation costs. For example, CME Group's random-length lumber contracts specify delivery within a particular state and type of boxcar.

Futures contracts are identified by their delivery month, such as the March Corn contract or the December WTI contract. This future date is crucial for the contract's value and execution. Depending on the market, delivery can range from one month to several years ahead. The exchange sets specific dates within the month for delivery and defines when trading starts and stops, typically halting a few days before delivery.

Understanding Contract Trading Codes

Futures contract codes are crucial for understanding pricing across multiple expirations. These codes usually consist of a one- to three-letter identifier for the product, followed by characters denoting the month and year of expiration. The format can vary depending on the asset class and trading platform. Originating from the trading floor to convey maximum information concisely, these codes have transitioned seamlessly to electronic trading.

Example: E-mini S&P 500 Futures Consider the E-mini S&P 500 futures contract. On CME Globex, the contract code for this product is ES, which is also used on CME ClearPort. However, contract codes can differ across platforms.

Contract Expiration Codes

Additional characters to the right of the contract code indicate the month and year of expiration. Each month has a unique single-letter code:

• January: F
• February: G
• March: H
• April: J
• May: K
• June: M
• July: N
• August: Q
• September: U
• October: V
• November: X
• December: Z

The letter following the contract code always indicates the expiration month. The year of expiration follows as a numeric value.

Let's create the display code for the E-mini S&P 500 futures contract expiring in January 2019 on CME Globex. The contract code is ES. For January, we add the letter F. For 2019, we add a 9. Thus, the display code is ESF9.

Now that we've covered the basics of what a futures contract is, let's dive into the practical aspect on how trading these assets operates.

2.Trading Futures Contracts

Expiration and Settlement

Every futures contract comes with a set expiration date. Before this date, traders can either close out or extend their open positions (this is called Rolling a contract in the jargon). Some, however, choose to hold the contract until it expires and proceed to settlement.

Settlement fulfills the legal delivery obligations of the contract. This can be in the form of physical delivery of the underlying commodity. For example, a food producer might take delivery of physical corn or wheat, and a farmer might deliver grain to the producer. While physical delivery is crucial for certain energy, metals, and agriculture products, only a small percentage of commodity futures are physically delivered.

Most contracts, however, are settled in cash. In cash settlement, a credit or debit is made based on the contract's value at expiration. Equity index and interest rate futures are commonly cash-settled, but some precious metals, foreign exchange, and agricultural products can be settled this way too.

The choice of settlement type—physical or cash—depends on the trader's needs and the specific characteristics of the traded product.

Tick Movements: Minimum Price Fluctuation

Every futures contract has a minimum price fluctuation, known as a tick, set by the exchange and varying by contract.

• E-Mini S&P 500 Tick:

For the E-Mini S&P 500 Futures Contract, the tick size is one-quarter of an index point, or each index point is 4 ticks. With each point worth $50, a tick move is: 0.25 x $50 = $12.50

• NYMEX WTI Crude Oil:

The NYMEX WTI Crude Oil contract has a tick size of 1 cent, with a contract size of 1,000 barrels. Thus, one tick move equals $10.

Exchanges set tick sizes to suit each financial instrument and market needs, ensuring optimal liquidity and tight bid-ask spreads. Check the product specification pages for the minimum price fluctuation of any CME Group contract.

Ensuring Orderly Markets: Price Limits and Banding

As a trader, it's essential to know that mechanisms are in place to maintain an orderly market. A regulated marketplace like CME Group achieves this through price limits and price banding.

Price Limits

Price limits define the maximum price range for a futures contract in each trading session. These limits, measured in ticks, vary by product. When markets hit these limits, different actions are triggered depending on the product. Some markets may halt temporarily to expand limits, or trading may be stopped for the day based on regulatory rules. For example, Equity Index futures have different price limit rules compared to Agricultural futures.

