Even the most successful futures traders were once beginners. If you’re new to commodities, it’s important to start with the basics and learn the ins and outs of the market.
What is a futures contract?
A futures contract is a legally binding agreement between a buyer and seller to receive (in the case of a “long” position) or deliver (in the case of a “short” position) a commodity or financial instrument sometime in the future, but at a price that’s agreed upon today. These contracts mature at a particular point in the future and are identified by reference to that date – for instance, a July Corn futures contract or a December S&P 500 stock index futures contract. The ability to make or take delivery of the underlying commodity at expiration creates a strong tendency for cash and futures prices to react to the same economic factors and move in the same direction by roughly equal amounts.
The process of futures trading
Futures trading takes place at centralized exchanges, mostly on electronic trade-matching platforms – such as the CME Group’s Globex system – but also, to a lesser extent, in open-outcry, auction-style trading pits. In every transaction, the exchange clearinghouse is substituted as the buyer to the seller and the seller to the buyer, thereby guaranteeing performance and eliminating counterparty risk.
Customers who trade futures are required to post margin deposits with an exchange member firm which, in turn, must deposit margin with the exchange. Margins are not payment against the market value of the commodity represented by the futures contract, but rather are performance bonds – good-faith deposits – to ensure the ability of market participants to honor their financial commitments and cover any obligations which might arise out of their trading activities.
Buying a futures contract is called taking a “long” position, while selling a futures contract is referred to as taking a “short” position. A long futures position profits when the futures price goes up, and a short futures position profits when the futures price goes down.
Maturing futures contracts expire on specific dates, usually during the contract month. At any time before the contract matures, the trader may offset, or close out, his or her obligation by selling what was previously bought or buying what was previously sold. By offsetting an open futures contract, a trader is relieved of any obligation to make or take delivery of the underlying commodity or financial instrument. This is made possible by the fact that futures contracts have standardized terms and trade on centralized exchanges. The vast majority of futures contracts, in fact, are closed out by offsetting market transactions prior to their maturity, rather than through the delivery process.
Futures exchanges, clearinghouses and market professionals
U.S. futures exchanges typically have operated with a trading floor where traders and brokers compete on equal footing in an auction-style, open-outcry market and where they communicate by voice and hand signals with others in the pit. Customer orders coming into the futures pit were delivered to floor brokers who executed them with other floor brokers representing other public customers or with floor traders (known as “locals”) trading for their own accounts.
However, trading by means of electronic order matching has grown dramatically in recent years, as more and more market participants have expressed a preference for the speed, convenience, and extended hours of electronic trading. Some markets have abandoned open-outcry altogether in favor of screen trading.
The clearinghouse system is an important aspect of the financial integrity of the futures market. Traditionally, each U.S. futures exchange has had its own clearinghouse to act as the master bookkeeper and settlement agent. In every matched transaction executed through the exchange, the clearinghouse is substituted as the buyer to every seller and the seller to every buyer. The clearinghouse deals exclusively with clearing members and holds each clearing member responsible for every position it carries on its books, regardless of whether the position is being carried for the account of a non-member public customer or for the clearing member’s own account. The clearinghouse doesn’t look to public customers for performance or attempt to evaluate their credit worthiness or market qualifications. Instead, the clearinghouse looks solely to the clearing member carrying and guaranteeing an account to secure all margin requirements and payments.
A futures brokerage firm – known in the U.S. as a futures commission merchant (FCM) – is the intermediary between public customers and an exchange. Some FCMs are part of national or regional brokerage companies that also offer securities and other financial services, while other FCMs offer only futures and futures options. An FCM must maintain records of each customer’s open futures and futures options positions, margin deposits, money balances and completed transactions. In return for providing these services and for guaranteeing the accounts carried on its books to the exchange clearinghouse – an FCM earns commissions. By U.S. law, an FCM is the only entity outside a futures clearinghouse that can hold the funds of futures customers.
Federal law also requires an FCM to segregate customer funds from the firm’s own funds at all times. The funds in segregation must be sufficient to meet the firm’s obligations to customers, and the FCM may not use those funds to satisfy any of its own obligations to creditors. Furthermore, an FCM must deposit its own funds to cover any customer-account deficits until the customer remits sufficient funds. Segregation of funds is designed to protect customer funds and make it possible to identify such funds in the event of an FCM’s default or bankruptcy.
Futures market participants: Hedgers and speculators
Futures market participants can be divided into two broad categories: Hedgers, who actually deal in the underlying commodity or financial instrument and seek to protect themselves against adverse price fluctuations, and speculators (including professional floor traders), who seek to profit from price swings.
The futures markets exist to facilitate the management of risk and are thus used extensively by hedgers – individuals or businesses who have exposure to the price of an agricultural commodity, currency, or interest rate, for instance, and take futures positions designed to mitigate their risks. This requires the hedger to take a futures position opposite that of his or her position in the actual commodity or financial instrument. For example, a soybean farmer is at risk should the price of the commodity fall before he harvests and sells his crop. A short position in the futures market will return a profit when the price of soybeans declines, and the hedger’s profit on the short futures position compensates to some extent for the loss on the physical commodity.
Speculators are attracted to futures trading purely and simply because they see the opportunity to profit from price swings in commodities and financial instruments. Speculators take advantage of the fact that the futures markets offer them access to price movements; the ability to offset their obligations prior to delivery; high leverage (low margin requirements); low transaction costs; and ease of assuming short as well as long positions (short futures positions are not subject to any uptick rule or broker/dealer interest charges). In pursuit of trading profits, speculators willingly take risks that hedgers wish to transfer. In this process, speculators provide the liquidity that assures low transaction costs and reliable price discovery – market characteristics which, in turn, make futures markets attractive to hedgers.
Regulation of the futures markets
The Commodity Futures Trading Commission (CFTC) is the federal agency that regulates the futures markets. The mission of the CFTC, which was created by Congress in 1974, is to protect futures market participants against manipulation, abusive trade practices and fraud; to guarantee the integrity of futures market pricing; and to assure the financial solvency of futures brokerage firms, exchanges, and clearinghouses. The CFTC’s oversight and regulation help ensure that futures markets provide effective price discovery and risk-transfer opportunities.
CFTC regulations designed to protect customer trading funds are impressive. The single most significant safeguard is that no brokerage company is permitted to hold customer funds in any of its corporate bank accounts. Rather, futures brokerage companies are required to maintain customer funds in bank account that are totally separate from their own bank accounts.
In addition, all registered Futures Commission Merchants (FCMs) in the U.S. are subject to strict financial requirements and are audited continuously. Every licensed Futures Commission Merchant that maintains a customer segregated funds account is required to file financial reports each and every morning to industry regulators. You’ll be glad to know that Charles Schwab Futures is a registered FCM and National Futures Association Member, which means we meet the industry’s highest financial standards and are subject to the most demanding requirements. We recognize the trust and confidence you’ve placed in us, and keeping your trading assets safe and sound is one of our most important responsibilities.
If you’d like to continue the futures learning process, we offer a number of free resources on the Street Smart Central site, under the Educate tab. You’ll find webinars, strategy papers, exchange brochures, and more. We invite you to explore the site and take full advantage of everything we have to offer.
Already a Charles Schwab client but not yet trading futures? You can enable your account for futures trading quickly and easily. Simply log in, and under the Trade tab, click the link to the Futures page. We’ll walk you through a very brief and totally painless process to enable your account for futures trading.
Want to learn more about trading futures at Schwab? Call the Schwab concierge team at 877-903-7544.