The Investor’s Guide to Futures

A futures contract allows the parties to the contract to buy or sell a specific underlying asset at a set future date. The underlying asset can be a commodity, a security or some other financial instrument.

For many investors, futures contracts, with their different terms and trading strategies, can be daunting. But the learning curve hasn’t stopped increasing numbers of investors from entering futures markets in recent years. According to the Futures Industry Association, futures trading worldwide more than doubled from 12.1 billion contracts in 2013 to 29.2 billion in 2023. They are not new, though, and futures have long been used as insurance for farmers and traders against devastating changes in nature and the market. For millennia, forward contracts have been employed to lock in future prices for financial stability no matter what happened to the harvest that year. But many have also used them to speculate and profit from changing prices in the market. For example, the ancient Roman orator Cicero left evidence the Romans used forward contracts in a letter criticizing traders who raced to get ahead of spreading knowledge of a major grain shipment arriving to profit by locking others into higher prices with them.

While much has changed as forwards have become standardized as futures contracts and exchanges offer ever more sophisticated products, the basics remain the same. Below, we guide you through the kinds of futures, who trades them, and why, all while showing you don’t need to get on horseback to beat news of a grain-filled ship arriving to gain from these investments.

Key Takeaways

  • Futures are a kind of derivative, an agreement whose returns depend on the value of an underlying asset.
  • A futures contract commits the buyer to buy or a seller to sell an underlying asset at a preset price and date.
  • Investors use futures to speculate on or hedge against changing prices for a security, commodity, or financial instrument.
  • Forward contracts are agreements between two parties, while futures are standardized contracts sold on an exchange.
  • You can trade futures in commodities, currencies, interest rate changes, livestock, oil and gas, securities, and much more. The most traded futures are for equities.

What Are Futures?

Futures commit you to buying or selling an underlying asset at a specific price on a preset date. We use “underlying asset” in the vaguest sense since investors trade futures for virtually all commodities, financial securities, and more. You can buy or sell futures related to weather events like temperature, rainfall, hurricanes, and even snow (useful for firms relying on it for tourists); shipping futures for freight rates and such; electricity and network telecommunication bandwidth; and real estate for volatility in property prices. This only begins the list. While the U.S. Commodity Futures Trading Commission has banned futures trading in American elections, the University of Iowa’s Henry B. Tippie College of Business for decades has been running (for research purposes) an online futures market where contract payoffs are based on real-world events such as political elections, companies’ earnings per share, and stock price returns. In 2022, the Chicago Mercantile Exchange began offering event-based futures where you essentially bet yes or no for questions on the value of indexes, currencies, commodities, and so on, with terms ending daily. In 2024, the exchange added quarterly and yearly expirations.

But let’s not get ahead of ourselves. First, we’ll set out some essential distinctions for forward and futures contracts before turning to who uses them and the kinds of underlying assets most often at play.

Forward Contracts

A forward contract is the oldest type of these agreements, predating the trading in futures that formalized “to arrive” contracts in the latter half of the 19th century. A forward is an agreement between two parties to transact in the future, with one party taking the “long position” and the second taking the “short position”; they are also called the long and short forwards.

The long forward must buy an asset from the short forward at a future time. What’s being bought in the future is called the “underlying asset.” As we’ve seen, this can be many things, but grains and other farm products were the assets when the Chicago Board of Trade opened in 1848. Today, forwards are traded over the counter and are customized for the parties involved. Despite variations, forwards include the following:

  • Contract price: This is the agreed-upon “forward price” that the underlying asset will be bought or sold for in the future. It’s determined at the time the contract is entered into.
  • Counterparties: The parties involved in the contract, a buyer (long position) and a seller (short position).
  • Delivery date: This is the date when the underlying asset will be exchanged.
  • Underlying asset: The commodity, financial instrument, or other asset bought or sold.
  • Quantity of the asset: The contract specifies the exact amount of the underlying asset to be delivered or received.
  • Settlement method: Forwards are settled by physically delivering the underlying asset or through cash.
  • Terms and conditions: Any extra terms about the execution of the contract, including how defaults are handled, the rights of the parties, and any conditions that, once met, mean the forward can be modified or voided.

