What Are Futures?
Futures are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Underlying assets include physical commodities and financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.
Key Takeaways
- Futures are derivative financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and set price.
- A futures contract allows an investor to speculate on the price of a financial instrument or commodity.
- Futures are used to hedge the price movement of an underlying asset to help prevent losses from unfavorable price changes.
- When you engage in hedging, you take a position opposite to the one you hold with the underlying asset; if you lose money on the underlying asset, the money you make on the futures contract can mitigate that loss.
- Futures contracts trade on a futures exchange and a contract's price settles after the end of every trading session.
Understanding Futures
Futures—also called futures contracts—allow traders to lock in the price of the underlying asset or commodity. These contracts have expiration dates and set prices that are known upfront. Futures are identified by their expiration month. For example, a December gold futures contract expires in December.
Traders and investors use the term futures in reference to the overall asset class. However, there are many types of futures contracts available for trading including:
- Commodity futures with underlying commodities such as crude oil, natural gas, corn, and wheat
- Stock index futures with underlying assets such as the S&P 500 Index
- Currency futures including those for the euro and the British pound
- Precious metal futures for gold and silver
- U.S. Treasury futures for bonds and other financial securities
It's important to note the distinction between options and futures. American-style options contracts give the holder the right (but not the obligation) to buy or sell the underlying asset any time before the expiration date of the contract. With European options, you can only exercise at expiration but do not have to exercise that right.
The buyer of a futures contract, on the other hand, is obligated to take possession of the underlying commodity (or the financial equivalent) at the time of expiration and not any time before. The buyer of a futures contract can sell their position at any time before expiration and be free of their obligation. In this way, buyers of both options and futures contracts benefit from a leverage holder's position closing before the expiration date.
Pros
Investors can use futures contracts to speculate on the direction of the price of an underlying asset.
Companies can hedge the price of their raw materials or products they sell to protect against adverse price movements.
Futures contracts may only require a deposit of a fraction of the contract amount with a broker.
Cons
Investors risk losing more than the initial margin amount since futures use leverage.
Investing in a futures contract might cause a company that hedged to miss out on favorable price movements.
Margin can be a double-edged sword, meaning gains are amplified but so too are losses.
Using Futures
The futures markets typically use high leverage. Leverage means that the trader does not need to put up 100% of the contract's value amount when entering into a trade. Instead, the broker would require an initial margin amount, which consists of a fraction of the total contract value.
The amount required by the broker for a margin account can vary depending on the size of the futures contract, the creditworthiness of the investor, and the broker's terms and conditions.
The exchange where the futures contract trades will determine if the contract is for physical delivery or if it can be cash-settled. A corporation may enter into a physical delivery contract to lock in the price of a commodity it needs for production. However, many futures contracts involve traders who speculate on the trade. These contracts are closed out or netted—the difference in the original trade and closing trade price—and have a cash settlement.
Futures for Speculation
A futures contract allows a trader to speculate on the direction of a commodity's price. If a trader bought a futures contract and the price of the commodity rose and was trading above the original contract price at expiration, then they would have a profit. Before expiration, the futures contract—the long position—would be sold at the current price, closing the long position.
The difference between the prices would be cash-settled in the investor's brokerage account, and no physical product would change hands. However, the trader could also lose if the commodity's price was lower than the purchase price specified in the futures contract.
Speculators can also take a short speculative position if they predict the price of the underlying asset will fall. If the price does decline, the trader will take an offsetting position to close the contract. Again, the net difference would be settled at the expiration of the contract. An investor would realize a gain if the underlying asset's price was below the contract price and a loss if the current price was above the contract price.
It's important to note that trading on margin allows for a much larger position than the amount held by the brokerage account. As a result, margin investing can amplify gains, but it can also magnify losses.
Imagine a trader who has a $5,000 brokerage account balance and has a $50,000 position in crude oil. If the price of oil moves against the trade, it can mean losses that far exceed the account's $5,000 initial margin amount. In this case, the broker would make a margin call requiring that additional funds be deposited to cover the market losses.
Futures for Hedging
Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges are using—or in many cases producing—the underlying asset.
For example, corn farmers can use futures to lock in a specific price for selling their corn crop. By doing so, they reduce their risk and guarantee they will receive the fixed price. If the price of corn decreased, the farmer would have a gain on the hedge to offset losses from selling the corn at the market. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable market price.
Regulation of Futures
The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market pricing, including preventing abusive trading practices, fraud, and regulating brokerage firms engaged in futures trading.
Example of Futures
Let's say a trader wants to speculate on the price of crude oil by entering into a futures contract in May with the expectation that the price will be higher by year-end. The December crude oil futures contract is trading at $50 and the trader buys the contract.
Since oil is traded in increments of 1,000 barrels, the investor now has a position worth $50,000 of crude oil (1,000 x $50 = $50,000). However, the trader will only need to pay a fraction of that amount up front—the initial margin that they deposit with the broker.
From May to December, the price of oil fluctuates as does the value of the futures contract. If oil's price gets too volatile, the broker may need to ask that additional funds to be deposited into the margin account. This is called maintenance margin.
