What Are Futures? The Ultimate Beginner’s Guide

Commodity investing has been around for decades, but it was only recently that its popularity has spread to the general public. It is now generally recommended that investors set aside anywhere from 5% to 10% of their capital for a commodity allocation, as these hard assets generally offer uncorrelated returns essential to diversification. While there are a number of funds and stocks that can be used to gain exposure to commodities, futures investing has long been the most popular and direct means of establishing a position [see also Jim Rogers Says: Buy Commodities Now, Or You’ll Hate Yourself Later].

What are Futures?

Futures contracts are agreements to buy/sell an asset  for a set quality and quantity on a specified date, with the price agreed upon today. Think of it as pre-ordering an item; the money exchanges hands immediately even though a product has not done the same. The majority of investors will sell futures contracts prior to their maturity, this is because when a contract expires, it is physically delivered to the owner. So if you own crude oil futures and elect not to sell your position, you are going to have barrels of crude appearing on your doorstep.

Futures contracts were originally utilized by farmers to hedge against poor crop yields or unpredictable weather conditions, but have since been utilized by a growing number of investors. The first futures contract appeared in Japan in the early 18th century and the U.S. saw the introduction of these securities in 1864 with the first offering from the Chicago Board of Trade (CBOT). Many futures contracts offer strong liquidity as well as a hefty volatility that entices those who don’t mind an added bit of risk in their lives. Futures contracts are traded all over the world 24 hours a day with products ranging from big hitters like natural gas and gold, to lesser-known options like pepper and canola oil futures [see also Doomsday Special: 7 Hard Asset Investments You Can Hold in Your Hand].

Who Should Use Futures?

This is an extremely important distinction to make; just because futures are available to everyone does not mean that they are intended for widespread use. In fact, it is safe to say that the majority of investors should not be utilizing actual futures, but may instead choose to use stocks, ETFs, or mutual funds. Futures contracts are only intended for serious investors and traders who fully appreciate their complexities and risks. Owning these contracts requires consistent management and a watchful eye, as a position can unravel in a matter of hours.

Trading futures requires a specific account that is complicated enough on its own, but when you add in the volatility of these contracts and all of the underlying price drivers, it becomes abundantly clear that futures investing is not meant for everyone. For those traders who have done their homework, these securities will offer an enticing play on the commodity world [see also The Ten Commandments of Commodity Investing].

Futures Exchanges

There are a number of trading platforms available to investors, each offering a slew of different commodities and rules to go along with them. Below, we outline a number of popular futures exchanges to help traders decide which will be best for their investing purposes:

  • Chicago Mercantile Exchange (CME): The CME is a financial and commodity derivatives trading platform headquartered in Chicago. Originally founded in 1898 as the Chicago Butter and Egg Board, the CME has one of the largest options and futures line-up of any exchange in the world. The CME offers contracts of all kinds including agriculture, credit, economic events, equity index, FX, interest rates and other futures/options investments. The CME is owned and operates under the CME Group.
  • Chicago Board of Trade (CBOT): Established in 1848, the CBOT ranks as the oldest futures/options trading exchange in the world. The exchange offers more than 50 different futures and option contracts for investors stretching across a number of asset classes. As of 2007, the CBOT operates as a subsidiary of the CME group [see also 50 Ways To Invest In Agriculture].
  • New York Mercantile Exchange (NYMEX): The NYMEX is the world’s largest physical commodity futures exchange, offering exposure to a wide variety of products. Commodity Exchange Inc. (COMEX) also operates as a division of the NYMEX and is best known for offering exposure to various metals contracts. The two divisions joined in late 2006, and were acquired by the CME Group in early 2008.
  • London Metal Exchange (LME): Stationed in the United Kingdom, the LME is a major exchange that offers exposure to futures and options to a wide variety of base metals and other commodity products. Some of the metals traded include aluminum, copper, tin, nickel, zinc, lead, and many more. Though founded in 1877, the exchange can trace its roots all the way back to 1571, when the Royal Exchange in London was opened, only trading copper at its origins.
  • Intercontinental Exchange Inc. (ICE): The Intercontinental Exchange is a U.S.-based company that operates futures and over-the-counter contracts via internet marketplaces. The company was originally focused on energy contracts but has widened its scope by offering exposure to a number of commodities including cocoa, cotton, sugar, iron ore, natural gas, crude products, and much more. The platform is much more focused on just a select few commodities and may be a good fit for traders looking to single out one or two commodities [see also 25 Ways To Invest In Natural Gas].
  • Multi Commodity Exchange (MCX): The MCX is a private commodity exchange based in Mumbai, India. The company was founded in 2003 and ranks as one of the top ten commodity exchanges in the world. Traders can gain access to a number of the usual suspects like gold and silver, but also have the option to trade a number of commodities focused on the Indian economy like pepper, cashew kernel, yellow peas, and a number of other futures that would be difficult if not impossible to find inside U.S. borders.

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Disclosure: No positions at time of writing.

This entry was posted in Academic Research, Asset Allocation, Commodity Futures and tagged , . Bookmark the permalink.

Commodity HQ is not an investment advisor, and any content published by Commodity HQ does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities or investment assets. Read the full disclaimer here.

4 Responses to “What Are Futures? The Ultimate Beginner’s Guide”

  1. [...] One of today’s biggest headlines was the highly anticipated earnings report from Alcoa (AA), which was announced yesterday after the closing bell. The blue-chip aluminum producer reported a quarterly loss, but its adjusted earnings and revenue came in above expectations. In the technology sector, two microchip makers cut their second quarter revenue outlook to reflect weaker industry conditions. As earnings reports keep piling in, markets will likely struggle to find a definitive direction over the course of this quarter’s earnings season [see also What Are Futures? The Ultimate Beginner's Guide]. [...]

  2. [...] Stocks slid into red territory yesterday as a dismal start to earnings season welcomed back the bears on Wall Street. Alcoa’s (AA) quarterly loss didn’t sit too well with investors, while disappointing results and a deteriorating outlook for the semiconductor industry from Applied Materials (AMAT) only added to the list of uncertainties eating away at investors’ confidence. To top it all off, small business confidence in the United States came in worse than expected; the figure dropped to 91.4 compared to last month’s reading of 94.4 [see also What Are Futures? The Ultimate Beginner's Guide]. [...]

  3. [...] is a virtue … especially when trading commodities. Many beginning traders find themselves lacking patience, which can quickly result in higher churn rates, missed [...]

  4. [...] Futures contracts enable buyers to secure the future delivery of a security–usually a commodity–at a specific price on a specific date. These contracts were originally used by commercial entities to protect themselves against price volatility, but they have since evolved into a tool that speculators can also use to bet on future price direction. There are two types of futures: Physical futures involve the actual delivery of the underlying asset to buyers, while cash-settled futures involve settling the differences in cash. [...]

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