Price limits are recalculated daily and apply to all trading days except in certain physically-deliverable markets, where limits are lifted before expiration to allow futures prices to converge with the underlying commodity prices. Typically, Agricultural futures hit their price limits more often than Equity Index futures, which rarely go limit up or down. It's crucial for traders to understand the specific price limits and mechanisms for the products they trade.

Example: Equity Index Futures Equity Index futures have a three-level expansion: 7%, 13%, and 20% to the downside, with a 7% limit up and down in overnight trading. When the price reaches these levels, the market will either go limit up or limit down.

Price Banding

Price banding ensures market orderliness by subjecting all orders to price validation and rejecting those outside a given band. These bands adjust dynamically based on the last price plus or minus a fixed band value, accommodating new trading ranges if markets move quickly in one direction.

Trading rules for each market can be found on cmegroup.com. Traders can place orders outside the daily price limits, and these trades will be executed when limits and bands move within the specified range. Despite fewer occurrences of markets hitting limits in recent years, being aware of these rules is crucial for informed trading.

Contract Notional Value

Contract Unit

The contract unit represents a standardized size unique to each futures contract, determined by volume, weight, or financial measurement, based on the contract and the underlying asset.

For instance, a single CME Lean Hogs contract unit (LH) represents 40,000 pounds of hogs, which is measured by weight.

A CBOT Corn contract unit (C) is 5,000 bushels of corn, measured by volume.

For financial contracts, such as the Nasdaq-100 futures contract (NQ), the unit is based on a fixed multiplier applied to the Nasdaq-100 Index.

Contract Notional Value

Contract notional value, or contract value, reflects the financial worth of the contract unit multiplied by the current futures price.

How to determine a Notional Value

If a Lean Hogs futures contract is trading at $70 per 100 pounds, the notional value is calculated as:

Contract unit x contract price = notional value

40,000 pounds / 100 pounds per unit x $70 = $28,000

For Corn futures trading at $4 per bushel with a contract unit of 5,000 bushels, the notional value would be:

$4 x 5,000 = $20,000

If Nasdaq-100 futures are trading at 13,000 with a multiplier of $20, the notional value is:

$20 x 13,000 = $260,000

Understanding contract units and notional values helps in calculating hedge ratios against other futures contracts or risk positions in related markets.

Understanding Mark-to-Market

Mark-to-market (MTM) is a crucial aspect of futures trading, ensuring that all contracts are settled at a uniform daily price. This practice sets futures apart from other financial instruments like forwards, which, until recent regulatory changes, often lacked an official daily settlement price.

Unlike over-the-counter (OTC) forwards and swaps, which previously operated without daily settlement transparency, futures markets have an official daily settlement price determined by the exchange. The methodologies for calculating these prices are detailed in the contract specifications and the exchange rulebook.

• Example 1: Soybean Futures For instance, Soybean futures on the CME Group are traded on CME Globex starting the previous evening and officially settle at 13:30 Central Time (CT). The daily settlement price is established based on the last minute of trading activity between 13:29:00 and 13:30:00.

• Example 2: Nasdaq-100 Futures Nasdaq-100 futures also begin trading on CME Globex the evening before at 5:00 p.m. CT. The final daily settlement price is calculated using a volume-weighted average price (VWAP) of all trades executed in the lead month contract between 15:14:30 and 15:15:00 CT. This VWAP is rounded to the nearest 0.10 index point. After closing for fifteen minutes from 15:15:00 to 15:30:00, trading resumes until 16:00:00 (4:00 p.m. CT), when CME Globex shuts down for an hour.

• Example 3: U.S. Treasury Bonds U.S. Treasury futures start trading at 5:00 p.m. CT and continue through the next day until 4:00 p.m. CT. The daily settlement price is determined based on trading activity from 13:59:30 to 14:00:00 CT.

Understanding how a futures contract's final daily settlement price is determined involves knowing the specific settlement procedures outlined in the contract’s specifications.

Once the final settlement price is established, back-office operations handle trade reporting, profit/loss calculations, and margin adjustments. In the futures markets, gains and losses are settled daily, meaning no losses or profits are carried over. If a trader’s daily losses cause their account equity to fall below required margin levels, they must provide additional funds to avoid position liquidation.

