Table of Contents
Chapter 1: What is Futures Trading
Chapter 2: How Futures Trading Works
Chapter 3: Futures Terminology
Chapter 4: Importance of Futures Market
Chapter 5: Limitations on Futures Trading
Chapter 6: Factors Affecting Futures
Chapter 7: Who Should Use Futures Trading
Chapter 8: How to Start Trading in Futures and Be Successful
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Chapter 3: Futures Terminology
– Margin
– Liquidation
– Maintenance Margin
– Margin Call
– Price Discovery
– Leverage
– Spot Month
– Limit Orders
– Long and Short Positions
– Spread
Chapter 3: Futures Terminology
For an investor to succeed in futures trading, understanding the various terms used in these contracts is very important. Here is a brief explanation of the terms most commonly used in the futures market.
- Margin
- A futures contract is based on an agreement between two parties to fulfill certain obligations at a given date as well as through the term of the contract. The obligation of both parties is further reinforced by an initial deposit into the futures account to show their commitment to the contract. This is called the margin. This amount is often decided by the exchange where you have entered into the futures contract.
- Liquidation
- When the futures contract term expires, the contract is liquidated. The daily gains or losses are set off against the margins maintained in the account throughout the term of the contract. This means that at liquidity, either party may get back funds equal to, more than or less than the initial margin deposited in the account. The remaining funds in the accounts are paid back to both parties at the end of the contract.
- Maintenance Margin
- As the losses and gains are set off against the minimum margin on a daily basis, there may arise a situation when there isn’t enough money left in the account. The future contract holder is then asked to add funds to the account to enable future setting off of losses. The level below which the account balance is not allowed to fall is referred to as the maintenance margin.
- Margin Call
- A broker makes a margin call on the futures holder when the maintenance margin level falls below the required minimum. The holder must immediately fund his account when he has been issued a margin call.
- Price Discovery
- The price of a commodity is subject to frequent changes due to various factors. Since futures are traded in a global marketplace, changes in any part of the world can affect prices significantly, as supply is affected. The constant changes in the prices of the underlying commodities is termed as price discovery.
- Leverage
- Leverage is the control wielded by the futures holder over a large quantity of the underlying commodity despite investing a small amount of money. The trader pays a fraction of the actual sale price of the commodity to get into a futures contract. If the trade goes as anticipated by the investor, leverage can lead to huge gains and a very high return on investment. But if the prices move in the opposite direction, a trader can suffer huge losses because of the same leverage.
- Spot Month
- The month in which the futures contract expires is called the spot month. Some of the pricing regulations may be relaxed in this period.
- Limit Orders
- Futures traders transacting through brokers may set buy or sell limits on a contract. They may ask the broker to execute a transaction if the price touches a specified trigger level. When such an instruction is given to a broker, it is called a limit order.
- Long and Short Positions
- A futures trade is a deal between two parties, one taking a short position on the underlying asset and the other taking a long position. The seller is in a short position because he anticipates the price to decline. He insulates his investment to offset any loss due to price fall.
In our earlier example, the farmer had a short position because he agreed to sell 100 lbs of coffee at $1 per lb to Starbucks with September as the spot month. His expectation turned out to be incorrect as the price of coffee rose instead of falling. But if the price had fallen, the farmer would have gained from the futures trade.
The buyer is said to have a long position. He protects himself from future increases in price by fixing the purchase price in advance. In the example, Starbucks had the long position and gained from it. The company was insulated against the price increase because of the futures contract.
Speculators who have no interest in the actual commodity but look to make money from price movements also resort to long or short investment positions. A short investor invests in a future of a commodity whose price he expects to fall. When it does, he sells at the pre determined higher price to make a profit. A holder of a long position invests in the future of a commodity he expects to become more expensive. When it does, he buys the commodity at the lower price fixed in the futures contract.
- Spread
- Speculators often resort to ‘spreading’ to lower their risk in a futures contract and to make money on arbitrage opportunities.
This involves:
- Investing in futures based on different commodities
- Investing in futures expiring at different times
- Investing in long positions in some futures and balancing the risk by taking short positions in others
Next Chapter: Importance of Futures Market
