Tin Futures Trading Basics

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Futures Trading Basics | Understanding Futures Products

| FRI JUN 12, 2020

Many traders are familiar with investment choices like stocks, bonds, and options, but less are familiar with futures. To get a better understanding of futures products, Pete explains the basics of futures contracts and explains some of the different terms used in the futures world.

What is a Futures Contract?

A futures contract is an agreement between two parties, a buyer and a seller.

  • Short Position (Seller) – delivers the commodity
  • Long Position (Buyer) – receives the commodity

A futures contract is a standardized contract comprised of:

  1. The quantity of the commodity/index
  2. The quality of the commodity/index
  3. The date of delivery and the method of delivery

What Is A Futures Tick Value?

A tick value is the minimum amount that a futures contract can fluctuate. Tick values vary depending on the product traded. For example in WTI Crude (/CL) it is $0.01 which is = to $10.00.

As the market moves, it can move in multiple ticks between trades, but the smallest movement the contract in the example above could make is to 52.00 to 52.01

Each product will have its own dollar value assigned to a tick. Some products have significantly high tick values than others. Here are some example tick values:

Before trading any futures product, be sure to understand the tick value of the instrument you are trading.

Calculating The Tick Size (In Dollars)

To find the monetary value of a tick, you must multiply the size of the contract by the minimum price movement of the underlying commodity/index.

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For example – if you wanted to find out the tick size for wheat futures, you would have to find out how many bushels one contract represents, then find out the minimum price fluctuation for a bushel of wheat. In this case, a bushel of wheat can trade in increments as small as $.0025. One wheat futures contract represents 5,000 bushels so the tick value would be $.0025 x 5000 = $12.50.

Futures Ticker Symbol Meaning (See Slides For Visual Representation)

Did you know that the ticker symbol when looking at specific futures contracts have unique meanings depending on the letters or numbers amended to the end of the symbol?

This is a little confusing, here’s an example to clarify. let’s get back to EURO FX futures.

The normal symbol for Euro FX futures is /6E. If you look up /6E you will see that there are several choices in products based on expiration. Some of the other products are: /6EU5, /6EZ5, and /6EH6. These are all Euro FX futures, but with different expiration months and years.

In the examples above, the third letter represents the contract expiration month, and the last number represents the contract expiration year. Each month has its own ‘month code’ (can be seen in the video) and the number represents the last digit of the year the contract is in.

What Is Notional Value?

Notional value is the value that a futures contract actually represents (remember that futures are highly leveraged instruments and are a multiplier of the actual value of the underlying).

Notional value can be calculated by multiplying the contract size (how much of the commodity the futures contract represents) by the current price of the underlying.

Notional Value Calculation Example

To find out the notional value of a contract, you need to first find out, how much of a given commodity/index that a futures contract represents. You can find this on the CME Group website here by selecting which product you want, then making sure that you are looking at the future specs (not the option specs).

For example, if we wanted to find the notional value of the Euro FX (/6E), we would need to find the contact specs, and then find the price. To find the contract specs, you go here, then you would go to your trading platform of choice and see where the underlying is trading at.

We see that /6E represents 125,000 Euros and the price is at $1.1236. Then, we multiply them to get the notional value:
125,000*$1.1236 = $140,450

Each and every time that you open a futures contract, the futures exchange will require a minimum amount of money be in your brokerage account. The margin is determined by the futures exchange, but is typically about 5-10% of the futures contract.

The original amount needed to place the trade is called the initial margin. Once the trade is placed, the margin needed to keep the trade on is called the maintenance margin. This is lower than the initial margin and represents the lowest the account can go before needing to add more funds.

Looking again at Euro FX futures (/6E) the initial margin would be $3,630 and the maintenance margin would be $3,300.

Once you liquidate your futures contract, you will be credited the margin, plus or minus any gains/losses accrued during the time you held the contract.

Options On Futures

Options on futures are one of the most versatile trading products out there and if you’re already familiar with options, the concepts, price, behavior and terminology, then they are very easy to use.