Mark-to-market practices enforce daily profit and loss adjustments, ensuring that every open position is settled fairly and promptly. This transparency benefits both commercial and speculative traders by providing a consistent and reliable pricing mechanism for futures contracts.

Margin: all you need to know

Futures margin is the amount you need to deposit with your broker to open a futures position. Unlike securities margin, which involves borrowing funds to partially pay for an asset like stocks or bonds, futures margin isn't a down payment. Instead, it's a security deposit that doesn't grant ownership of the underlying asset.

Comparing Margins

In contrast to securities margin, which can be up to 50% of the asset’s purchase price, futures margin typically represents a much smaller percentage of the contract’s notional value—usually between 3% and 12%. This means you only need to deposit a fraction of the total contract value to maintain a position.

Margin Adjustments with Market Conditions

Margin requirements can fluctuate based on market volatility. During periods of high volatility, clearinghouses may raise margin requirements to manage increased risk. Conversely, margin requirements can be reduced if market conditions stabilize.

There are several types of margins:

• Initial Margin: This is the amount required by CME Clearing to start a futures position. Your broker might need to collect additional funds from you beyond this initial margin.

• Maintenance Margin: This is the minimum balance you must keep in your account to maintain your position. If your account balance falls below this level, several things may occur:

You might receive a margin call requiring you to deposit more funds to return your account to the initial margin level. If you can't meet the margin call, you might need to reduce your position based on the remaining funds. Your position could be liquidated automatically if it falls below the maintenance margin level.

Futures margin is crucial for initiating and maintaining futures positions, but it’s not a down payment or ownership of the commodity. Understanding the differences between securities margin and futures margin is vital before engaging in futures trading.

Navigating Futures Expiration and Contract Roll

Futures contracts have a set lifespan that affects trading strategies and exit plans. Key concepts to understand are expiration and rollover.

The expiration date marks the final day a futures contract can be traded. This usually falls on the third Friday of the expiration month, though specifics can vary by contract.

Before a contract expires, traders have three main options:

1. Offset the Position: Offsetting, or liquidating, is the most common method for exiting a futures position. To offset, a trader executes an opposite trade to cancel out the original position. For instance, if a trader holds a long position in coffee futures expiring in October, they would sell an equivalent amount of coffee futures with the same expiration date to realize any profits or losses without taking delivery of the commodity.

2. Rollover: Rollover involves shifting a position from the expiring contract to a later-dated contract. Traders monitor the trading volume of both the expiring and the new contract to decide when to roll over. For example, if a trader is holding a long position in gold futures expiring in July, they might sell these contracts and simultaneously buy futures contracts expiring in December.

3. Settlement: If no action is taken before expiration, the contract will settle. Traders with short positions are obligated to deliver the underlying asset, which could be either physical delivery or cash settlement, depending on the contract terms. For example, if a trader is short on soybean futures and hasn’t rolled over or offset their position, they will need to deliver the physical soybeans or settle in cash.

Managing futures positions effectively requires understanding and choosing the right strategy for expiration and rollover. This knowledge will impact the final outcome of your trades and help in executing successful trading strategies.

How to calculate Profit and Loss in Futures trading

Market participants engage in futures trading to either profit from price movements or hedge against potential losses. Each futures market has its own method for calculating profit and loss, so it's crucial for traders to understand how these calculations are made for the specific contract they are trading.

For instance, let’s consider the E-mini S&P 500 (ES) futures contract. This contract is valued based on the S&P 500 Index, with a multiplier of $50. The contract size, tick size, and the current price of the index are key factors in determining profit and loss. The tick size for the ES contract is 0.25 index points.

To illustrate, if you buy an ES contract when the S&P 500 Index is at 4,000 and the index moves to 4,025, you need to calculate the profit or loss based this movement of 1 tick or 0.25 point that represents 0.25 * 50$ = 12.5$ of profit in this case before comissions and other costs.

