Futures
April 6, 2022
What are Futures?
Futures contracts are popular derivatives used to exchange physical assets, speculate, and hedge prices. A futures contract is an agreement whereby two parties agree on the sales and delivery terms for a specific asset to be exchanged on a specified date in the future. The asset can be a commodity or financial instrument. A futures contract is traded on the active secondary market, subject to government regulation, and requires a daily cash settlement of gains and losses. Futures trading has a long history, with the first futures contract listed in 1864. The futures market is a high-risk, high-reward trading environment. Futures trading requires that participants are familiar with all the risks and possess the skills to manage those risks.
For example, A and B agree on a contract where A agrees to buy x amount of wheat from B at USD180/bushel. Both A and B must honor the agreement at the time of expiry, i.e., A must purchase x amount of wheat at USD180 from B, and B deliver x amount of wheat to A at a specific location.
Key Learning Points
- A futures contract is a security that derives its value from the value or return of another asset or security.
- Futures contracts have standard terms that specify the quality and quantity of assets for each underlying asset and the delivery procedure.
- Futures contracts allow investors to take a position on a commodity without taking delivery of the underlying asset.
Understanding Futures Contracts
An investor holding a long position in a futures contract makes profits if the underlying asset’s price increases above the price predetermined by the contract. The investor exercises the contract and buys the asset at the predetermined price, which is lower than the market price, and then resells the asset at the higher current market price. Investors will profit from the short position if the price of the underlying asset decreases. The investor sells the asset at the higher predetermined price and then repurchases it at the lower market price.
Futures trading has become increasingly popular across the world. The CME Group is the largest futures exchange in the world which consists of the Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX), Commodity Exchange Inc. (COMEX), Kansas City Board of Trade (KCBT), and the NEX Group. The Intercontinental Exchange (ICE) and London Metal Exchange (LME), which have been in existence for over 130 years, are also major future exchanges. Other exchanges include Eurex (Europe), Nasdaq (US+Europe), Moscow Exchange (Russia), Korea Exchange (South Korea), Shanghai Futures Exchange (China), and National Stock Exchange of India (India).
Futures Trading Terminology
The following are key concepts and terminology related to futures trading:
Long position – the buyer’s position in a futures contract whereby the person is committed to buying the assets at a predetermined price on the specified future date. The buyer is obliged to buy the asset on the specified future date in the futures contract.
Short position – the seller’s position in a futures contract whereby the person is committed to delivering the assets for the predetermined price on the specified future date.
Covered – the seller has the assets when the delivery of the physical asset takes place.
Naked – the seller does not have the assets when required to deliver the physical asset.
Open – when a market participant first enters into a futures contract. For example, a participant buys a future which is referred to as opening a long position. By contrast, when a participant sells a future it is known as opening a short position.
Close – not all futures contracts end up with the underlying assets being delivered. This is because the investors are sometimes financial institutions that trade futures contracts in order to speculate on the price of the assets. Financial institutions usually offset their contract and get out of their obligation by buying or selling an opposing contract before the time of expiry. This is known as closing.
Futures delivery – the short position holder transfers the ownership of the assets to the long position holder.
Price Limit – many futures contracts have price limits, the exchange sets out how each day’s settlement price can change from the previous trading day’s settlement price.
Examples of Commodity Futures Contracts
Example of a commodity futures contract
Crude oil is currently selling at $92 a barrel, and a futures contract for $93 per barrel is available for three months time. As the investor believes the price will rise above $93 by the time of expiry, the investor will take a long position to buy at $93. At the time of expiry, the actual market price rises to $98. The investor can buy the crude oil at $93 per barrel and sell it at $98, making a $5 profit. By contrast, if the market price drops to $91, the investor pays $2 above the market price on settlement, making a $2 loss per barrel.
Example of stock index futures trading
Index Futures are derivative products based on a portfolio of equities as represented by a particular index. Stock prices fluctuate throughout the trading day. Many investors benefit from the liquidity and volatility in the stock market by investing in different types of futures contracts. Common index futures include E-mini S&P 500 Micro E-mini S&P 500, E-mini Dow Jones, E-mini NASDAQ 100, Nikkei 225 Futures, etc.
0n 17 February 20XY, an investor enters into a short position of $2,000 of 3-month S&P 500 stock futures with a settlement price of $1,415. If on 17 May 20XY, the value of the S&P 500 index is actually $1,418.21, the investor is committed to provide $2,000 x 1,418.21 in return for $2,000 x 1,415. The investor makes a loss of $6,420.
Conclusion
Futures are popular types of derivative contracts which derive their value from the value or return of another asset or security. The underlying asset could be a financial asset or commodity.
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