A futures contract - now we don't say 'futures contract', we talk about a 'futures', it is assumed everyone understands we mean a
contract - a futures contract is what I will negotiate when I visit uncle Tom on the farm. I want to buy cattle, now he'll show me
around and we'll have a cup of coffee and negotiate the terms of a deal. We'll agree on how many cattle, the price I will pay and when
he will deliver the cattle to me. When I leave the farm, I don't leave with a truck and trailer full of cattle - my wife will have a heart
attack, my backyard is waayyy to small, the dogs will go nuts and the neighbours too.. I leave with a contract, a negotiated deal. The
contract specifies how many cattle, how much I pay for them and when will I take delivery of the cattle - which typically may be only in
September, six months from now. The farmer is happy, he has sold his cattle and he will carrry on with his business, raising them and
whatever it is he does, but the price he gets for them is pre-negotiated.
Back home I will go see the butcher and start negotiating selling these cattle to him or someone else at a better price. Comes delivery date, the farmer delivers to the butcher, or whoever I sold the cattle to, I only act as the middleman, I brokered a deal with the farmer and sold the cattle off to someone else.
Now I need to run a profitable business here, so I'll make certain I get more for the cattle than what I paid for them. I could of course have done it the other way around. I could first have approached the butcher and negotiated a deal to sell him the cattle. Then once I know how much he is willing to pay and how many he will take, then approached the farmer and brokeraged the deal on that side. So I could have sold the cattle to the butcher first, then buy from the farmer later.
The point is this: Because I am dealing with something that is DELIVERED IN THE FUTURE, I have time on my side. I have time to broker a deal. I will never take physical delivery of whatever it is that I am dealing with, I am only the middleman who brokers a deal and make a profit doing so. That is my business.
A FUTURES therefor is a contract that I negotiate for a specific amount of a commodity, to be delivered somewhere in the future. I can BUY the contract now and then SELL the contract on to someone else. (for a profit of course). Or I may first SELL the contract then find a willing party and BUY a contract from him to offset the contract that I have already sold! Anyway I want to do it, as long as it works for me (I make a profit).
Role of the Exchange
Now farmer Tom up here is going to have a hard time tracking where to deliver the cattle to. For before I even got home, I met a friend
who happens to be into cattle as well and I sold the contract to him for a little profit. He in turn sold it to a very optimistic chap for
a really nice profit, who in turn discussed it with his friend who also happened to be a cattle farmer and informed him that we was taken for
a ride - cattle prices are likely going to drop, so he got out at a loss...
Come delivery day..- where does the farmer deliver and whoever it is who needs to collect, how do we know he gets his cattle? The Exchange was created to solve this problem. The Exchange is the central location where all transactions take place, they act as clearing house, all producers, on delivery date delivers their produce to the Exchange and all buyers collect their stuff from the Exchange. By allowing speculators (you and me) into the picture, they created price volatility - speculators drive the prices all over the show - thus when prices are high, the producers are able to sell their goods at price levels good for them. When prices are low, the consumers are able to get their raw product at prices favourable for them. The speculators in between eat up the price difference, some of them loose, some of them profit.
The Exchange solved a very difficult problem - how to ensure that both the producer and the consumer are able to trade at favourable prices. With no Exchange, when the farmer's produce was ready, all other farmers' produce was ready as well, surplus, prices low, the farmer was at a disadvantage. Now with the Exchange, the farmer is able to sell on a forward basis - DELIVERY INTO THE FUTURE - and are able to get better prices. The same for the consumer.
What about the Speculator
The Speculator - that is you and me..? We are not interested in the physical commodity (I don't want the physical cattle, what do I do
with it?). Thus when I register with the exchange, they will ask and I will tell them I am only interested in price speculation. I am of
course more than welcome - without speculators there cannot be price movement and then, well, then we all sort of miss the point - we want
price volatility to ensure both the producer and consumer is able to get favourable prices.. As Speculator the Exchange knows that I am not
interested in physical delivery or receipt. Thus there are certain rules.
There is a set date in the future when physical delivery (and receipt) of the commodity has to take place! I mean live goes on, we cannot just forever pass on the contract. At some point the cattle has to be delivered and whoever has a use for them has to collect. This is the futures expiry date. As Speculator, at some point before this date I HAVE TO GET OUT!! We need to give the Exchange enough time to settle all outstanding contracts, clear everything and organize receipt and delivery of the commodity.