To calculate the current value of an ES contract, multiply the current index price by the contract multiplier. For instance, if the S&P 500 Index is at 4,200, the current value of one ES contract would be:

Current Value = 4,200 × 50 = $210,000

The dollar value of a one-tick move in the ES contract is computed by multiplying the tick size by the contract multiplier. For the ES futures, with a tick size of 0.25 and a multiplier of $50, the value of a one-tick move is:

Value per Tick = 0.25 × 50 = $12.50

To determine the profit or loss from a trade, multiply the dollar value of a one-tick move by the number of ticks the contract has moved since purchase. Then multiply by the number of contracts held to get the total profit or loss.

For example, if a trader buys one ES contract when the S&P 500 Index is at 4,180 and the index moves to 4,200:

The difference in index points is 4.200 − 4.180 = 20 points.

Convert this into ticks: 20 ÷ 0.25 = 80 ticks.

The profit in dollars is 80 × 12.50 = $1,000.

If the trader holds more than one contract, the total profit would be:

Total Profit = $1,000 × Number of Contracts

Losses are calculated in the same way as gains.

Understanding Your Position

The contract size significantly impacts the profit and loss of a futures position. It's essential to understand how price fluctuations and market volatility affect your open positions. Analyze the average price movement and tick value of the contract to gauge the impact of typical market moves.

For instance, if the 14-day average true range (ATR) for the ES contract is 7.5 points and each point is worth $50:

The dollar value of a typical daily move is 7.5 × 50 = $375.

Compared to other contracts, like the Silver futures (SI), which has a higher ATR:

If the ATR for Silver is 0.32, with a tick size of $5, the value of a daily move would be 0.32 × 160 = $800.

This comparison shows that, on average, the ES contract experiences smaller price moves compared to contracts like Silver futures. Traders should consider these factors when planning their risk and reward strategies.

Futures Contracts vs. Forward Contracts

Both futures and forward contracts are financial instruments used to buy or sell assets at a predetermined price for delivery at a future date. These agreements enable market participants to lock in prices, thereby managing the risk of price fluctuations until the delivery date.

Historically, forward contracts were used primarily for seasonal agricultural goods like wheat and corn, involving direct agreements between buyers and sellers. Nowadays, forward contracts can be customized for any commodity and delivery timeframe, and are traded over-the-counter (OTC). This customization, however, introduces a higher risk of default because these contracts are not centrally cleared.

In contrast, the futures market emerged in the mid-19th century, driven by the need for a more structured and reliable risk management system. What started with agricultural commodities has expanded to include a diverse range of asset classes such as equities, currencies, energy products, interest rates, and precious metals. Futures exchanges have evolved to cater to a broad spectrum of trading needs, offering a standardized and regulated platform.

Key Differences

Here’s a comparison highlighting the distinctions between futures and forward contracts:

Futures:

• Traded on exchanges
• Standardized contracts (unit, expiration, tick size, notional value)
• No counterparty risk due to exchange clearing house
• Actively traded on exchanges
• Subject to regulation

Forwards:

• Privately negotiated
• Customized terms and conditions
• Exposed to credit default risk; reliant on the counterparty
• Typically non-transferrable
• Not regulated

The standardized nature of futures contracts—encompassing uniform contract terms, the ability to transfer positions, and elimination of counterparty risk—makes them highly attractive to traders. These features have established futures exchanges as crucial components of the global financial system.

What began as an agricultural trading platform has since diversified into numerous markets, including interest rates, sector-specific contracts, and foreign currencies. The evolution of futures exchanges has led to a rich array of trading opportunities.

The addition of options on futures and increased frequency of contract expirations have broadened the scope for strategies and products available to both individual and institutional traders. This ongoing innovation and expansion contribute to the enduring popularity and utility of futures contracts in today's markets.

Understanding Volume

Volume measures the total number of futures contracts traded within a specific period. It reflects both buying and selling activity, and can be tracked over various intervals such as daily or intraday.

Each transaction, whether a buy or sell, contributes to the contract’s volume.

