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.
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Concepts Related to Futures Contracts
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Futures Contracts: Futures contracts 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.
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Underlying Assets: Futures contracts can be based on various underlying assets, including physical commodities (such as crude oil, natural gas, corn, and wheat) and financial instruments (such as stock market indices, currencies, precious metals, and U.S. Treasury bonds).
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Hedging: Futures contracts can be used for hedging purposes. Hedging involves taking a position opposite to the one held with the underlying asset to mitigate potential losses from unfavorable price changes. For example, companies can hedge the price movement of their raw materials or products they sell to protect against adverse price movements.
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Speculation: Futures contracts also allow investors to speculate on the price movement of an underlying asset. Traders can take long positions (expecting the price to rise) or short positions (expecting the price to fall) in futures contracts to potentially profit from price swings.
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Leverage: Futures contracts typically involve high leverage, meaning that traders do not need to put up the full contract value when entering into a trade. Instead, they are required to deposit an initial margin amount, which is a fraction of the total contract value. Leverage can amplify both gains and losses.
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Expiration and Settlement: Futures contracts have expiration dates and set prices that are known upfront. The contracts can be settled in two ways: physical delivery or cash settlement. Physical delivery involves taking possession of the underlying asset upon expiration, while cash settlement involves settling the contract's net difference in cash without physical delivery.
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Regulation: The futures markets are regulated by the Commodity Futures Trading Commission (CFTC), a federal agency created to ensure the integrity of futures market pricing and regulate brokerage firms engaged in futures trading.
Difference Between Futures and Options
Futures contracts differ from options contracts in several ways. While both are derivative products, there are key distinctions:
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Obligation vs. Right: In a futures contract, the buyer is obligated to take possession of the underlying asset at the time of expiration, while the seller is obligated to sell. In contrast, options contracts give the holder the right (but not the obligation) to buy or sell the underlying asset before the expiration date.
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Exercise Timing: American-style options contracts can be exercised at any time before the expiration date, while European-style options can only be exercised at expiration. In contrast, futures contracts are settled at expiration, and the buyer can sell their position at any time before expiration and be free of their obligation.
Pros and Cons of Futures Contracts
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.
Example of Futures Trading
Let's consider an example of trading crude oil futures:
- A trader buys a December crude oil futures contract in May, expecting the price to be higher by year-end.
- The contract is worth $50,000, but the trader only needs to pay an initial margin amount upfront.
- If the price of oil rises by December, the trader can sell the contract and earn a profit. If the price falls, the trader may incur a loss.
In conclusion, futures contracts are derivative financial instruments that allow traders to buy or sell an underlying asset at a predetermined future date and price. They can be used for speculation or hedging purposes. It's important to understand the concepts of leverage, expiration, settlement, and the distinction between futures and options. The futures markets are regulated by the CFTC.
