What is a futures contract?
A futures contract is a contract for the purchase or sale of a primary instrument with deferred execution. The primary or underlying instrument may be almost anything: stocks, commodities, currencies.
The price of the futures varies depending on the market situation. The buyer and seller of a futures contract assume the obligation to fulfill the contract on the agreed upon date. The value of the asset itself may change by that time, but it cannot affect the terms of the deal.
How does futures contract work?
When a trader enters into a futures contract, they specify the value of an exchange-traded asset and the expiration date on which the contract will be executed. If at the time of expiration of the contract the price of the purchased asset is higher than what the trader specified when creating the contract, then they will receive a profit.
Since futures are derivatives, the trader can not only buy the asset, but also sell it. In the latter case, the trader will profit if the selling price is higher than the price of the asset at the time of expiration of the futures.
Futures are a contract between two parties, but with the participation of the exchange. The exchange, acting as a trade organizer, establishes requirements for the contracts and obliges to adhere to the specifications.
Types of futures contracts
- Financial futures is a contract associated with the purchase and sale of a security or index. Examples of financial instruments for which financial futures contracts can be concluded are S&P 500 and NASDAQ indexes, long- and short-term treasury bonds, securities. To use financial futures in trading, you must first understand how to trade stocks.
- Currency futures is a contract under which a currency is bought or sold at a certain fixed rate with delivery after a certain period of time.
- Energy futures is a contract for earning income when buying and selling fuels and energy products such as crude oil and gas.
- Metal futures is a contract that provides traders with access to the market for precious metals such as gold, silver, platinum and palladium.
- Grain futures is a contract between the buyer and the seller for the purchase or sale of grain such as corn, oats, soybeans, and wheat. Grain futures contracts are traded on the Chicago Mercantile Exchange (CME).
- Livestock futures are traded on the CME as well and include cattle, pork, broilers, turkeysб etc.
- Food & fiber futures are also traded on the CME and include cocoa, coffee, cotton, orange juice, sugar, etc.
Pros and cons of trading futures contracts
Pros of futures contracts
- Investors can use futures contracts to speculate on the price direction of the underlying asset.
- Companies can hedge the prices of their currencies that they sell to protect themselves from adverse price fluctuations.
- Savings on up-front payment. Futures contracts may require only a portion of the contract amount to be paid.
- Trading futures contracts provides the opportunity to increase leverage for certain instruments, such as cryptocurrencies.
Cons of futures contracts
- Futures contracts are extremely high-risk instruments because they are usually only traded with a leverage above 100, and moreover, there is a possibility of the futures price turning negative.
- There is a possibility of losing profitable price advantages. There are too many factors influencing the futures price: from the state of the foreign and domestic economy to the situation in individual companies issuing securities and even the weather.
- There is a possibility of incurring heavy losses. First, because the contract has a limited life span, and second, because of the variation margin write-offs: you either have to fund your account or close your position. That is why you should always clearly define for yourself the amount of money for trading, which you are ready to spend.
How futures contracts are traded?
Futures can be traded by both professional market participants and private investors by contacting a broker. There are several strategies of futures trading; they depend on the purposes pursued by the trader.
- Risk Hedging. Futures can help insure the owner of an asset against adverse price changes because they fix the price and do not require immediate payment of the full transaction amount. Moreover, hedging is used not only with securities, but also with real assets, such as raw material supplies, or currency pairs.
- This futures trading strategy involves making multidirectional trades in futures in such a way that a profit is made on the difference in the buy and sell price. Arbitrage can take place at different times or on different platforms.
In all cases, the trader can open long or short positions.
- Long positions are focused on the prospect of growth in the value of the futures asset and, more importantly, the futures itself. The trader buys futures for the delivery of the asset and, as the value of the futures rises, can sell it without waiting for the end of the contract.
- Short positions involve speculation to the contrary. At the moment of an unfavorable forecast, the trader sells his futures and waits for its value to fall even lower, then he buys it back at a lower price, benefiting from the difference between selling and buying.
For a deeper understanding of trader's strategies on futures and forward contracts, it is worth to familiarize yourself with rollover and swap.
The world futures exchanges are located in Chicago (Chicago Mercantile Exchange, Chicago Board Of Trade), New York (New York Mercantile Exchange), London (London International Financial Futures and Options Exchange, LME). Other major futures exchanges are Eurex, the French International Financial Futures Exchange (MATIF), the Singapore Exchange (SGX) and the Australian Stock Exchange (ASX).
Foreign futures exchanges can be accessed with the help of a broker.
Futures contracts vs forward contracts
Forward is a deferred contract with stipulated obligations. There are a number of fundamental differences between a futures and a forward:
- Forward is always concluded for a real asset: raw materials, currency, securities. Futures may be concluded for indices or interest rates.
- Forward specifies not only delivery terms and contract value, but also other conditions, including the asset itself. That is, futures is more standardized.
- Forward is an over-the-counter transaction, while a futures contract can only be concluded on the stock exchange.
- Forwards are not insured against delivery failure, while futures are regulated by the exchange clearing house.
Example of futures contracts
Contracts are divided into two types depending on the nature of the fulfillment of obligations.
- A deliverable futures implies that the contract is based on an asset that must be shipped and paid for at the end of the contract. That is, if the futures mean the delivery of 1,000 barrels of oil by a certain date, this type of contract is called a deliverable futures contract.
- A cash-settled futures can be concluded for any assets, including indices, interest rates and anything else that cannot be shipped or touched. In such a case, there is a recalculation of profits and losses at the end of the contract. The intangible nature of the futures allows it to be used to insure risks in the stock market.
Futures give traders advanced tools to trade different markets. These tools are useful for risk management. However, for beginners who do not understand the structure of the market, futures can seem complicated. If you want to learn how to trade from scratch, it is better to start with simple and understandable instruments, and move to derivatives only when you show positive trading results. The possibility of increasing your income through the use of leverage can be both attractive and disastrous for inexperienced traders.
2022-08-25 • Updated