This is part 3 of a 3 part series on Futures.
If you’ve seen the movie Trading Places with Eddie Murphy and Dan Aykroyd, then you’ve seen the nitty gritty futures market in action. If you haven’t, here’s a quick clip explaining the basics of the market.
Let’s Start with Some Key Definitions
Futures Contract: An standardized agreement between two parties to buy or sell a given commodity at a set time and price.
Commodity: The underlying asset involved in the futures contract. Oil, gold, orange juice and wheat are all examples.
Initial Margin: The initial deposit your broker requires to open a new contract /position.
Maintenance Margin: the ongoing cash required by your broker to maintain your position based on fluctuations in the price.
Leverage: Using a small amount of cash to control a large position.
Traders use futures contracts a little differently than businesses that want to take delivery of the underlying asset. When you trade an oil future you probably don’t have a place to store 1000 barrels of light sweet crude oil. Most futures traders are speculators.
Speculators trade futures contracts on the assumption that the price will move in their preferred direction. When the price of a futures contract changes by 1 cent, the trader will make or lose $10 dollars. This is the power of leverage. The cash requirements to buy or sell a contract vary by broker; they will set the initial margin requirement for your account.
OptionsXpress has a really nice virtual account that comes free with your new live account when you open it. For one crude oil contract you will need about $5,000 dollars in initial margin. However, if your position goes against you, then you will have to deposit more cash to keep up with the maintenance margin. Some commodities require less margin so check with your broker for the requirements.
Each month there is a new contract set to expire. So if it’s March and you want to trade the August contract you have less than 5 months to buy and sell the contract before it expires. The front-month contract is the contract that is closest to expiration and will have the most movement.
Trading futures is pretty risky for new investors. But if this is the asset class that interests you the most then you should check out CMEgroup.com. They have more details on each commodity including rainfall and snow futures.