Forward Contract Example

Let’s flesh this out with an example. Suppose a couple owns a farm and expects to harvest 5,000 bushels of wheat in six months. They’re worried about what a fall in the price of wheat would mean for covering their bills while getting ready for the next season. So, they look for a way to lock in a price today to ensure they have enough income. They know by locking the price in, they might not profit as much if wheat prices go up, but stability is more important right now. Meanwhile, a local organic cereal producer needs a consistent supply of wheat but is concerned prices might go up, which would raise production costs. So, the farmers and the cereal company sign a forward contract that would include the following:

  • Underlying asset: 5,000 bushels of wheat.
  • Contract price: $5.00 per bushel. This price is agreed upon when the contract is signed.
  • Quantity: 5,000 bushels.
  • Delivery date: Six months after the contract’s signing date.
  • Settlement method: Physical delivery of the wheat to the cereal producer.
  • Parties: The wheat farmer (seller) and the cereal manufacturer (buyer).

Under these terms, the farmers have to deliver 5,000 bushels of wheat to the cereal manufacturer in six months, and the cereal producer must pay the farmer $5.00 per bushel when that’s done, no matter what happens to the price of wheat in the meantime. If the price goes up to $7.00 a bushel, the farmers get less than they would have otherwise, though the cereal producer makes out. Alternatively, if the price goes down to $3.00 a bushel, the farmers still keep the stable income they need, and the cereal manufacturer is out more money than otherwise, but in the meantime, neither party had to stress over volatility in the wheat market.

Futures contracts take this concept, standardize its elements, and make it tradable on exchanges.

Futures Contracts

A futures contract is like a forward, but it’s done through an organized exchange, committing traders to buy or sell an underlying asset at a preset price on a future date. Like forwards, some contracts require physical delivery. But others are settled in cash, the amount of which is the difference between the agreed-upon price and the market price when the future date arrives.

Futures are traded through open outcry in trading pits in an auction or through electronic screen-based systems with centralized exchanges like the Chicago Mercantile Exchange (CME). There are also cryptocurrency exchanges like Binance that trade futures, including those with and without an expiration date. The role of the futures exchange is not to buy or sell the contracts but to enable trades, ensure they are legally conducted, check that they follow the exchange’s own rules, and publish the trading prices. This last element is crucial for price discovery, helping other buyers and sellers find a mutually agreeable price based on supply and demand.

Since a futures contract is an obligation in the future, a trader can sell contracts without buying contracts first. Traders who sell more contracts than they buy have a short futures position, while traders who buy more contracts than they sell have a long futures position.

Futures Contract Example

Let’s make this concept concrete with an example. Suppose an airline wants to hedge against the risk of rising fuel prices. To manage this risk, it enters into a futures contract to buy crude oil at a predetermined price. At the same time, an oil company is trying to lock in a price for its oil in case prices fall. These transactions take place on a regulated exchange, ensuring standardized terms and avoiding the need for the parties to know each other directly.

Under these futures contracts, the airline agrees to buy, and the oil producer agrees to sell 1,000 barrels of crude oil for $60 per barrel on a certain date. Here’s what the details might look like:

