Trading Futures Contracts: How Does it Work?

In this article, we will discuss in detail about how futures contracts are traded.

The futures contracts are traded on futures exchange, and the trading happens in to ways: 1) Pit trading, and 2) Electronic screen or terminal.

Pit Trading

Also known as floor-based trading, in this method, the traders stand in a pit (trading floor) and shout and place their orders. They make use of shouting and hand signals to buy and sell futures contracts. there are different hand signals to indicate things such as bid rate, offer rate, number of contracts, etc.

Pit trading is the traditional form of trading and is a physically and mentally strenuous activity.

Electronic screens or terminals

This is the newer form of trading where the traders/members of the exchange place their orders through a computer terminal, the orders are displayed and executed electronically.

In most countries electronic trading is completely replacing pit trading, for example, in france most trading happens electronically. In the United States, however, both pit trading and electronic trading are popular.

How a Trade Works?

A trader can take either a long or a short position in a futures contract. When a trader takes a long position, he is entering into an agreement to buy the underlying asset at the pre-agreed price. Similarly, when a trader takes a short position, he is agreeing to sell the underlying asset at the pre-agreed price.

Each position requires the trader to keep a small deposit with the clearinghouse known as the margin money. This margin money is a certain percentage of the value of the trade. This is also called margin trading. The traders positions are marked-to-market on a continuously and margin account is adjusted for and profits or losses. Any profits are added to the margin account, and any losses are deducted form the margin account.

The futures contracts can be settled in different ways. Before the expiry of the futures contract, the trader can take an offsetting position in the same contract and thereby closeout the futures position. For example, if he is long a futures contract, he can take a short position in the same contract, which will closeout his long position. Futures contracts are fungible which means that any futures contract can be closed out by any other futures contract. It's not necessary that the counterpart is the same.Even though the trader now has a long and a short position, the clearinghouse considers that there is no remaining exposure.

Alternatively, the trader can let the futures contract expire, in which case it will be settled by physical delivery or through cash settlement.