Table of contents:
- 1 The history of futures trading
- 1.1 Difference: Forward contract – future
- 1.2 Explanation Futures contract
- 1.3 The leverage effect of futures
- 1.4 Trading on futures exchanges
- 1.5 Recommended reading
- 1.5.1 Options, futures, and other derivatives
- 1.5.2 Outright Futures vs Spreads
- 1.5.3 Contract Specifications
- 1.5.4 Contract Size (Contract Unit)
- 1.5.5 Trading Hours
- 1.5.6 Minimum Price Fluctuation
- 1.5.7 Product code (Product Code)
- 1.5.8 Listed Contracts
- 1.5.9 Settlement Method
- 1.5.10 Settlement Procedures
- 1.5.11 Position Limits (Position Limits)
- 1.5.12 Price Limit (Price Limit or Circuit)
- 1.5.13 Vendor codes
- 1.6 The Margin System in Futures Trading
- 1.7 Monthly codes
- 1.8 Market participants
- 1.9 The CoT Report
- 1.10 Strategies in futures trading
- 1.11 Hedging
- 1.12 Various forms of high-frequency trading
- 1.13 Strategies for private traders
- 1.14 The private trader as speculator
- 1.15 Broker
- 1.16 Germany or USA
- 1.17 Trading software
- 1.18 Required account size
- 1.19 Risk of undercapitalized accounts
- 1.20 The right account size
In professional trading, futures (along with options, shares, ETFs) are one of the most important trading instruments. Futures can be used in medium-term trading as well as in extremely short-term trading and for hedging. Since volatility does not play a direct role in the price development of futures, futures are easier to understand than options, but are also less versatile.
The history of futures trading
Why are there futures at all?
First of all we clarify what a future actually is. For this purpose we will go back briefly to the 19th century:
What are futures?
What are the special features of futures?
Futures are standardised forward contracts with a leverage effect. The underlying value (underlying instrument) is usually a commodity, a currency, a bond or a (stock) index. Futures are traded on futures exchanges and can be traded by anyone. By buying or selling a future, it is possible to buy or sell the underlying at the current market price for a delivery date in the future.
The leverage effect can generate considerable profits; however, the leverage effect also provides for the increased risk profile that futures have.
Difference: Forward contract – future
Forward contracts are the predecessors of today’s futures. The difference between a foward contract and a future contract is the standardization. In a forward contract, the two parties to the contract must/can renegotiate the specifications of the commodity each time it is traded.
A futures contract, on the other hand, is a standardised contract, i.e. the specifications of the commodity are precisely defined by the exchange on which the futures contract is traded.
Explanation Futures contract
Futures are forward contracts. This means that futures can be used to determine in the present what price you will have to pay for an asset in the future. The name “futures contract” comes from the fact that all futures contracts have an expiry date. This distinguishes futures contracts from shares, which exist as long as the respective company exists in the legal form of a corporation.
The leverage effect of futures
Futures have a leverage effect, because you have to provide less money for the buying/selling of the future than the future is actually worth. Due to this leverage, large profits can be made in futures trading, but also large losses.
In this video we explain the leverage of futures in more detail:
Trading on futures exchanges
Another important difference is that forward contracts are traded in OTC (“over the counter”) trading, while futures contracts are traded on regulated futures exchanges.
The most well-known futures exchanges include, for example
- Chicago Mercantile Exchange (CME)
- Chicago Board of Trade (CBOT)
Forward contracts as well as future contracts can still be traded today. However, since the trading of forward contracts is only of importance in institutional trading and this page is aimed at private investors, we will not go into the subject of forward contracts any further.
Options, futures, and other derivatives
Another important difference between forward contracts and futures contracts is the way they are settled. Forward contracts are only settled at the final maturity of the contract, whereas futures contracts are settled daily (mark to market).
Through this settlement mechanism, forward contracts influence the price of a future in practice.
If you want to deal with the topic of calculating futures prices in a very intensive and scientific way, the following book is recommended: John C. Hull – Options, Futures and Other Derivatives, Pearson, 9th edition)
Note: To understand the formulas presented in the book, a sound knowledge of mathematics is essential. In order to be able to trade futures successfully in the private trader’s practice, an understanding of the mathematical calculation of the futures price is helpful, but not absolutely necessary].
