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Investing Basics: Futures

A futures contract is an agreement to buy or sell a specific amount of a commodity or

financial instrument at a specific price on a specific date in the future.

To help you understand why businesses and individuals trade futures, let's examine

how futures contracts can be used, the key components that make up a contract, and how

much it costs to trade a futures contract.

One use of a futures contract is to allow a business or individual to navigate risk

and uncertainty.

Prices are always changing, but with a futures contract, people can lock in a fixed price

to buy or sell at a future date.

Locking in a price lessens the risk of being negatively impacted by price change.

Let's look at how this might work for businesses using the coffee industry as an example.

If the price of coffee beans goes down, it's good news for coffee shops but bad news for

coffee farmers.

However, if the price of coffee beans goes up, the tables turn.

With coffee bean futures, both coffee producers and coffee users are able to lock in prices

ahead of time.

Now let's look at how this might work for individuals.

Say you're looking to buy a new home in a year, and you're afraid interest rates

might rise and increase your mortgage payment.

You could offset a potential interest rate increase by trading interest rate futures

such as the 30-Year U.S. Treasury Bond, or 10-Year Treasury Note, depending on your time

horizon.

A second use of futures contracts is to allow traders to speculate on the price movement

of commodities, currencies, stock market indices, and other assets.

For example, consider the fluctuations in the price of a commodity like gold.

A futures trader can potentially profit by correctly guessing the direction that the

price of gold will move.

But if the futures trader guesses wrong, he can lose his entire investment and more.

Now that you know how a futures contract is used, let's look at five key components

of a contract.

These are also known as standard contract specifications.

First, there's trading hours.

Futures markets are open virtually 24 hours per day, 6 days per week; however, each product

has its own unique trading hours.

Next, each contract specifies the tick size.

Tick size is the minimum price increment a particular contract can fluctuate.

Tick sizes and values vary from contract to contract.

A third standard component is contract size.

Each commodity or financial instrument has a standardized contract size that doesn't

change.

For example, one contract of crude oil always represents 1,000 barrels.

One contract of gold futures represents 100 troy ounces.

And one contract of E-Mini S&P 500 futures represents $50 times the price of the S&P

500® Index.

Another component is contract value, which is also known as notional value.

This is the current market value of the commodity represented in a futures contract.

To calculate this, multiply the size of the contract by the current price.

As you just learned, the E-mini S&P 500 contract is $50 times the price of the index.

If the index is quoted at 2,250, the value of one E-mini contract would be $112,500.

Finally, there's delivery.

Contracts are either financially settled or physically settled.

Financially settled futures contracts expire directly into cash at expiration.

This includes products like the E-mini S&P 500 index future.

Physically settled futures contracts expire directly into the physical commodity.

This includes products like crude oil.

For example, anyone long a contract in crude oil at expiration will receive 1,000 barrels

of crude oil.

However, don't be worried about 1,000 barrels showing up at your front door.

TD Ameritrade Futures & Forex LLC does NOT allow clients to take physical delivery, you

are required to close the position before the delivery date, and if you don't, it'll

be closed for you.

You can find more information about contract specifications on the TD Ameritrade website.

Now, to understand how much it costs to trade a futures contract, let's look at an example.

Suppose a crude oil futures contract is trading at $50.

At this price, 1,000 barrels of crude oil would cost $50,000.

But, a trader doesn't actually have to come up with this amount.

With a futures contract, a trader could control the $50,000 worth of crude oil with just a

small deposit.

This deposit is called the initial margin requirement, and it refers to the minimum

amount of funds a trader needs to enter into a futures contract.

The initial margin requirement is set by the exchange and subject to change, but in our

example we'll say that to purchase one crude

oil futures contract, the trader had to put up $3,000 for margin to control nearly $50,000

in oil.

As you can see, futures can allow you to leverage a relatively small amount of capital to control

a larger underlying asset.

Because of this leverage, small changes in the price of the underlying asset have a much

larger impact on the futures contract.

Keep in mind that although leverage allows for strong potential returns, it can also

result in significant losses.

And if losses are substantial, you will have to add more money to cover losses.

Now you know how futures contracts can be used, what the contract specifications are,

and how much a futures contract costs.

If you're interested in learning more about futures, it's important that you expand

your investing education before you make investments.

But we're here to help.

Visit the TD Ameritrade website for more helpful resources and to continue learning.