  • Contract months: Crude oil futures are available for several months ahead, providing flexibility for hedging strategies. The airline might choose a contract with a delivery month that aligns with its predicted fuel needs, such as “CLZ24” for December 2024 delivery.
  • Contract size: The standard contract size for crude oil futures is 1,000 barrels. This standardization makes it easy to calculate the contract’s total value, which, at a trading price of $60 per barrel, would be $60,000.
  • Deliverable grade: This notes the quality and grade of the product that can be delivered under the contract. For crude oil futures, this includes details like how heavy the oil is and its sulfur content.
  • Exchange: The contract is traded on a regulated exchange like the New York Mercantile Exchange, where many contracts for crude oil are sold.
  • Last trading day: The final day on which trading can occur for the contract is usually a few business days before the delivery month begins. For crude oil futures, this might be the last trading day in the month preceding the contract month, ensuring all obligations are settled before delivery.
  • Price quoted in: Prices for crude oil futures are quoted per barrel.
  • Settlement type: Futures contracts can be settled through physical delivery of the underlying asset or cash settlement. For crude oil futures like “CLZ24,” physical delivery is more standard, though many participants close their positions before the delivery date to avoid actual delivery.
  • Tick size: The contract specifies the minimum tick size, which could be $0.01 per barrel for crude oil, translating to a $10 change in the contract’s total value for each tick movement.
  • Ticker: The specific contract for crude oil can be identified by a ticker symbol such as “CL” for crude oil, followed by a suffix for the delivery month and year, for example, “CLZ24” for a contract expiring in December 2024.

With forwards, there’s a risk that the other party won’t fulfill the contract. This is mitigated for futures by the exchange clearinghouse, which guarantees the contract. While each side is taking a risk that the price they pay now is close to the actual price at the settlement month, each party insures against the risk of a wide swing against them in oil prices.

Who Uses Futures?

Measured by volume, most futures are traded by commercial or institutional entities. Of these, most are hedgers looking to cut their risk of financial losses, as in our examples thus far. Buying futures for these traders is a form of insurance. Meanwhile, speculators trade futures contracts only to profit from price fluctuations. They don’t want the underlying assets but buy or sell futures based on their predictions about future prices.

Futures traders include arbitrageurs and spread traders, investors who use price discrepancies between different markets or related instruments to profit. They are a kind of speculator, buying and selling futures or other financial instruments to profit from cross-market price differences. They use sophisticated software to search markets for price discrepancies and execute trades quickly before they disappear.

Hedgers

Hedgers use futures contracts to mitigate the risk of price changes going too low when the time comes for them to sell an asset or increase too much if they have to buy it later in the spot market. These traders include producers, consumers, or investors with exposure to the underlying asset who employ futures contracts to lock in prices, effectively insuring against price volatility.

Hedgers are not primarily motivated by profit but by the need to manage risk related to their business or investment portfolio.

Speculators

These are futures traders who aim to profit from price moves, betting that price will move in a direction favorable to their trades. Speculators do not intend to take delivery of the physical goods if any are involved in the first place. Futures speculation adds greater liquidity to the market since more parties are buying and selling.

While they don’t make up most futures traders, many protections in the market are to guard against speculators profiteering or causing volatility that would affect everyday consumers and other industries. For example, speculation in futures markets for agricultural commodities like wheat, corn, and soybeans has been linked to significant price swings. The 2007-2008 global food crisis is a textbook example, given the dramatic increases in the prices of these staples at the time, with weather conditions and biofuel demand initially thought to be the cause. Ultimately, speculative trades took more of the blame for the price increases that hit consumers just as the financial crisis of that year was about to wreak widespread havoc.

A look at how it happened shows that hedging can turn into speculation, which can cause a major jump in prices. In early 2007, wheat prices began to climb because of bad weather conditions in key producing regions (e.g., Australia had a drought) and increased demand for grain used for food and biofuel. These problems were worsened by the lowest global wheat stockpiles in decades. Soon, there was a sharp rise in wheat futures prices, reaching record highs. In February 2008, the price for wheat futures on the Chicago Board of Trade surged to over $13 per bushel from around $4 to $5 per bushel in the preceding years. This spike in wheat prices had consequences worldwide: traders bought up contracts, speculating on future price gains, and suppliers and manufacturers, anticipating higher future costs, raised prices preemptively, directly affecting consumer prices for wheat and related products. This increased the cost of bread and other wheat-based products, posing severe challenges to food security for billions across the globe.

