The Language of Futures: Key Terms in Futures Trading
Futures are derivative instruments. In the world of commodities, each futures contract seeks to replicate the price performance of the underlying physical commodity it represents. Futures exchanges are centralized marketplaces that bring buyers and sellers together in a transparent environment. By virtue of standardization, market participants have the ability to hedge, invest, speculate, and arbitrage liquid contracts on a variety of commodities.
Futures markets also remove credit risk from buyers and sellers. Upon execution of a futures trade, the exchange clearinghouse becomes the buyer for the seller and the seller for the buyer. The exchange manages performance risk by the use of margin. The exchange requires each market participant to post margin for each transaction.
The futures business has a language all its own. Those who plan to get involved in this exciting and fast-paced environment need to understand the terminology. Here is a list of some of the key terms and concepts when it comes to trading futures contracts.
This refers to the amount or quantity of the commodity represented by each futures contract. For example, standard COMEX-CME gold futures contracts represent 100 fine troy ounces of gold. A standard NYMEX-CME crude oil futures contract represents 1,000 barrels of crude oil. Standard ICE world sugar contracts represent 112,000 pounds of sugar. Each exchange publishes contract size for all listed futures contracts on its website.
Contract value is the current price of the futures contract multiplied by the contract size. If gold is trading at $1200 per ounce, then the contract value for one COMEX-CME gold futures contract is $120,000 ($1200 x 100).
Tick size is the minimum price fluctuation for a futures contract. Different futures contracts have different tick sizes. For example, in COMEX-CME gold the tick size is 10 cents per ounce. In NYMEX-CME crude oil, the tick size is 1 cent per barrel.
Tick value is tick size multiplied by the contract size for a particular futures contract. In the gold example, the tick value would be $10 or the tick size, 10 cents multiplied by the contract size 100 ounces.
In some commodity futures, the exchange imposes a circuit breaker for very volatile periods for purposes of controlling price risk and margin flows. In the live cattle futures market on the CME futures contracts have a daily limit of 3 cents per pound. Since the contract size of a live cattle futures contract is 40,000 pounds once a contract value moves by $1,200 in a day trading stops.
Futures trade for a variety of months. The exchange sets the months for each contract with input from the underlying industry. A letter represents each month:
First notice day
Since many futures contracts have a physical delivery mechanism, this is the first day in which the owner of a futures contract may be required to take physical delivery of the underlying commodity.
Pit Trading Hours
Today, very few futures trade in pits, with brokers and traders executing orders. Pit trading hours are the times that the exchange is open for active business.
Electronic Trading Hours
Today most trading takes place on the exchange's electronic platform. Electronic trading hours are the times that the contracts are available for buyers and sellers to transact on that platform.
Basis is the differential between the cash price for a physical commodity and its nearby futures price. Basis is generally a term used by those in the agricultural commodity business.
Convergence is the process of futures prices gravitating to the same level as cash prices for a commodity as the futures contract moves through first notice day into the delivery period. The success of futures markets depends on the effective convergence of futures prices and the cash commodities they represent as a futures contract expires.
Futures exchanges provide an investment and trading platform that is exciting and volatile. Futures differ from many other financial products and assets due to the high degree of leverage offered by these vehicles. Before you dip a toe into the world of futures, make sure you do your homework and understand all of the risks as well as the terminology in this area of trading and investing.