For example, if a trader buys one E-mini S&P 500 (ES) futures contract to close a short position, the volume for the ES contract will increase by one.

Volume trends are often analyzed by traders to make informed decisions. Key insights from volume data include:

• Price Levels: Changes in volume can signal key price levels where trading interest is high or low, potentially indicating a change in price direction.

• Contract Roll: Volume helps traders determine when to transition from the expiring contract to the next month’s contract. As the volume in the old contract declines, traders shift focus to the new front month contract.

• Active Periods: High volume periods are preferred by traders because they generally mean tighter bid-ask spreads, quicker order execution, and fewer gaps. For instance, trading volume may drop between 12:00 p.m. and 2:00 p.m. ET, but often increases around market open and close.

Example: When the June ES futures contract is nearing expiration, volume typically shifts from June to September. On rollover week Thursday, you would observe the June contract losing volume while the September contract gains volume. Once September surpasses June in volume, it's time to transition.

While volume indicates how much trading activity is happening, it does not specify whether traders are entering or exiting positions. For instance, an increase in volume at a lower price level might indicate either new long positions at support (bullish) or liquidations of long positions (bearish).

Volume data is a crucial element for understanding market activity and can significantly aid in making trading decisions. However, it does not alone reveal market sentiment or predict price movements.

Open Interest

Open interest represents the total number of outstanding futures contracts that are held by market participants at the end of a trading day. It provides insights into market sentiment and helps gauge the strength of price movements.

Unlike the fixed number of issued shares in a company, which usually remains unchanged, the number of open futures contracts fluctuates daily.

Open interest is determined by tracking the total number of contracts from opened trades and subtracting those from closed trades.

For Example:

If Sharon buys one futures contract, open interest increases by one. Cynthia buys six contracts, raising the open interest to seven. Kurt sells three contracts short, increasing open interest to ten. Open interest will remain at ten until traders start closing their positions:

Sharon sells one contract, reducing open interest to nine. Kurt buys back his three contracts, bringing it down to six. At this point, open interest stays at six until Cynthia sells her six contracts, potentially affecting the open interest further.

Volume vs. Open Interest

While volume counts all contracts traded during a session, open interest measures the total number of contracts still open in the market.

Traders can view open interest as an indicator of market liquidity: an increase signifies more money flowing into the contract, while a decrease indicates money leaving the market.

Key Open Interest Products

The CME Group’s products with the highest open interest include Eurodollars, Treasury futures, and stock index futures.

Analysts use open interest to validate the strength of a market trend:

Rising open interest often confirms the trend's strength, indicating increased market participation. Falling open interest may suggest a weakening trend, reflecting a reduction in market interest. Open interest data is updated daily, with a detailed report published every Friday afternoon by the CFTC. This report, known as the Commitment of Traders, provides insights into the positions of various market participants, including producers, merchants, processors, users, swap dealers, and money managers.

Many futures traders incorporate open interest into their market analysis alongside other indicators to make informed trading decisions. Significant changes in open interest can signal shifts in market participation and offer clues about potential market direction.

Conclusion

In summary, understanding the dynamics of futures contracts and their associated metrics—such as volume and open interest—is crucial for effective trading and risk management. Futures and forwards, while both agreements to buy or sell assets at a future date, differ significantly in their trading mechanisms and risk profiles. Futures contracts are standardized and traded on exchanges, offering liquidity and regulatory oversight, whereas forward contracts are customized and privately negotiated, often carrying higher credit risk.

Volume provides insights into market activity by reflecting the number of contracts traded over a given period, helping traders gauge market interest and liquidity. It is essential for identifying active trading times and assessing market trends. Open interest, on the other hand, represents the total number of outstanding contracts and helps traders assess market sentiment and trend strength. Rising open interest can signal strong trends, while decreasing open interest may indicate a weakening trend.

Both metrics, along with other analytical tools, are integral for traders in making informed decisions. By interpreting these indicators, traders can better navigate the complexities of the futures market, align their strategies with market conditions, and optimize their trading outcomes.