How to Understand Futures

I could tell you that you need to understand derivatives in order to understand futures, but you do not. The concept of futures is not hard to understand, however, the agreements take some learning. Futures agreements are written as contracts. These contracts are traded on a standard market and used by speculators and hedgers alike. This article will provide insights into this process.

Difficulty: Moderately Easy

Instructions

Understanding Futures

1. Understand the concept. A futures contract is written on an electronic data exchange that matches buyers with sellers of assets at a future price and date. The agreement is standardized, meaning it is possible for a farmer in Arkansas to enter into a contract with someone in Japan for a set number of bushels or yen at a predefined rate. The best way to understand this concept is through an example.

2. Pick a service or commodity you use on a regular basis. Let's use gas for an example. The price of gas changes on a daily basis. Would you prefer for gas prices to be stable? How much would you pay for this option?

3. Determine the cost of this option. If the price of gas is highly variable and you purchase a lot of it, the price of the option goes up in value. If gas prices are unchanging and you do not purchase often, the price of the option goes down. The price is dynamic and changes on a day-to-day basis. Futures contracts trade on the option to purchase or sell an asset in the future.

4. Compare a wheat futures contract to your option to buy gas at a fixed rate. Contract size for wheat futures is 5,000 bushels, and 20 gallons for the fixed-rate option. Tick size (trading increment) for wheat is $0.25 per bushel ($12.50 per contract), and 0.5 gallons for the fixed-priced option. The point of comparison is to understand how simple these contracts are. They contain standard information that has been pre-negotiated for you across languages and cultures.

5. Pick one futures contract to follow for six months. Set up a paper (virtual) trade and mark ups and downs in price with political events, weather or market announcements. You will begin to see a rhythm to the contract price.

6. Record virtual profits and losses. Profits and losses on futures contracts are priced daily. If wheat is selling for $10 per bushel the day after a farmer enters into a contract for $8 per bushel, the farmer has lost $2 per bushel on the contract. If each contract contains 5,000 bushels, the total loss is $10,000.

7. Look up the margin requirement for purchase. The last part to understanding futures is understanding margin. The Chicago Board of Trade (CBOT) has information on every major commodity. See Resources for links to wheat margin requirements. These rates are dynamic and change on a daily basis.

Tips & Warnings

• Futures positions are settled on a daily market-to-market (MTM) basis. This loss or gain is settled at the end of each day rather than at the point of sale.
• This is not to be construed as legal or investment advice.

References

• University of Colorado at Boulder Leeds School of Business
• NYMEX

Resources

• Chicago Board of Trade: Wheat Futures Contract
• Chicago Board of Trade: Outright Margin Rates for Agricultural Commodities
• U.S. Commodity Futures Trading Commission