What a futures contract is

The word "futures" sounds like something only banks and farmers deal with. In truth, the idea is simple. A futures contract is an agreement to buy or sell something at a set price, and it trades on an exchange where anyone with an account can take either side.

In this lesson I'll explain what you are actually trading when you trade NQ or MNQ. Once this clicks, the rest of the course will make a lot more sense.

A standard contract on an exchange

CME Group describes a futures contract as a legally binding agreement to buy or sell a standardized asset. The key word is standardized. Every contract for a given month has the same size, the same tick, and the same expiration date. The only thing that changes is the price, which buyers and sellers set by bidding and offering.

That sameness is what makes futures easy to trade. You never haggle over the details. One MNQ contract is the same as every other MNQ contract for that month, so you can get in and out quickly.

Index futures settle in cash

Some futures end with real goods changing hands, like oil or corn. Stock index futures work differently. Nobody delivers a basket of 100 stocks. Instead, when a contract expires, CME says open positions are cash-settled to a final price based on the index.

For a day trader this rarely matters, because you close every trade the same day. Still, it is worth knowing. You can't wake up owning a truckload of anything.

Long and short are equally easy

When you buy a contract, you are long. You make money if the price rises and lose if it falls. When you sell first, you are short. You make money if the price falls and lose if it rises.

With stocks, going short often means borrowing shares and dealing with extra rules. With futures, selling first is just as simple as buying first. You click sell, and you're short. That two-way setup suits day traders, because markets can fall as well as rise during a session.

Central clearing

Who is on the other side of your trade? You don't need to know. CME notes that every exchange-traded futures contract is centrally cleared. The exchange's clearing house becomes the buyer to every seller and the seller to every buyer. So you are not relying on a stranger to pay up when you win.

The clearing house also marks every account to the market at the end of each day. Gains are added and losses are taken out. That is part of why margin, which we cover in lesson 5, works the way it does.

Why day traders use futures

Here are the main reasons I see traders choose index futures:

• Nearly round-the-clock hours. Equity index futures trade from Sunday evening to Friday afternoon, with a short daily break.
• No pattern day trader rule. That old $25,000 rule for stock margin accounts has been replaced, and it never applied to futures anyway.
• Easy shorting. As above, selling first is as simple as buying.
• Simple math. Each point is worth a fixed dollar amount, so you always know your risk.

None of this makes futures easy to profit from. They are leveraged, and the CFTC warns that people can be required to pay more than they invested initially. Most people who day trade lose money. Learn the mechanics first, and practice in a simulator before real money is involved.

The takeaway

A futures contract is a standard agreement traded on an exchange and guaranteed by a clearing house. Index futures settle in cash, and going short is as easy as going long. Those features are why day traders like them, and also why the risk is real.

Do this today

• Read CME Group's short definition of a futures contract and write it in your own words.
• In a simulator, place one buy and one sell on MNQ and watch how each position gains or loses as price moves.
• List two ways shorting a futures contract differs from shorting a stock.

Check yourself

Answer each one in your head, then open it to check.