A futures contract is a commitment to deliver or
receive a standardized quantity and quality of a commodity (or financial
instrument) at a specified future date. The price associated with
this trade is the trade entry level.

• The futures contract is standardized
  - this means the farmer doesn’t have to find a specific buyer.
• The transaction can be executed nearly instantaneously
  with a one-line phonecall order (e.g. “Sell 2 March grain
  at the market”).
• The cost of the trade (commissions) is minimal
  compared with the cost of an individualized forward contract (ie.
  if the farmer were to sell to one specific buyer in the future
  via a “contract”).
• The farmer can offset his sale at any time between
  the original transaction date and the final trading day of the
  contract (the reason why he’d want to do this will be discussed
  shortly).
• The futures contract is guaranteed by the exchange.

Until the early 1970’s, futures markets were restricted to commodities
such as wheat, sugar and copper. Three additional market sectors
have been added to the futures area since then: currencies,
interest rate instruments, and stock exchanges.
The same basic principles apply to these non-commodity futures markets.
Trading quotes (futures contract prices) represent prices for a
future expiration date, as opposed to current market prices. These
new financial markets have witnessed spectacular growth since their
introduction and account for approximately two thirds of all trading
volume. In this sense, futures appear to be a far more appropriate
designation than commodities, although the term “commodities”
is still often used when referring to futures (they are considered
synonymous).

Delivery

Shorts who maintain their positions after the last trading day are obligated to deliver the actual commodity (or financial
instrument) against the contract. Similarly,
longs who maintain their position after the last trading day must accept delivery.
In the commodity markets, the number of open long contracts is always equal to the
number of open short contracts (see the Volume & Open Interest section). Most
traders have no intention of making or accepting delivery, and hence will offset
their positions before the last trading day. (Longs offset their position by entering
a sell order, shorts by entering a buy order).

Only a very small fraction of open contracts actually result in delivery. Since
the early 1980s, there has been a strong settlement toward using a cash settlement
(ie. outstanding long and short positions are offset at the prevailing price level
at expiration) instead of a delivery procedure. Most financial contracts and some
commodity-type markets use cash settlement.

Volume & Open Interest

Volume is simply the total number of contracts traded
on a given day. Volume figures are available for each traded month in
a market, but most traders focus on the total volume of all traded
months.

Open interest is the total number of outstanding long
contracts, or equivalently, the total number of outstanding short contracts.
In futures markets, the two are always equivalent. When a new contract
begins trading (normally about 9 – 18 months before its expiration date),
its open interest is equal to zero. If a buy order and sell
order are matched, then the open interest increases to 1. Basically,
open interest increases when a new buyer purchases from a new seller,
and decreases when an existing long sells to an existing short. The
open interest will remain unchanged if a new buyer purchases from an
existing long or a new seller sells to an existing short.

Volume and open interest are very useful as indicators
of a market’s liquidity. Not all listed futures markets are actively
traded. Some are virtually dead, while others are borderline cases in
terms of trading activity. Illiquid markets should be avoided,
because the lack of an adequate order flow will mean that the trader
will often have to accept very poor trade execution prices if he wants
to get in or out of a position.

The breakdown of volume and open interest figures by contract
month can be very useful in determining whether a specific month is
sufficiently liquid. For example, a speculater wishing to enter a long
position may prefer the futures contract with an expiration date nine
months forward, as opposed to more nearby contracts, because he believes
the forward position is relatively underpriced. The most important reservation
about trading the more distant contract would be whether its level of
trading activity was sufficient to avoid problems related to illiquidity
(poor execution prices). In this case, the breakdown of volume and open
interest figures by contract month can help the speculator decide whether
its reasonable to enter a position in the more forward contract or if
its better to restrict trading to the nearby positions.

