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Futures Trading Lingo Explained

Posted by Tom Craig in Futures Trading                          Words in this Post: 952

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A Forward Contract is a contract between a buyer and seller in which the seller agrees to deliver a specific commodity to the buyer at some time in the future. The terms of this contract: price, quantity, quality, time, and location were negotiated between the buyer and seller. Though enforceable by law, these agreements often were violated by buyers and sellers.

A Futures Contract is a legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument some time in the future. Futures contracts are standardized according to quality, quantity, and delivery time and location for each commodity. The only variable is price, which is discovered on an exchange trading floor.

The standard Grades of commodities or instruments are listed in the rules of the exchange that must be met when delivering against a futures contract. Grades are often accompanied by an exchange set schedule of discounts and premiums allowable for delivery of commodities of lesser or greater qualify than the standard called for by the contract rules.

Most financial instruments are a Commodity in the sense that they are an article of commerce or a product that can be used for commerce. For example, Treasury Bonds are a commodity because they are indistinguishable from each other, as long as the length of time to maturity is equal. Stock certificates, too, are a commodity, as one share is the same as the next. Hence we have financial instruments as commodities now.

Offset is taking a second futures or options position opposite to the initial position or opening position. To offset the purchase of a futures contract, a second futures contract on the same commodity with the same delivery month is sold. To offset the sale of a futures contract, a second futures contract on the same commodity with the same delivery month is purchased.

The cash market refers to physical commodities, which you can touch—be they Corn, Wheat, Beef, Bonds, or Stock, you can touch them. Arbitrage is when you buy something in one market and sell it in another. For example, if Corn future, were overvalued relative to the cash market, arbitragers would sell Corn futures and sell cash corn, waiting to take delivery of the corn from the futures to deliver the physical corn, pocketing the price differential. However, usually as the arbitragers buy or sell future they drive the price back in line with the physical market, and can offset their positions at a profit.

Long Position

A long position is entered into by purchasing a futures contract. Long positions are profitable if the underlying futures contract increases in price during the holding period. A long position is offset by selling the same quantity and contract month that one initially purchased. For example, if you buy one March Corn at $2.35 per bushel, this position could be offset later by selling one March Corn contract. If the resulting sale price is higher than the entry price, then a profit is earned. If the resulting sale price is less than the original purchase price, then a loss occurs. Long positions are typically used by consumers to hedge against rising prices, and initiated by speculators in anticipation of higher prices.

Short Position

A short position is entered into by initially selling a futures contract. In the futures market, unlike the stock market, it is just as easy to establish a short position as a long position. Short positions are profitable if the underlying futures contract decreases in price during the holding period. Short positions are offset by buying the same quantity and contract month that you initially sold. For example, if you sell one March Corn at $2.35, this position could be offset by buying one March Corn at a later time. If the resulting purchase price is less than the original sale price, a profit is achieved. However, if the resulting purchase price is greater than the original sale price, a loss is incurred.

Commodity producers who wish to "avoid" potentially lower prices as a short position increases in value as prices decline—usually establish short positions. Speculators "anticipating" lower prices in the future establish short positions.

Speculators

The dictionary defines "speculate" as follows: (1) To meditate on a subject; reflect. (2) To engage in a course of reasoning often based on inconclusive evidence; synonym: think. (3) To engage in the buying or selling of a commodity with an element of risk on the chance of profit.

For potential commodity traders they should think of speculating as engaging in a thought process to reach a conclusion, based on incomplete facts, for the purpose of profit.

Hedging

Hedging is the practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures markets.

Hedgers use the futures market to protect their businesses from adverse price changes.

Margins Can Vary

The margining system is key to making futures trading viable. By requiring funds to back up positions, and the exchange clearinghouse acting as middleman to all transactions, the margining system allows contracts to offset and all counterparty risk is removed.

Margin levels are set by the exchange in accordance with the potential risk involved in the futures contract (refer to the following figure).

For example, if you wished to establish a position in the Gold market, you would have to have $1,350 in your account before placing an order to enter the market— initial margin. In order to maintain a position, the account balance would have to stay above $1,000—maintenance margin. From this, a participant in the commodity futures market can ascertain that Gold is about three times more risky than Corn, as Gold requires three times the amount of margin required initially to enter this market.

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Tags: Arbitrage, Arbitrators, Commodity, Forward Contract, Futures Contract, Grades, Hedging, Long Position, Margins, Offset, Short Position, Speculators