Futures Fundamentals
A futures contract is a standardized, exchange-traded agreement to buy or sell a set quantity and grade of an underlying commodity at a price agreed today, for delivery on a future date. This chapter covers the vocabulary, margin mechanics, order types, and account rules that every futures professional must know cold.
What a Futures Contract Standardizes
An exchange writes the contract so that everything except the price is fixed in advance: the quantity per contract, the acceptable grade or quality, the delivery months, and the delivery location or settlement method. Because the terms are uniform, contracts are fungible and can be freely offset. The only term the buyer and seller negotiate through the auction market is the price. A long position agrees to take delivery (buy), while a short position agrees to make delivery (sell).
Margin and Marking to Market
Futures margin is a good-faith performance bond, not a loan or a down payment. The customer posts initial margin to open a position and must keep equity at or above the maintenance margin level. Each day the exchange clearinghouse marks every open position to the settlement price; gains are credited and losses are debited from the account. If a loss drives equity below maintenance, the customer receives a margin call and must restore the account to the full initial margin level, usually with cash.
Leverage, Notional Value, and Profit or Loss
Because margin is only a small fraction of the contract's value, futures are highly leveraged: a small price move produces a large percentage gain or loss on the margin posted. Notional (contract) value equals the price times the contract size. A long profits when the futures price rises and loses when it falls; a short profits when the price falls. Profit or loss per contract equals the price change times the contract multiplier.
Order Types and Account Basics
A market order executes immediately at the best available price. A limit order sets the worst acceptable price (buy at or below, sell at or above). A stop (stop-loss) order becomes a market order once the market trades at the trigger price and is used to limit losses or protect gains. Accounts include speculative accounts, which seek profit from price change, and hedge accounts, which offset a business risk. Before trading, a customer must receive and acknowledge the risk disclosure document.