Market side: Futures trading basics

LESSON 2: WHAT IS A FUTURES CONTRACT?

Marty Hibbs, Grain Merchandiser, Grain Farmers of Ontario

This monthly educational series will feature the basic workings of the futures and options markets and how they can be utilized to help farmers with risk management.

FOR THE PURPOSE of this lesson, we will assume that my explanation of the U.S. futures markets is not used as a direct hedge against Canadian grains. This explanation of the futures contract and market function will be geared towards speculators only, as Canadian origin grains are not deliverable against a Chicago futures contract. As we continue in this educational series, we will add the Canadian element to the mix, since we have a much more complicated situation by factoring the local supply and demand coupled with the fluctuating price of the Canadian dollar. Once we understand the principle of the futures contracts, we can utilize them to manage risk in our Canadian markets.

In the simplest terms, a futures contract is a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts allow for physical delivery of the asset in the U.S., while others are cash settled.

Unlike a stock certificate, futures contracts give no ownership and have an expiry date which is usually near the beginning of the futures month of the contract. If you were to buy a December 2014 wheat futures contract, you would be required to settle the contract before December 1 in one of two ways. The seller can deliver the underlying asset to the buyer (in the U.S. only), or one or both parties may satisfy their obligations by taking the opposite position on their futures contract of the same asset and settlement date. The difference in futures prices from entry to exit, reflects the profit or loss.

There are many standardized futures contracts trading on recognized exchanges today — they range from contracts in Australian dollars to wheat. The underlying item or commodity is described specifically in the contract specifications which are determined by the futures exchange on which it trades. Any differences in grading issues will be adjusted on delivery.  All futures contracts can only be executed on futures exchanges. These exchanges are located primarily in Chicago and New York.

The above example is over simplified for study purposes. We will explain in detail the finer points of trading with hedgers in a later lesson. •

Marty Hibbs is a 25 year veteran futures trader, analyst, and portfolio manager. Hibbs was a regular guest analyst on BNN for four years. He is currently a grain merchandiser with Grain Farmers of Ontario.

Lesson Definitions:

Contract Specs: Each and every futures contract on the futures exchange has a standardized set of specifications, unique to that contract. They include, contract size, expiry date, and dollar value to name just a few items.

Futures Exchange: A board of trade designated by the Commodity Futures Trading Commission to trade futures or option contracts on a particular commodity. Commonly used to mean any exchange on which futures are traded.

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Grain Merchandiser, Grain Farmers of Ontario