In December,the end date of the contract is approaching (the third Friday of the month). The price of crude oil has risen to $65. The trader sells the original contract to exit the position. The net difference is cash-settled. They earn $15,000, less any fees and commissions owed the broker ($65 - $50 = $15 x 1000 = $15,000).
However, if the price oil had fallen to $40 instead, the investor would have lost $10,000 ($50 - $40 = a loss of $10 x 1000 = a loss of $10,000).
What Are Futures Contracts?
Futures contracts are an investment vehicle that allows the buyer to bet on the future price of a commodity or other security. There are many types of futures contracts available. These may have underlying assets such as oil, stock market indices, currencies, and agricultural products.
Unlike forward contracts, which are customized between the parties involved, futures contracts trade on organized exchanges such as those operated by the CME Group Inc. (CME). Futures contracts are popular among traders, who aim to profit on price swings, as well as commercial customers who wish to hedge their risks.
Are Futures a Type of Derivative?
Yes, futures contracts are a type of derivative product. They are derivatives because their value is based on the value of an underlying asset, such as oil in the case of crude oil futures. Like many derivatives, futures are a leveraged financial instrument, offering the potential for outsized gains or losses. As such, they are generally considered to be an advanced trading instrument and are usually traded only by experienced investors and institutions.
What Happens if You Hold a Futures Contract Until Expiration?
Oftentimes, traders who hold futures contracts until expiration will settle their position in cash. In other words, the trader will simply pay or receive a cash settlement depending on whether the underlying asset increased or decreased during the investment holding period.
In some cases, however, futures contracts will require physical delivery. In this scenario, the investor holding the contract upon expiration would take delivery of the underlying asset. They'd be responsible for the goods and covering costs for material handling, physical storage, and insurance.
As an expert and enthusiast, I have access to a vast amount of information and can provide insights on various topics, including futures contracts. I can help explain the concepts used in the article you provided. Here is the information related to the concepts used in the article:
Futures Contracts
Futures contracts are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price. These contracts can be used for hedging or trade speculation. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date. Futures contracts are standardized to facilitate trading on a futures exchange and can include physical commodities and financial instruments as underlying assets [[1]].
Types of Futures Contracts
There are various types of futures contracts available for trading. Some examples include:
- Commodity futures: These contracts have underlying commodities such as crude oil, natural gas, corn, and wheat.
- Stock index futures: These contracts have underlying assets such as the S&P 500 Index.
- Currency futures: These contracts include futures for currencies like the euro and the British pound.
- Precious metal futures: These contracts are for gold and silver.
- U.S. Treasury futures: These contracts involve bonds and other financial securities [[1]].
Difference Between Futures and Options
It's important to note the distinction between futures and options contracts. Futures contracts obligate the buyer to take possession of the underlying commodity at the time of expiration, while options contracts give the holder the right (but not the obligation) to buy or sell the underlying asset before the expiration date. Additionally, futures contracts can be sold at any time before expiration, allowing buyers to be free of their obligation [[1]].
Pros and Cons of Futures Contracts
Investors and companies use futures contracts for various purposes, and they come with their own set of advantages and disadvantages. Some pros of futures contracts include the ability to speculate on the price of an underlying asset, the ability for companies to hedge against adverse price movements, and the requirement of only a fraction of the contract amount as a deposit with a broker. However, cons include the risk of losing more than the initial margin amount due to leverage, the potential for companies to miss out on favorable price movements if they hedge, and the double-edged sword nature of margin, which can amplify both gains and losses [[1]].
Leverage and Margin in Futures Trading
Futures trading typically involves high leverage, meaning traders don't need to put up the full contract value when entering a trade. Instead, they are required to deposit an initial margin amount, which is a fraction of the total contract value. The specific margin requirements can vary based on factors such as the size of the futures contract, the investor's creditworthiness, and the broker's terms and conditions. Margin can amplify gains but also magnify losses, so it's important to consider the risks involved [[1]].
Futures for Speculation and Hedging
Futures contracts can be used for both speculation and hedging. Speculators aim to profit from price movements in the underlying asset. They can take a long position if they expect the price to rise or a short position if they predict the price will fall. If the price moves in their favor, they can close the contract and realize a gain. On the other hand, hedgers use futures contracts to protect against adverse price changes. For example, a corn farmer can use futures to lock in a specific price for selling their crop, reducing the risk of price decreases [[1]].
Regulation of Futures Markets
The futures markets are regulated by the Commodity Futures Trading Commission (CFTC), a federal agency created by Congress in 1974. The CFTC ensures the integrity of futures market pricing, prevents abusive trading practices and fraud, and regulates brokerage firms engaged in futures trading [[1]].
Example of Futures Trading
An example of futures trading involves a trader speculating on the price of crude oil. The trader enters into a futures contract in May with the expectation that the price will be higher by year-end. The contract is for December crude oil futures, which is trading at $50. The trader buys the contract, which represents a position worth $50,000 of crude oil. However, the trader only needs to pay a fraction of that amount upfront as the initial margin. If the price of oil fluctuates, the broker may require additional funds to be deposited into the margin account. In December, as the contract's end date approaches, the trader sells the contract at the current price, earning a profit if the price has risen or incurring a loss if the price has fallen [[1]].
I hope this information helps you understand the concepts related to futures contracts. If you have any further questions, feel free to ask!
