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Futures Contract Trading

Aug 17, 2007
A futures contract has a limited life span. It is also not the cash commodity that is really in play here. Instead, traders use a futures contract for hedging against price fluctuations or to gain some profits from potential variations in the price of commodities. In other words, if you are the buyer of the futures contract, you will agree with the seller to buy the underlying commodity at a set date and at a fixed price. The change in price between the fixed price and the actual price of the underlying commodities, will determine whether you gain profits or suffer losses on your futures contract. The seller and the buyer usually liquidate their respective short and long positions independently before the futures contract expires, and very rarely take delivery of the commodities in play.

Fluctuations in futures contract pricing
Fluctuations in the price of a futures contract are driven by a variety of different and largely unpredictable factors. Interest rates make the greatest power plays. If you are trading in a currency futures contract, the policies and trading activities of the Federal Reserve, U.S. Treasury and foreign central banks, will impact interest rates and then, currency pricing. If you are playing stock indexes, you will find that your futures contract is influenced by anything that influences the stock market in general. Once again, interest rates are a serious factor to consider. If these hike, there will some pain in the stock market and pressure on your much hoped for gain. Naturally not only interest has an impact. General economic factors, seasonal influences as well as the expected future pricing of a commodity should all be kept in mind.

The price of a futures contract is a great deal more turbulent than that of the average stock on the stock market. A commodity could be upwardly mobile one year and in a downward spiral the next. Nobody who trades in a futures contract can afford to rest on his or her laurels. The commodity trader will (ideally) need to make use of both fundamental analysis and charting, to better predict what the future could hold.

Fundamental analysis is a bit of a hard slog: supply and demand need to be closely monitored. If there is greater supply than there is demand, the commodity price will most certainly plunge and if there is too little supply to meet the demand, the futures contract trader could make very good gains from the resultant commodity price increases.

Pricing changes in commodities are generally influenced by fundamentals, natural disasters, poor seasons, politics and perception. You can use charting to find those formations or patterns that pre-empt bullish or bearish shifts. Bar charts make for a simple, yet effective tool for the futures contract trader. It contains information on the particular futures market price movements, volume and open-interest. These commodity charts are compiled daily, weekly and monthly. The historical patterns will abet your efforts to gain a long-term view of the market. You should however also be looking at things like moving averages and oscillators when planning your trades.

Who plays the futures contract game?
As we mentioned earlier in this article, there are two motives for buying futures contracts: One is for hedging commodity price changes and the other for making money out of those inevitable changes. Those who hedge are generally also those who have some sort of a requirement for the underlying commodity. In example, if the commodity is wheat, it may be a miller that is hedging against higher future wheat pricing. The speculator on the other hand, has no interest in the underlying commodity and will buy a futures contract purely to make a quick buck.

Effectively there are two types of futures contract hedges: a long hedge and a short hedge:
Short hedge - Futures are sold, normally by a trader who either owns the underlying commodity or who stands to suffer some sort of a loss if the pricing drops.
Long hedge - Futures are bought, normally by somebody who uses or processes the commodity, because there is concern that the pricing will increase. The trader could sell the futures contract at a later date, potentially for more than he would have to pay the producer at that point in time - and pocket the profits.

The speculators have a role to play here too, albeit that they do not have a natural long or short position. Their sole aim is to buy low and sell high. In the process, they cause the liquidity needed as they frequently take the opposite side of the trade of the hedger.

Advantages of futures contract trading
There are a variety of advantages to be had from trading in futures contracts:

Owing to volatility one can potentially make more money sooner from futures contract trading than from trading on the stock market if your trading judgement is sound. If not, you could end up losing more money faster too.

Futures are highly leveraged investments. You only need to raise a small fraction, between 10% and 15% of the underlying futures contract value as margin, whilst enjoying the full value of the contract as it dips and peaks. The money put up, is a performance bond. A further upside is that there is no interest on the difference between the margin and the full contract value.

The way in which a futures contract trades, makes it one of the most fair and efficient markets. It takes place publicly by open outcry after all.
Comparatively low commissions are charged on futures contract trades, and only once a position is liquidated.

The majority of the commodity markets are liquid and broad. There is quick turnaround on futures contract transactions, and subsequently a smaller chance that adverse market movements will take place between the decision to trade and the execution of the trade.
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