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:
- 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.
- 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 from Morgan Stanley, 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 futures contracts, 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.