How to Trade Futures

Just landed here? Start at the beginning of this futures trading course.

Now that we have a basic understanding of the purpose of futures markets and how they operate we can talk about how one actually trades futures contracts. The title of this lesson isn't in reference to the very open-ended question of trading strategies.  Instead, it's in reference to the actual steps of opening and closing a position in the market.

Simply put, trading futures consists of choosing how to enter the market and then placing the order to do so.  After entering the market, the trader will then exit the market after a period of time - hopefully at a profit.  

 

Going long and short

To understand how to trade futures you must banish some preconceived notions from your mind, especially if you have already been influenced by stock trading. 

As a futures trader you can profit from selling or buying contracts in any order, neither action is superior to the other at face value.  You must look at buying and selling as equal sides of the same coin.  In  order to open a futures contract there must always be one buyer and one seller as mutual parties to the agreement.  Remember that we are not talking about buying or selling an asset here, as in the exchange of a stock certificate.  We are talking about two parties entering into an obligation - a contract. 

Long and short are terms used to describe a trader's position in the market.

A futures trader who is long has bought a futures contract and a trader who is short has sold a contract.  Naturally, the trader with a long position will stand to gain if prices rise and a short position will gain if prices fall.  In other words, long is synonymous with buy and short is synonymous with sell. 

After a trader enters the market by going long or short, they would exit the market by taking the opposite position, in which case they would become "flat", meaning they have no position in the market.  The price movement between this entry and exit would of course determine profits or losses.

The idea of buying a contract at a certain price, then waiting for prices to rise, and finally selling the contract for a profit is easy for most to understand.  This is the "buy low, sell high" mentality that many have learned from the stock markets.  However, going short and profiting from falling prices is an equally viable position, yet it is an idea that is foreign to many people. 

A "Short" Example

The fact is, you have doubtless entered into such "short" agreements yourself in ordinary life.  When you contract with a homebuilder, this builder has not yet produced a house, but has promised to deliver it at a certain price and at a future date - he therefore holds a short position and you hold a long position.  If his cost of producing the house falls in the meantime, then the builder would profit from the bargain.  The same is true if you order a car from a dealer that he doesn't have in stock.  The dealer is "short" one vehicle and you are "long" one vehicle.  If the material and operational costs of manufacturing this vehicle decline in the meantime, then the dealer stands to profit from the arrangement.  But, if the production costs rise, then the you will have profited from the deal because you contracted to buy the vehicle much cheaper than it will cost in the future.  This is the concept of opportunity cost, which is at the heart of all futures trading.

Open outcry and electronic trading

Regardless of whether you choose a short or long position, entering the market is accomplished in the same way - by placing an order in an open outcry market or the electronic market.

One of the iconic images of futures trading is that of floor traders in a circular pit, with fists full of orders from brokerage houses, shouting and yelling specialized jargon in a furious fashion. This is called open outcry.  Open outcry was the standard way of transacting futures contracts on the the exchange floor for well over a century.  After a trader gave an order to a broker, the order would be passed along to a floor trader who added it to a handful of already existing orders.  The floor trader would then trade this bulk collection of orders with other floor traders via the open outcry method.  But, this pit trading method has all but disappeared. 

 

In the last decade electronic trading has virtually supplanted open outcry.  At first there was a trasitional period whereby contracts were traded on an electronic basis alongside the traditional pit method.  This was called side-by-side trading.  Now, the trading of many contracts is conducted solely on an electronic basis.  The reasons for this are obvious - more accurate and efficient order entry, more efficient data collection, and reduced overhead costs. 

With electronic trading, a trader enters an order via an online trading platform and this order is then entered into the exchange's electronic trade matching platform.  Once inside this exchange platform, the trade is quickly filled by matching it with an acceptable buyer or seller.  Two of the benefits of electronic trading are near instant order execution and fill confirmation.  Electronic trading also gives traders instant access to trading volume and bid/ask data, which reveals the "depth of market", something that was previously only discernible to floor traders. 

It's important to understand that the transition to electronic trading hasn't necessarily changed how the markets or prices behave (though algorithmic trading probably has).  Electronic trading is simply a more efficient means of entering and executing orders.