Contract Specifications

Futures are traded for a wide variety of markets on a
number of exchanges both in the United States and abroad. Although we’ll
not provide a full list of available futures markets and their exchanges,
an example market will be provided:

(…continued)

1. Exchange

The exchange is where the market is being traded. In this case we have
wheat being traded on the Chicago Board of Trade (CBT).
Among the other US futures exchanges are the Chicago Mercantile Exchange
(CME), New York Futures Exchange (NYFE) and the Financial Instruments
Exchange (FINEX) to name but a few. Foreign exchanges include the Deutsche
Terminboerse (DTB), International Petroleum Exchange of London (IPE),
Marche a Terme International de France (MATIF).

2. Trading Hours

As indicated, trading hours are listed in terms of the local times
for the given exchange (All US exchanges are currently located in either
the Eastern or Central time zones).

3. Contract Size

The specification of a uniform quantity per contract is one of the
key ways in which a futures contract is standardized. By multiplying
the contract size by the price, you can determine the dollar value of
the contract. For example, if wheat is trading at $3.00/bushel (bu.),
the contract value equals $15,000. Although there are a few important
exceptions, roughly speaking, higher per-contract dollar values will
imply a greater reward / risk level. (The concept of a contract has
no meaning in the interest rate markets).

4. Months Traded

The code for the monthly symbols is shown in the table above. Each
market is traded for specific months. For example, corn is traded for
March, May, July, September and December. The last trading day for a
contract will occur on a specified date in the contract month or, in
some cases, the month preceding the contract month. For most markets,
futures are listed for contract months at least one year forward from
the current date. However, trading is usually heavily concentrated in
the nearest one or two contracts.
5. Price Quoted In

Indicates the relevant unit of measure for the given market.

6 . Minimum Fluctuation

This column indicates the minimum increments in which
prices can trade. For example, the minimum fluctuation for wheat is
1/4 c/bu.. This means you can enter an order to buy December wheat at
$3.01 1/2 or $3.01 3/4, but not $3.01 5/8 per bushel.

7. Value of Minimum Fluctuation

This figure is obtained by multiplying the minimum fluctuation
by the contract size. For example, for wheat, 1/4 c/bu. x 5,000 = $12,50.

8. Maximum Daily Limit

Exchanges normally specify a maximum amount by which the
contract price can change on a given day. For example, if the December
wheat contract closed at $3.10 the previous day, and the daily price
limit is 20c/bu., wheat cannot trade above $3.30 or below $2.90. Some
markets employ formulas for increasing the daily limit of a specified
number of consecutive limit days.
This has quite a profound effect upon us as traders: In
cases in which free markets would normally seek an equilibrium price
outside the range boundaries implied by the limit, the max-limited futures
market will simply move to the limit and virtually cease to trade. For
example, if after the market close the U.S. Department of Agriculture
(USDA) releases a very bullish wheat crop production estimate, which
hypothetically would result in an immediate 30c/bu. price rise in an
unrestricted market, prices will be locked limit up (20c/bu.)
the next day. This means that the market will open and stay at the limit,
with virtually no trading taking place. The reason for the absence of
trading activity is that the limit rule restriction maintains an artificially
low price, leading to a large surplus of buy-orders at that price but
few if any sell orders.
In the case of a very sever surprise event (e.g. sudden
major crop damage), a market could move several limits in succession.
If this occurs, traders on the wrong side of a trade might not able
to liquidate their positions until the market trades freely! The
new trader should be aware of and practice caution to this possibility.
However there’s no need for overly frightened, since such events of
extreme volatility rarely come as a complete surprise. In most cases,
markets vulnerable to such volatile price action can be identified early.
Some examples of such markets would include commodities in which the
USDA is scheduled to release a major report, coffee or frozen concentrated
orange juice during their respective freeze seasons, and markets that
have exhibited recent extreme trading volatility.

9. First Notice Day

10. Last Trading Day

This is the last day on which the positions can be offset
before delivery becomes obligatory for shorts and the acceptance of
delivery obligatory for longs. As indicated previously, the vast majority
of traders will liquidate their positions before this day.

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