Outright Futures vs Spreads
Basically, two types of futures can be distinguished: the “Outright Futures” and the “Spreads”. The “Outright Futures” are those futures that are traded most often and which, as an underlying, simply follow the price development of an asset (example: “YM” for the Dow Future, or “ZC” for the Corn Future).
If we go long in the Corn Future with a June expiry date and short in the Corn Future with a September expiry date, we create a spread trade consisting of two individual outright futures.
The contract specifications of the futures contain the most important information and conditions for trading the futures. You can usually find the contract specifications for the respective future using your broker’s software and on the websites of the futures exchanges.
Contract Size (Contract Unit)
Defines the value of the contract.
Defines the time in which the future can be traded. Please note that most futures are not traded around the clock.
Minimum Price Fluctuation
Defines the value of a future per tick or point. For most futures, the smallest change in value is called a tick. This tick has a value set by the exchange. A point usually consists of several ticks.
ES (Future on the S&P500)
1 point = $50
1 point = 4 ticks
50/4 = $12.50 = 1 tick
Product code (Product Code)
The abbreviation of the future. It usually consists of one, two or three letters.
YM = Abbreviation for the future on the Dow Jones Industrial Average
List showing which contracts are available. Many contracts follow a quarterly cycle, in which case there would be a “March Future”, a “June Future”, a “September Future” and a “December Future” for a given year.
Determines whether the underlying is physically delivered (deliverable) or simply cash (financailly settled / cash settlement) from the contract onwards.
The YM (Future on the Dow Jones Industrial Average) is simply settled in cash, there is no delivery of any shares.
The ZC (Corn Future) is not settled in cash. If you hold the future at the delivery date, there will be an actual delivery of corn (Corn).
(Note: Brokers exclude the actual delivery of goods to private futures traders)
End of trading of the contract (Termination Of Trading)
Determines until when the future can be traded, or when its exact expiry date is.
In YM, it is the third Friday of the month 09:30 ET.
Here it is precisely defined how, where, when and in what quality the delivery of the underlying of the future can take place. For those interested, here is an example of the corn futute. However, private investors can ignore this point.
Position Limits (Position Limits)
There are various position limits; for example, from which position size positions are reported to the CFTC. However, this topic is less important for private traders.
Price Limit (Price Limit or Circuit)
Price limits set a certain maximum trading range for one day. If this is reached, trading is interrupted.
Data vendors that send the exchange’s data to the traders’ trading platforms (example: CQC) are called “vendors”. These vendors sometimes have different product codes for futures.
The codes for all CME products can be downloaded as Excel files from this link.
The Margin System in Futures Trading
As you have already learned, futures are financial instruments with a leverage effect. When you open a futures position, you do not have to pay the full value of the futures, but only a margin.
In total, there are four margin terms, which are explained in more detail below:
- Initial Margin
- daytrade margin
- maintenance margin
- Variation Margin
Initial Margin is the amount of Margin that must be paid when a Futures position is opened. However, most broker futures traders grant a “day trade spread”. This is during the trading day and often, but not always, ends around 21:40 German time.
In this day trade margin, not the full initial margin but only a fraction of it has to be paid. This fraction is called daytrade margin.
For example, if a broker grants a daytrade margin of 25% and the initial margin of a future is $7000, only $1750 would have to be deposited as margin to open the position.
However, if you want to hold a future overnight for the first time, the initial margin must be deposited.
Mark To Market
Futute contracts are settled daily, i.e. the broker checks daily whether a trader’s positions are in profit or loss. This process of daily settlement is called “Mak to Market”.
Losses on a futute trader’s margin account may only take a certain amount, namely up to the limit of the maintenace margin.
The maintenance margin is always lower than the initial margin.
Let us look at an example:
Initial Margin = $6930
Maintenance margin = $6300
In this example, we assume that the trader only holds one contract and that his trade is not going well so far. His margin account has dropped to $6200.
This amount of $6200 is below the maintenance margin of $6300 and the trader will now receive a margin call from his broker.
As soon as a future position falls below the maintenance margin, the trader receives a margin call. He now has a clearly defined period of time to answer this call. To do so, the trader must now pay the variation margin.
The variation margin is the amount that the trader must pay to answer the margin call. In our example from above, the variation margin would now be $730.
The variation margin is always the sum of the account balance and the initial margin. A Margin Call is always associated with costs, just like the forced closure of the position by the broker. In practice, one should always try to avoid margin calls if possible.
Forced closure of the position
If a margin call is left unanswered, the broker will force the position to close. The margin call is made well before the trader’s account falls to zero. However, it can happen that a future falls so quickly that the broker cannot close the position before the account falls below zero.