Types of Futures Traders

The futures market has diverse participants, each with distinct strategies, objectives, and roles. Among these are hedge funds, individual traders, and market makers, who together contribute to the liquidity, depth, and efficiency of the market.

Hedge Funds

Hedge funds are managed pools of capital that have wide latitude in generating returns for their investors. In the futures market, they may participate as speculators, leveraging their substantial capital to bet on the direction of commodity prices, interest rates, indexes, and other assets. Hedge funds often employ sophisticated trading strategies, including both long and short positions, to capitalize on predicted market moves. Their activities can significantly influence prices because of the large volumes of trades they execute.

Individual Traders

Individual traders who trade futures contracts for their own accounts. They might speculate on price moves to profit from short-term fluctuations or hedge personal investments in other markets. Individual traders have different strategies, risk tolerance, and amount of capital at stake. With the advent of electronic trading platforms, individual traders have easier access to futures markets, allowing them to participate alongside institutional investors.

Institutional Investors

Institutional investors include professional asset managers, pension funds, insurance companies, mutual funds, and endowments. They invest large sums of money in financial instruments, including futures contracts, on behalf of their stakeholders or beneficiaries. In the futures market, institutional investors may engage in hedging to protect their portfolios from adverse market moves or speculate on future price directions to enhance returns. Given the large volume of assets under management, institutional investors can significantly affect market prices through their trading activities.

Market Makers

Market makers provide liquidity to the market by staying ready to buy and sell futures contracts at publicly quoted prices. They profit from the spread between the buying and selling prices. By continually offering to buy and sell contracts, market makers help ensure that there is enough volume for trades to be executed promptly, reducing market volatility and making it easier for investors to enter and exit their positions.

Proprietary Trading Firms

Proprietary trading firms trade their own capital, not that of clients. These firms are in the business of making speculative trades to benefit directly from market moves. Prop trading firms may employ high-frequency trading, arbitrage, and swing trading (entering trades at or near the end of a downward movement and exiting at a near-peak in an upward movement, or vice versa for short positions) to generate profits. They are significant players in the market because of their aggressive trading tactics, sophisticated technology, and their ability to take on substantial risks. Unlike hedge funds, prop trading firms invest their own funds rather than managing external capital, which can lead to different risk management strategies.

What’s Traded in the Futures Market?

The range of assets underlying futures covers everything from agricultural products to financial indexes. As of early 2024, the most traded futures were in equities (65% of futures trading by volume), currencies (9%), interest rates (9%), energy (5%), agriculture (4%), and metals (4%).

Commodities

A commodity is a physical product whose value is determined primarily by the forces of supply and demand. This includes grains (corn, wheat, etc.), energy (such as natural gas or crude oil), and precious metals like gold or silver.

A commodity futures contract is an agreement to buy or sell a predetermined amount of some commodity at a given price on a specific date. Like all futures contracts, commodity futures can be used to hedge or protect an investment position or to bet on the directional movement of the underlying asset.

Individuals can enter the commodities futures market through a managed futures account, available through specialized brokerage firms called Commodity Trading Advisors.

Cryptocurrencies

Although relatively new to the futures market, cryptocurrency futures have quickly gained popularity, offering contracts on Bitcoin, Ethereum, and other digital currencies. These futures allow traders to speculate on future crypto price moves without the need to hold the digital assets. Given the extreme volatility in cryptocurrency markets, futures provide a way for investors to hedge their digital asset portfolios or speculate on price changes without the security issues and other hassles of holding crypto directly.

Currencies

Currency or forex trading involves making money or hedging risk in foreign exchange rate changes. A wide variety of currency futures contracts are available. Aside from popular contracts such as euro/U.S. dollar currency futures, there are also E-Micro Forex Futures contracts that trade at one-tenth the size of regular currency futures contracts.