Types Of Futures Strategies

There are several types of futures strategies that you can use to speculate or hedge risk. They can be categorized as:

  • Calendar Spread: the simultaneous purchase and sale of 2 futures of the same type, but with different delivery (expiration) dates.
  • Intermarket Spread: buying 1 market and selling a related product. (i.e. long WTI and short Brent crude)
  • Inter-Exchange Spread: any spread in which the positions are created in different exchanges. (i.e. going long CBOT wheat and short KCBT wheat)

Strategy: Short Call Spread

Products Discussed In This Episode: /6E, /M6E

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Futures

What Are Futures?

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.

Key Takeaways

  • Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset and have a predetermined future date and price.
  • A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument.
  • Futures are used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.

Futures Explained

Futures—also called futures contracts—allow traders to lock in a price of the underlying asset or commodity. These contracts have expirations dates and set prices that are known up front. Futures are identified by their expiration month. For example, a December gold futures contract expires in December. The term futures tend to represent the overall market. However, there are many types of futures contracts available for trading including:

  • Commodity futures such as in crude oil, natural gas, corn, and wheat
  • Stock index futures such as the S&P 500 Index
  • Currency futures including those for the euro and the British pound
  • Precious metal futures for gold and silver
  • U.S. Treasury futures for bonds and other products

It’s important to note the distinction between options and futures. Options contracts give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of the contract.

Investors can use futures contracts to speculate on the direction in the price of an underlying asset

Companies can hedge the price of their raw materials or products they sell to protect from adverse price movements

Futures contracts may only require a deposit of a fraction of the contract amount with a broker

Investors have a risk that they can lose more than the initial margin amount since futures use leverage

Investing in a futures contract might cause a company that hedged to miss out on favorable price movements

Margin can be a double-edged sword meaning gains are amplified but so too are losses

Using Futures

The futures markets typically use high leverage. Leverage means that the trader does not need to put up 100% of the contract’s value amount when entering into a trade. Instead, the broker would require an initial margin amount, which consists of a fraction of the total contract value. The amount held by the broker can vary depending on the size of the contract, the creditworthiness of the investor, and the broker’s terms and conditions.

The exchange where the future trades will determine if the contract is for physical delivery or if it can be cash settled. A corporation may enter into a physical delivery contract to lock in—hedge—the price of a commodity they need for production. However, most futures contracts are from traders who speculate on the trade. These contracts are closed out or netted—the difference in the original trade and closing trade price—and are cash settled.

Futures Speculation

A futures contract allows a trader to speculate on the direction of movement of a commodity’s price.

If a trader bought a futures contract and the price of the commodity rose and was trading above the original contract price at expiration, then they would have a profit. Before expiration, the buy trade—long position—would be offset or unwound with a sell trade for the same amount at the current price effectively closing the long position. The difference between the prices of the two contracts would be cash settled in the investor’s brokerage account, and no physical product will change hands. However, the trader could also lose if the commodity’s price was lower than the purchase price specified in the futures contract.

Speculators can also take a short or sell speculative position if they predict the price of the underlying asset will fall. If the price does decline, the trader will take an offsetting position to close the contract. Again, the net difference would be settled at the expiration of the contract. An investor would realize a gain if the underlying asset’s price was below the contract price and a loss if the current price was above the contract price.

It’s important to note that trading on margin allows for a much larger position than the amount held by the brokerage account. As a result, margin investing can amplify gains, but it can also magnify losses. Imagine a trader who has a $5,000 broker account balance and is in a trade for a $50,000 position in crude oil. Should the price of oil move against their trade, they can incur losses that far exceed the account’s $5,000 initial margin amount. In this case, the broker would make a margin call requiring additional funds be deposited to cover the market losses.

Futures Hedging

Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges are using—or in many cases producing—the underlying asset.

For example, a corn farmer can use futures to lock in a specific price for selling their corn crop. By doing so, they reduce their risk and guarantee they will receive the fixed price. If the price of corn decreased, the company would have a gain on the hedge to offset losses from selling the corn at the market. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable market price.

What are the basics of futures trading?

