Learn about futures contracts, derivatives trading, hedging strategies, and leverage management in the commodities and financial markets.
Futures are standardized contracts to buy or sell an asset at a predetermined price on a specified future date. They are traded on exchanges and cover commodities, currencies, indices, and interest rates.
Futures contracts are marked to market daily with gains and losses settled.
Each futures contract has standardized specifications including contract size, tick size, delivery months, and settlement method. Understanding these specifications is crucial for proper position sizing and risk management.
Contract sizes vary widely between different underlying assets.
Futures trading requires initial margin and maintenance margin. Initial margin is the upfront deposit, while maintenance margin is the minimum account balance. Margin calls occur when your account falls below maintenance levels.
Margins are typically a small percentage of contract value.
Futures contracts can be settled through physical delivery or cash settlement. Most traders close positions before expiration to avoid delivery obligations. Cash-settled futures simply exchange the difference in prices.
Financial futures typically use cash settlement methods.
Futures markets facilitate price discovery by aggregating information from thousands of traders worldwide. Prices reflect supply and demand expectations for the underlying asset at the contract expiration date.
Futures prices often lead spot market prices for commodities.
Contango occurs when futures prices are higher than spot prices, while backwardation is when futures trade below spot. These conditions reflect storage costs, interest rates, and market expectations about future supply and demand.
Contango is common for storable commodities in normal markets.
Basis is the difference between the spot price and futures price. As expiration approaches, futures prices converge toward spot prices. Understanding basis relationships is essential for hedging and arbitrage strategies.
Basis risk affects the effectiveness of hedging strategies.
Traders roll positions by closing the near-term contract and opening a position in a later expiration. This allows maintaining exposure without taking delivery. Roll timing affects profitability due to basis changes.
Roll costs can accumulate in contango market conditions.
Futures markets include hedgers seeking price protection, speculators pursuing profits, and arbitrageurs exploiting price discrepancies. This diverse participation provides liquidity and efficient pricing mechanisms.
Commercial hedgers often take the opposite side of speculator positions.
Contract liquidity varies by underlying asset and expiration month. The most liquid contracts have tight bid-ask spreads and high trading volume. Front-month contracts typically have the highest liquidity.
Always check volume and open interest before trading.
Index futures can hedge equity portfolios against market declines. By selling futures contracts proportional to portfolio value, investors can reduce market risk while maintaining individual stock positions.
Hedging reduces both upside and downside portfolio volatility.
Producers use futures to lock in selling prices for their output. This protects against price declines but foregoes benefits from price increases. Agricultural and energy producers commonly use this strategy.
Hedging transforms price risk into basis risk.
Consumers and manufacturers hedge by buying futures to lock in purchase prices. Airlines hedge fuel costs, and food processors hedge commodity inputs. This provides budget certainty and protects margins.
Natural hedges exist when operations offset price exposures.
Cross hedging uses a related futures contract when no direct futures exist for the asset being hedged. Effectiveness depends on price correlation between the two assets. Basis risk is typically higher with cross hedges.
Calculate hedge ratios based on historical price correlations.
Dynamic hedging involves adjusting hedge positions as market conditions change. This can improve hedge effectiveness but requires active monitoring and management. Delta hedging is a common dynamic strategy.
Frequent adjustments increase transaction costs.
The optimal hedge ratio minimizes portfolio variance and depends on the correlation and volatility relationship between the asset and futures contract. Sophisticated hedgers use regression analysis to determine optimal ratios.
Hedge ratios should be recalculated periodically.
Futures provide significant leverage through low margin requirements. A small price movement creates large percentage gains or losses relative to margin posted. Leverage magnifies both profits and risks exponentially.
Typical leverage ranges from 10:1 to 50:1 depending on the contract.
Leverage allows traders to control large positions with limited capital, increasing potential returns. It enables efficient hedging of large portfolios and provides access to markets that might otherwise require substantial capital.
Leverage improves capital efficiency for experienced traders.
High leverage can quickly deplete trading capital through adverse price movements. Margin calls force position liquidation at unfavorable prices. Overleveraging is a primary cause of trading account losses.
Never risk more than you can afford to lose completely.
Successful traders use only a fraction of available leverage and maintain significant excess margin. Position sizing based on account volatility limits and stop losses are essential for managing leveraged positions safely.
Conservative traders target 10 to 20 percent of maximum leverage.
Know the exact specifications of every contract you trade including size, tick value, trading hours, and settlement procedures to avoid costly mistakes.
Maintain excess margin above minimum requirements to avoid forced liquidations during volatile periods. Exchange margin requirements can increase during high volatility.
Be aware of contract expiration dates and settlement procedures. Close or roll positions before expiration to avoid delivery obligations or cash settlement surprises.
Always use stop loss orders to limit potential losses on futures positions. The high leverage makes risk management absolutely critical for long-term survival.
Begin trading with highly liquid contracts that have tight spreads and deep order books. Avoid thinly traded contracts until you have significant experience.
Maintain comprehensive records of all trades including entry and exit reasons. Review your performance regularly to identify patterns and improve your trading approach.