The Basics of Futures Trading

Margins

Perhaps the biggest advantage to trading futures contracts is the leverage provided by the exchange. However, controlling large contracts with relatively low amounts of capital can create high levels of volatility. As a result, many traders will argue that leverage is actually a disadvantage. Regardless of your opinion on leverage and margin requirements, it is important that you fully understand the concepts.

Before a customer can establish a position he is required to make a minimum “good faith deposit”, or margin, to assure the performance of his obligations. A margin deposit is in essence a performance bond, which is usually between 5% and 10% of the underlying contract value. A good faith deposit indicates the buyer or seller’s willingness and capability to compensate the opposite party to a transaction.

Because margin requirements are low, hedgers are given the ability to lock in pricing of cash market goods without tying up a lot of capital. It would be counter productive for a hedger who handles large quantities to put up 100% of the value of the hedged commodity. The exchange grants margin discounts to those that are deemed to be “bonefied” hedgers, due to the fact that the underlying cash position is seen as collateral to secure the capital risked in the futures market.

Low margins make speculation in the futures markets very attractive, without the advantage of leverage the rate of return on most commodities would be marginal. The exchanges are responsible for setting margin requirements, but brokerage firms have discretion to require higher deposits. Generally, the initial margin is sufficient to cover the maximum daily price fluctuations. It is not uncommon for margin requirements to fluctuate with the volatility of the market. A maintenance level is established below the initial margin, usually 75% of the initial margin. Once a traders good faith deposit falls below this threshold additional funds must be deposited or positions must be liquidated. This is known as a margin call.

Orders

There are several types of orders that can be placed. In order to maximize efficiency and profitability traders must be comfortable in executing each of the following options.

Market Order: The purpose of a market order is to execute a trade immediately at the best possible price. Such orders give traders the ability to enter or exit a trade quickly, but do not guarantee a favorable price. This order should be used when time is more valuable than price.

Limit Order: Limit orders are used to buy or sell at a specified price or better, and will only be filled at the state price or one that is more favorable. For a sell limit order “ better” means higher, for buy limit orders “better” means lower.

Stop Order: This type of order is usually placed to close a position; its name is derived from the fact that if placed properly will “stop loss” should the market go against a trader’s position. Most traders chose to place a stop order at the time that they enter a position. By definition a sell stop will be placed below the market while a buy stop will be placed above.

All orders are day orders unless specified otherwise and are canceled at the end of the trading day. By entering the order GTC (good ‘til canceled), the order will be working in each trading session until canceled by the trader.

Execution

Many beginning traders are unaware of the mechanics of executing a futures trade. When you call your broker, an order ticket is completed and time stamped in order to keep accurate track of the time and specifics of each order. The broker then transmits the order to his firm’s trading desk located on the floor of the exchange either by a computerized trading platform or by phone. The order clerk then fills out an order card; time stamps it and hands it to a runner who will take it directly to a broker in the pit. The pit broker will execute the order by open outcry and record the execution on the card before it is given back to the runner. The runner takes the executed order back to the desk where the order clerk time stamps the card one more time before the fill is reported to your broker.

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