Entering the world of futures can be quite overwhelming for novice traders. The terms leverage, margin, and expiration date alone can intimidate someone. Yet, learning those basic terms is the first step to understanding the market. Whether you are beginning futures trading or going into more advanced avenues like futures options trading, understanding the basics will allow you to trade with greater confidence and precision.
This article aims to categorize the core terms and concepts every beginner should know before jumping into futures markets.
What's Futures Trading?
In essence, futures trading means buying or selling contracts that obligate the parties to exchange an asset at a certain price at a determined future date. Such contracts are traded in regulated exchanges, thus guaranteeing transparency and standardization.
The underlying asset can be a commodity such as oil or gold or may also include stock indices, currencies, or even cryptocurrencies. Futures are bought by hedgers looking to protect themselves against price changes and are sold by speculators aiming to get profit from these changes.
For example, should a trader believe that crude oil prices will rise, he or she would buy a crude oil futures contract. This contract is profitable for them should prices rise by expiration. The very ability to act upon speculations makes futures trading an exciting and profitable field for traders.
Key Terms Every Beginner Should Know
Before jumping into futures trading for beginners, it’s essential to understand the common terminology used in this market. Let’s break down the most important ones:
1. Futures Contract
Futures contracts refer to standardized agreements of purchasing or selling an asset, at a default price and at a future date. Each contract specifies the quantity, quality, and delivery details of the underlying asset. Traders buy or sell these contracts in order to speculate or hedge against price movements.
2. Long and Short Positions
Going long is the buying of a futures contract in expectation of a rise in prices. On the other hand, going short entails selling a futures contract in anticipation of a price decline. Those positions form the basis of virtually all futures trading strategies.
3. Leverage
The leverage of futures trading refers to the fact that only a small fraction of the total contract value, called margin, must be deposited to open a trade. In this way, a trader can control a large position with only a small amount of capital. However, leverage magnifies gains as well as losses, so it cuts both ways.
4. Margin and Margin Calls
Margin refers to the minimum amount of money that a trader must deposit with a broker to open or maintain a position in a given future. If the market goes against a trader, their broker can throw a margin call at them, asking for a deposit to keep the position open. Managing margin is one primary skill all beginners need to master while learning futures trading.
5. Tick Size and Tick Value
A tick represents the minimum incremental price movement that can ever occur in a futures contract. Each contract has a certain tick size and tick value. To illustrate, if gold futures have a tick value of $0.10 and each tick of $10, then the $1.00 price change amounts to $100 in value. By understanding tick values, traders are better able to project their possible profits and losses.
6. Expiration Date and Settlement
An expiration date is assigned to all futures contracts and refers to when the contract reaches its deadline for settlement. Settlements can happen in either of the two ways:
Physical delivery: This involves the actual delivery of the asset (common in commodity deals).
Cash Settlement: This refers to the profits and losses being credited in cash (Common in financial futures).
7. Hedging vs. Speculation
In futures trading for beginners, this distinction is very important. Hedgers use futures to defend against discouraging movements in prices (for example, a farmer locking in a wheat price before harvest). Speculators, on the other hand, use futures in an attempt to profit from expected price movements.
Introduction to Futures Options Trading
After having learned about regular futures, new traders are often interested in futures options trading, which is a more flexible and risk-managed way to trade futures.
A futures option gives the holder the right, but not an obligation, to either buy (the call option) or sell (the put option) a futures contract at a specified price prior to expiration. In this respect, futures options deviate from futures because the worst loss is restricted to the premium paid for the option, but the profit potential could be immense.
Supposing you bought a call option on crude oil futures with a view that prices were going to rise and they did, you could then either exercise your right or sell your option. Conversely, if crude oil prices dropped, your maximum loss was the premium that you had paid.
Common Concepts in Futures Trading
1. Open Interest and Volume
Open interest is the total number of futures contracts that remain unfulfilled. Volume means the number of contracts traded in a given period.
2. Mark-to-Market
Futures market positions are marked to market at the end of each trading day. This means that each day's profit or loss is calculated and transferred to your account.
3. Volatility
The term volatility means the degree to which a market experiences price fluctuations. With high volatility come present opportunities for great profits as well as high risk. A good number of futures options trading strategies are designed to take advantage of volatility, as opposed to price direction.
Final Thoughts
Before risking real capital, it is necessary to know the key terms and concepts of futures trading for beginners. These fundamentals form the backbone of each successful trading strategy; from knowing how leverage and margin work to appreciating volatility and contract specifications.
When you are ready, you can move on to futures options trading, which offers even greater flexibility and control over risk.