In this case you would lose more money than you originally deposited in the account and would have to close the account down to zero. This is the reason why futures are financial instruments with a high risk profile.
To be able to call a futures contract on a trading platform, a product code is always required, followed by month and year details, or a month code.
The product codes of futures are usually two digits long.
Who trades everything on the future market?
As a trader it is very important to know who is “taking part” in the game. Because the different market participants neither have the same intentions nor the same financial strength. Therefore it makes sense to keep an eye on how the different market participants are trading.
This is relatively easy on the futures and options markets with the help of the so-called CoT report (Commitments Of Traders).
The CoT Report
In the USA, market participants above a certain position size must report their transactions in the futures and options market to the regulatory authority CFTC. Based on the data received, the CFTC prepares the Commitments of Trades Report (COT Report), which is published every Friday.
In the CoT Report, the market participants in the futures market are generally divided into 3 groups:
- Non-Commercials/Large Speculators
- Non-Reportables/Small Speculators
The commercials – also known as hedgers – are all those market participants who hedge against price risks on the futures and options markets and are not interested in speculative profits. As a rule, these are companies/institutions that physically buy or sell or own the respective underlying (e.g. a wheat farmer, a coffee producer, commodity traders and processors, financial institutions, portfolio managers, etc.).
In most markets, the commercials are the financially strongest market participants and know the market best. They therefore receive special attention.
Non-Commercials – also known as Large Speculators – are all those market participants who pursue the goal of making speculative profits and are subject to reporting requirements due to their position sizes. (e.g. hedge funds, CPOs, CTAs etc.)
Non-Commercials can be seen as a “homogeneous mass” and are speculators who usually follow trends. In comparison to the commercials, however, the non-commercials usually control only a small part of the total open interest.
Non-reportables – including small speculators – are all those market participants whose position size is below the reporting requirement. However, the term “small speculators” is somewhat misleading, since not only – as is sometimes erroneously stated – only small speculators or private traders and private investors belong to this category, but also smaller commercials and institutions whose position sizes are below the reporting requirement.
The non-reportables are therefore not a “homogeneous mass”. In some markets they nevertheless provide relatively good anti-cyclical signals.
Strategies in futures trading
Futures can be used for hedging or speculation
Futures markets were once created to allow commercial market participants whose business is the production, trading or processing of physical commodities to hedge against price risks or price fluctuations. The purpose of hedging is therefore not to make a speculative profit, but to hedge another transaction. (Hedging = hedge)
A company receives an order to deliver a large machine worth $25 million in 8 months. The manufacturing company is based in Germany, the client comes from Asia. The contracting parties agree on the US Dollar as currency for payment.
For the manufacturing company there is now the risk that the EUR/USD exchange rate will change in the next 8 months. If it changes to the disadvantage of the company, less than the equivalent value of the order would actually be paid by the customer.
To hedge against this “currency risk”, both can enter into a “hedge” in a future, or option, on the EUR/USD currency pair.
(Note: there are other ways of hedging in practice. These are not relevant for this article)
Heding does not play a role for the speculative oriented trader at first. Nevertheless, it is necessary to understand how hedgers and commercials operate, as they have a major influence on the development of the market price.
Any other type of trading that is not hedging is speculation. Within this group of “speculators”, however, there are again a very large number of completely different approaches, such as
- Swing Trading
- Position Trading (Trend Trading)
- Day trading
- Spread Trading
Various forms of high-frequency trading
The procedures are completely different with the concepts mentioned above; all of them are united only by the intention to achieve a speculative profit with their trade.
Strategies for private traders
Which trading approaches make sense?
The private trader as speculator
The private trader will usually execute some kind of speculative transaction.
The private investor, on the other hand, can also act as a hedge, e.g. by hedging his portfolio with options or even futures against a correction on the stock markets.
It is difficult to say which strategies are suitable for the private trader and which are not. Basically, however, it is safe to say that the private trader has more chances to earn money with strategies from the area of swing and position trading.
Do not limit yourself to technical analysis!
Although we consider technical analysis to be very important in futures trading, it is equally important not to rely solely on it. In futures trading, it makes sense to take into account, among other things, the anylse of seasonality and the Commitments Of Traders data.
Day trading is not suitable for most private traders.
In the area of day trading, things are already getting harder. A lot of time, capital and above all experience is necessary to have a chance to achieve really stable income with day trading.