Thus, there is a date - the last trading day - that I have to settle all of my outstanding contracts - whether the price on that day is favourable for me or not. At the end of business on that date, if I have not settled my outstanding, then the Exchange will automatically settle all of my outstanding contracts at the then going price and done, I am out of it. And then they clear and physical exchange of the commodity occurs.
The Futures Contract
The futures contract, for every commodity, specifies a certain fixed amount of that commodity that the parties are negotiating to trade. For
every commodity, this amount, the futures contract amount, is fixed, pre-determined. For example for Gold it is 100 ounces of Gold. For Oil it
is a 1,000 barrels of Oil. For Cattle it is 50,000 pounds of cattle. These conditions are determined and published by the relevant Exchange.
You may trade any number of contracts (well there is a max limit), but you cannot trade a fraction of a contract - thus you cannot trade half a contract or a tenth of a contract. The minimum size you can trade is one contract.
NB: THIS IS IMPORTANT... Since the contract size is fixed, pre-determined, the amount of money you will make or loose when the price of the commodity changes by one US Dollar, is fixed, pre-determined. For example, since a Gold contract is 100 ounces, if the price of Gold goes up (or down) with $1 / ounce, I will make (or loose) $100, depending of course on whether I bought or sold Gold. If crude oil canges by $1 / barrel, I will make or loose $1,000 per contract (a contract is 1,000 barrels of Crude). Thus - THE POINT VALUE of a commodity futures is the amount of money that a futures (contract) will change by when the commodity's price move by $1. This value - the point value - is a very important value that we need to keep track off. Please review this link for a table listing the point values for all the commodities that we are interested in.
There are certain fixed rules, published by the Exchange, for when a futures contract will expire. We are interested in the last trading date the date when we have to get out.. The Exchange determines this - for example for our cattle trade it is "the last Thursday of the contract month at 12 p.m.". There are of course exceptions surrounding holidays and business days. In general, these dates are published by the Exchange
Expiry Months / Futures Contract Months
Note that there are many different contracts. For cattle for example there is a Jan, Mar, Apr, May, Aug, Sep, Oct, Nov contract. It differs
from commodity to commodity. For stuff like Oil or Gold there is a contract month for almost every single month, for a currency like the British
Pound there may be fewer contract months. Note that each of these contracts are entirely separate contracts. If you look for example at Gold,
there is a Mar, Apr, Jun contract. The price for Gold for March is not the same as the price for April Gold as the price for Jun. Even the
Gold Spot Price - the cash price if you want to buy Gold right now, for cash, may not be the same as the March Gold contract price! These are
entirely different contracts!
You may of course hold the same commodity, different contracts, at the same time! For example you may have bought March Gold and sold April Gold. Come contract expiry end of March - last trading day - you have to get out. You can try to explain to them that you have offset your position with an April contract. It does not matter! These are separate contracts - they are unrelated!! Come end of March you have ot get out of the March contract, no matter what position you hold in the April contract - they are unrelated, they are different contracts!!
How do I Trade these Contracts (Futures)?
We will discuss this in detail in our "how to (trade)" section. All we need to note here is that we are free to buy or sell these contracts. As in
the example, you can buy now and sell later, or you can sell now and buy later. It does not matter how you do it. You can buy now, then buy
more later, then sell part of what you hold, then buy more, etc. as long as, on or before the last trading date, you get out!! Or neutralize
your position - if not, the Exchange will do it for you at whatever price the commodity closes at on the last day!!
Note:Traders are a different bunch of people, they have changed the terminology of almost everything. They do not talk about "buy" or "sell", they talk about "long" or "short". Thus if you go long the futures, it means you have bought a contract. If you go short the futures it means that you have sold a contract.
If you go LONG, it means you are expecting the PRICE of the futures to RISE (go up) - you bought and in order to make a profit you need to sell at a higher price.
If you went SHORT you are expecting the PRICE of the futures to DROP (go down) - you sold something to someone, you need to buy that same something back at a lower price in order to make a profit.
Click here to proceed to Options.. BUT - you need to be certain you thoroughly understand Futures. And what long and short (buy and sell) of a futures is.