Not sure if futures trading is right for you? In this article, we’ll help you find out by taking a close look at what futures are and how they work.

What are futures?

To start, here’s a quick definition: Futures are contracts for the delivery, or cash settlement, of many things you may encounter every day, like materials, products, or even the stock market itself. But what does that really mean? Let’s break it down by exploring a few key traits that make futures unique.

All futures share the following three characteristics:

  1. Easy contract trading. Futures are contracts that trade on an exchange. That means if you buy or sell them, closing your trade is as easy as it would be for a stock. The futures market is relatively deep and liquid.
  2. Settlement by cash or physical delivery. Like stocks, most futures—including the CME E-mini S&P 500 and other equity index futures—settle in cash. There’s no exchange of physical goods or shares of stock. The only thing that changes hands is money.

However, some commodity futures, like corn and soybeans, are physically settled, meaning each party to the trade is expected to deliver or receive the actual commodity at expiration. But very few futures contracts are settled this way, and at E*TRADE, while you should be sure to close your positions on time, there are mechanisms in place to minimize this risk.

  • Backed by commodities or other assets. Futures contracts represent the pricing of essential things that affect our daily lives, including agricultural products (like wheat and cattle), energy products (like crude oil and gasoline), and financial products that facilitate international trade (e.g., those involving interest rates and currency exchange).
  • Equity index futures are one of the most popular, providing another way for investors to trade on price movement in the stock market. These include the CME E-mini S&P 500 mentioned above, plus the CME E-mini Nasdaq and CME E-mini Russell 2000.

    What are the basic terms used in futures trading?

    Now that we’ve seen what futures are, let’s explore how they work by defining and illustrating some essential futures terms.

    • Tick . Futures contract prices move in minimum increments called “ticks.” These are different for each futures product and can usually be found by checking the futures page. As an example, the CME E-mini S&P 500 has a tick size of a quarter of an index point.
    • Tick value. Unlike stocks (where each tick is worth a penny), tick size for futures is product-dependent, and as a result, the dollar value will vary. The tick value of the CME E-mini S&P 500 is $12.50, so if you buy a contract and end up selling it, say, two ticks higher, you’d make $25.00, assuming no commissions or fees.
    • Contract size. The specified quantity behind each futures contract (i.e., how much of a commodity or financial instrument is backing that contract) is called its contract size. For example, the CME gold futures contract represents 100 troy ounces of gold.
    • Notional value. Knowing the size of a futures contract enables you to determine its notional value—i.e., how much each contract is worth. You can figure this out by multiplying the contract size by the current price of the futures contract.

    Consider gold: If gold futures are trading at $1,300 per ounce and the size of the CME gold futures contract is 100 ounces, the contract’s notional value would be $130,000 ($1,300 x 100). In dollar terms, that’s how much one gold contract is worth.

    If a contract’s notional value ever seems too big for your wallet, check to see if there’s a contract with a smaller size. With gold, there is. It’s the CME E-micro gold, which has a contract size of 10 ounces—and a notional value of $13,000 ($1,300 x 10). That’s one-tenth the size of the bigger contract.

    How to Get Started Trading Futures

    A futures contract is an agreement to buy or sell an asset at a future date at an agreed-upon price. All those funny goods you’ve seen people trade in the movies — orange juice, oil, pork bellies! — are futures contracts.

    Futures contracts are standardized agreements that typically trade on an exchange. One party agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party to the contract agrees to provide it.

    The futures market can be used by many kinds of financial players, including investors and speculators as well as companies that actually want to take physical delivery of the commodity or supply it. To decide whether futures deserve a spot in your investment portfolio, consider the following:

    How do futures work?

    Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel:

    • An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.
    • A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices.
    • Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.

    In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it’s the basis of their business. They use the futures market to manage their exposure to the risk of price changes.

    But not everyone in the futures market wants to exchange a product in the future. These people are investors or speculators, who seek to make money off of price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they’re just in the market to wager on price movements.

    With speculators, investors, hedgers and others buying and selling daily, there is a lively and relatively liquid market for these contracts.

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