Many private traders are often missing at least one of the three mentioned prerequisites.
High frequency trading is completely unsuitable for private traders!
However, we can only strongly advise private traders against trying to become a “high frequency trader”. Against the expertise and the technological advantage of the employees (e.g. mathematician/physicist, IT-experts) you have no chance as a private trader! Unless you are an expert in the field yourself and have a capital of several million dollars, which is probably not the case in most cases of the private trader.
How to find the right futures broker?
To trade futures, you need a broker who can give you access to the futures exchanges where the most common futures are traded. With access to these exchanges you are usually well supplied:
- EUREX: for example FDAX, BUND, etc.
- CME: for example S&P 500, Nasdaq 100, EUR, AUD, etc.
- NYMEX: e.g. WTI, natural gas, etc. (belongs to the CME Group)
- COMEX: for example gold, silver, etc. (belongs to the CME Group)
- CBOT: For example, corn, soybeans, etc. [belonging to CME Group]
- ICE: for example sugar, coffee, etc.
Germany or USA
Futures trading is much more widespread in the USA than in the German-speaking world. This is mainly due to the fact that in this country the financial industry mainly advertises CFDs, certificates, warrants etc. All these products are prohibited in the USA.
This means that there are considerably more futures brokers in the USA than in Germany. With a German broker you have the advantage that he is on site and offers German support and is usually easier to reach by phone. In addition, a local broker, who is subject to German legislation, is advantageous in the event of any problems.
With US brokers you have the advantage that you often have somewhat lower costs.
Below you will find an overview of German and American futures brokers:
Overview: Futures Brokers from DE and USA
- Agora Direct*
- Sino AG
German speaking brokers (but not based in DE)
- Advantages Futures
- AMP Futures
- Interactvie Brokers
- dormant trading
- Optimus Futures
- Trade Station (Future Account)
- *IB from Interactive Brokers
Which software can be used for futures trading?
As a trader you need software to
- transmit your orders to your broker or to the stock exchange
- To analyze the markets (chart software)
Either you use a single software for both requirements, or you use two different software, i.e. one for analysis only, and one for order placement only. Both approaches are common among traders, depending on personal preference and requirements.
Usually your broker offers a software. Now you have to decide whether it meets your requirements or whether you want to use external software.
Detailed software introductions will follow in a separate article. Here is a list of known software for futures trading:
- Trade Navigator
- Trader Workstation (TWS)
- Agena Trader
- Sierra Chart
- TT (Trading Technologies)
- Ninja Trader
- Trading View
- trade station
Required account size
How much capital is required for futures trading?
Some futures accounts can be opened with just a few hundred dollars of capital. However, this is clearly too little for trading with futures.
Risk of undercapitalized accounts
Undercapitalized accounts are a very common problem for private traders and often lead to the loss of the account. The reason for this is that undercapitalized accounts increase the psychological pressure so massively that it becomes unbearable. However, as this happens subconsciously, we do not notice it and the loss of the account is thus partly pre-programmed.
The right account size
A very simple formula can be used to determine the required account size. This is:
Initial margin*25 = minimum account size
Since usually not only one market but several markets are to be traded, the highest initial margin must always be used when calculating the formula.
Here is an example:
Let us assume a trader plans to trade the futures markets ES, YM and ZC. Let us look at the respective margin rates for these three markets:
ES = $6930
YM = $6490
ZC = $154
The highest initial margin in this example is $6930.
So, it can be calculated: 6930*25 = 173,250. The minimum account size in this example is therefore $173,250.
Account size for private traders
We are well aware that many private traders do not have this capital at their disposal.
Therefore, it is advisable for private traders to specialize in markets and strategies with low margin requirements at the beginning of their future trading career.
Here is another example:
MES (Micro ES) = $693
M2K (Micro Russel) = $391
MGC (Micro Gold) = $374
In this example, the highest margin rate is only $693, so it is to be calculated:
693×25 = 15975
The required account size here would be only $15975.
See my other articles about futures:
- CFDs vs. Micro Futures – Which one is better?
- Futures Broker Comparison – Find The Best Broker And Save Money
- How does the Volume Profile work? – Tutorial
- How to calculate the Tick Value of Futures
- Options vs. Futures – Two Different Types Of Futures Contracts
- orderbook – The Most Common Order Types
- What is Future Trading – tutorial
- What is the Footprint Chart? – Tutorial