A basic introduction to futures trading basics

Like all investment activities, futures trading involves speculation. As the term implies, futures traders gamble on future commodity prices. Fund raising is the fundamental objective of stock exchanges. By contrast, risk transference is the motivation for futures transactions.

Futures buying entails executing a formal commitment to purchase goods for a fixed price at some subsequent time. Most futures buyers never assume actual possession of any products, however. Futures trades are purely pecuniary.

Anatomy of a futures transaction

On August 23, 2011, Novice Investor buys a contract for 5,000 bushels of Russet potatoes at $2.00 per bushel. Delivery is scheduled for September 30. Investor liquidates his position on September 15 by reselling the contract for $2.25 per bushel.

Thus, Investor’s gross profit is 25 cents per bushel – a total gain of $1,250.00 for 23 days of ownership.

The long and short of futures trading basics

Futures positions may be either “long” or “short.” These terms respectively denote buying or selling contracts. Long positions profit only if a commodity’s price increases during the holding period. Commodity distributors often buy futures to hedge against rising prices. Investors initiate such trades to profit from anticipated price increases. Short positions profit only if commodity prices ultimately decrease.

Standard conventions

Futures contracts feature standardized terms designed to custom-fit the needs of market participants. Quality, quantity, and delivery data are preset. Price is the only negotiable term and is established via organized exchange venues. Such standardization allows futures contracts to be traded just like liquid financial instruments.

Futures trading requires nerves of steel and is not for the feint of heart. Highest trading volume often originates from investors with preexisting connections to particular commodities. Produce distributors or petroleum product suppliers that take long positions are apt illustrations of futures trading basics.