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- The Basics of Futures Trading & Commodity Trading: Education
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These are contracts signed by two parties for trading a stock asset at a predetermined price on a later date. Such contracts try to hedge market risks involved in stock market trading by locking in the price beforehand. Future and options in the share market are contracts which derive their price from an underlying asset known as underlying , such as shares, stock market indices, commodities , ETFs , and more.
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Futures and options basics provide individuals to reduce future risk with their investment through pre-determined prices. However, since a direction of price movements cannot be predicted, it can cause substantial profits or losses if a market prediction is inaccurate. Typically, individuals well versed with the operations of a stock market primarily participate in such trades.
Future and option trading are different in terms of obligations imposed on individuals. While futures contract holds the same rules for both buyers and sellers of a contract, an options derivative can be divided into two types. Individuals entering an options contract to sell a particular asset at a pre-asserted price on a future date can do so by signing a put option contract.
Similarly, individuals aiming to purchase a particular asset in the future can enter into a call option to lock in the price for future exchange. Traders engaging in future and option trading can be classified into the following types. Such individuals enter into futures and options contracts in the share market to reduce investment volatility concerning price changes.
Locking in a price for transaction at a future date helps individuals realise relative gains if the price moves adversely with respect to a trading position assumed by a buyer. However, in case of a favourable fluctuation, individuals entering into a futures contract can incur significant losses. Such risk is mitigated in an options contract, as an investor can pull out of a deal in case of favourable price swings.
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Hedgers aim to secure their gains or expenditures in the future by entering into a derivative contract. Such traders are popular in the commodity market, wherein individuals try to secure an expected price of a particular item for a successful exchange. You either need to bring in fresh margins or your broker will compulsorily cut your positions.
This is true of all leveraged positions. While trading in Futures and Options , your primary focus is that of a trader and not as an investor. Therefore, your accent should be on protecting your capital. That is possible only if you define your loss and profit trade-off for each trade. These costs add up. If you sit down and add these up, you first need to get a perspective. You can trade options even when you are not sure of direction of market.
You can combine options and futures to trade markets where you are not sure of the direction. Options can be used to profit in volatile markets and in lacklustre markets. These aspects of options are more meaningful to you than using options as a substitute for trading in equities. A proper understanding will surely help you make better use of these innovative financial products!
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The original use of futures contracts was to mitigate the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions. This could be advantageous when for example a party expects to receive payment in foreign currency in the future, and wishes to guard against an unfavorable movement of the currency in the interval before payment is received. However, futures contracts also offer opportunities for speculation in that a trader who predicts that the price of an asset will move in a particular direction can contract to buy or sell it in the future at a price which if the prediction is correct will yield a profit.
In particular, if the speculator is able to profit, then the underlying commodity that the speculator traded would have been saved during a time of surplus and sold during a time of need, offering the consumers of the commodity a more favorable distribution of commodity over time. The Dutch pioneered several financial instruments and helped lay the foundations of the modern financial system.
The Basics of Futures Trading & Commodity Trading: Education
Among the most notable of these early futures contracts were the tulip futures that developed during the height of the Dutch Tulipmania in The Chicago Board of Trade CBOT listed the first-ever standardized 'exchange traded' forward contracts in , which were called futures contracts. This contract was based on grain trading, and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world.
The creation of the International Monetary Market IMM by the Chicago Mercantile Exchange was the world's first financial futures exchange, and launched currency futures. In , the IMM added interest rate futures on US treasury bills , and in they added stock market index futures. Although futures contracts are oriented towards a future time point, their main purpose is to mitigate the risk of default by either party in the intervening period.
In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. Margins, sometimes set as a percentage of the value of the futures contract, must be maintained throughout the life of the contract to guarantee the agreement, as over this time the price of the contract can vary as a function of supply and demand, causing one side of the exchange to lose money at the expense of the other.
To mitigate the risk of default, the product is marked to market on a daily basis where the difference between the initial agreed-upon price and the actual daily futures price is re-evaluated daily. This is sometimes known as the variation margin, where the futures exchange will draw money out of the losing party's margin account and put it into that of the other party, ensuring the correct loss or profit is reflected daily.
If the margin account goes below a certain value set by the exchange, then a margin call is made and the account owner must replenish the margin account. On the delivery date, the amount exchanged is not the specified price on the contract but the spot value , since any gain or loss has already been previously settled by marking to market. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house.
The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations.
Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value.
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Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available.
Margin calls are usually expected to be paid and received on the same day.
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If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. Some U. The Initial Margin requirement is established by the Futures exchange, in contrast to other securities' Initial Margin which is set by the Federal Reserve in the U. A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in their margin account. Margin-equity ratio is a term used by speculators , representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader.
The broker may set the requirement higher, but may not set it lower.