Futures Trading

Commodities trading has always traditionally relied on the futures market to allow traders to buy and sell commodities. While some traders are buying on behalf of end users, like airlines which need to secure future oil supplies at a specific price, many represent speculators, whether they be banks, hedge funds, or wealthy individuals. Futures exchanges, like the famous Chicago Mercantile Exchange, publish prices on what are called 'exchange traded contracts', namely a specific, tradable futures contract, that will expire at a specific date.

A good example is the Brent Crude futures contract, traded on the ICE exchange in London. This is one of the most closely followed oil futures contracts, and is priced in US dollars. There is a different Brent futures contract for each month of the year. Hence, you may hear commodity brokers or analysts talk about 'June Brent', meaning the June delivery contract for Brent crude oil. In the case of the Brent futures contract, it expires on the 15^th day of the month before the delivery month. A June contract, for example, would expire on the 15^th of May.

Commodity brokers and traders generally won't want to still be holding a commodity futures contract when it expires, as they would need to clear some space in their garage for all those barrels of oil that will turn up! Whoever holds the contract at expiry date is going to take delivery.

Commodity trading with futures is quite expensive for the private investor, as the minimum contract sizes on exchanges are substantial. Some exchanges are introducing smaller minimum lot sizes in an effort to make futures trading more accessible for private investors (e.g. the e-Mini futures introduced by the Chicago Mercantile Exchange), but for the UK-based investor, the best way to trade futures is via a spread bet.

A spread bet is tax free, lets the trader use margin (borrowing most of the value of the trade from the spread bet company), and does not require the same levels of cash to open a trade that  commodity brokers would require. Many spread bets will be based on futures contracts. You will usually see on your trading screen the next one or two futures contracts on each commodity that is being priced.

Commodities are not all produced as regularly as oil, of course. Some are dependent on harvests and seasonal factors for their delivery. The ICE coffee futures contract is priced for delivery in March, May, July, September and December.

Prices for the different contracts will be affected by a range of factors, and while your spread bet provider may only quote you the next two contracts, it is sometimes worth keeping an eye on what is happening further out in the trading range to see where the market is expecting prices to go. If prices further out are higher, then commodity brokers are obviously expecting prices to climb, and the market is looking 'bullish'.

Futures are also based on indices, including the big stock market indices like the Dow Jones Industrial Average or the FTSE 100. Called 'index futures', these contracts are often used by big money managers and investors to hedge their risks in the share markets. Gains in the futures markets can help to off-set losses in physical share portfolios. Again, these markets are cheaper to trade using a spread bet or contracts for difference (CFD Trading) account. You get all the price action from the futures markets without having to commit a small fortune in trading capital – unless you want to, of course!

Index futures are mostly based on stock market indices, but there are some other indices like the VIX, the volatility or 'fear' index, which are not based on the performance of share prices. In the case of the VIX, it is powered by option trading activity in Chicago, and reflects how much volatility the market is expecting in the near future. It tends to spike during periods of extreme market uncertainty, as we saw in March after the Japanese earthquake and tsunami.

Beyond commodities and indices, many other spread bet and CFD prices are determined by underlying futures prices. They may not precisely track these markets, but their overall movement will be similar.

Other markets include futures based on the price of government bonds, particularly the larger markets like US 10 year Treasury bills or Japanese government bonds (JGBs). There are even some futures contracts based on the prices of shares in major companies, and big futures exchanges are adding more companies all the time. For the spread bet or CFD trader, it helps to know what prices are driving the prices of the positions you are taking, and to keep any eye on what is happening to the prices of futures contracts further out than the next couple of contracts to expire.