One strategy speculators use to trade currencies is scalping, which tries to make short-term profits off incremental changes in the value of a currency. Doing this repeatedly means that your earnings could add up over time. In general, your time frame can be as short as one minute or may last several days. A scalping strategy requires strict discipline to continue making small, short-term profits while avoiding significant losses.

Currency futures should not be confused with spot forex trading, which is more prevalent among individual traders.

Energy prices

Geopolitical events, supply disruptions, and changes in demand because of economic growth can significantly impact energy prices. As such, energy futures are among the most vital parts of the commodities market, including crude oil, natural gas, gasoline, and heating oil. These contracts are crucial for energy producers and consumers to hedge against the volatile nature of energy prices. Downstream, the use of them by utilities could mean more affordable prices for people heating their homes.

Indexes

Introduced in 1982 by the Chicago Mercantile Exchange with futures for the S&P 500, index futures, such as the e-mini S&P 500 index futures contract, are among the most popular for individual investors, with event futures featuring wagering yes or no on specific occurrences often tied to indexes as well. Index futures are a way to gain exposure to an entire index in a single contract. The Financial Industry Regulatory Authority requires a minimum of 25% of the total trade value as the minimum account balance. However, some brokerages will demand greater than this 25% margin.

Index futures are available for the Dow Jones Industrial Average and the Nasdaq 100, as well as their fractional value versions, e-mini Dow and e-mini Nasdaq 100 contracts. Index futures are also available for foreign markets, including the Frankfurt Exchange and the Hang Seng Index in Hong Kong.

Interest rates

Interest rate futures are financial derivatives that allow investors to speculate on or hedge against future changes in interest rates. These futures include those for Treasury bills, notes, and bonds, as well as on interest rate benchmarks. Treasury futures allow investors to speculate on or hedge against changes in interest rates, which affect the value of Treasury securities. For example, T-note futures are widely used to hedge against fluctuations in the 10-year Treasury note yields, which are benchmarks for mortgage and other important financial rates.

More generally, bond futures are contracts to buy or sell a specific bond at a predetermined price on a future date. Investors use these to hedge against or speculate on changes in bond prices, which inversely correlate with interest rates. As interest rates rise, bond prices typically fall, and vice versa. Investors, fund managers, and financial institutions use bond futures to protect their portfolios against interest rate changes or to take positions based on their interest rate outlook.

Metal prices

Metals, including gold, silver, copper, and platinum, have futures that trade extensively. These contracts are used by miners, manufacturers, and investors to hedge against price volatility. Precious metals like gold and silver are often considered safe havens during times of economic uncertainty, while industrial metals like copper are sensitive to economic growth and industrial demand since they are essential in electronics and construction. Futures trading in metals enables price discovery and risk management, providing a way to lock in prices for future delivery or a cash substitute.

What Is the Difference Between Futures and Options Trading?

Futures and options are both derivatives, financial instruments derived from the value of underlying assets like commodities, currencies, or indexes. The key difference lies in the obligations they impose on buyers and sellers. A futures contract is an agreement to buy or sell the underlying asset at a predetermined price on a specific future date, committing both parties to fulfill the contract at maturity. By contrast, an option gives the buyer the right, but not the obligation, to buy (the call option) or sell (the put option) the underlying asset at a set price before the option expires. This difference means that options offer a way to hedge against risk or speculate with a lower upfront investment compared with futures, where the potential for both gain and loss can be more significant because of the obligation to execute the contract.

What Are Event Futures?

Unlike traditional futures contracts, which are based on the price changes of physical commodities or financial instruments, event futures are based on the occurrence of particular events. These events can range from elections to changes in indexes and commodities prices. An event futures contract has a binary outcome: it settles at a predefined value if the event occurs (or a specific outcome is achieved) and settles at zero if the event doesn’t happen.

How Does Leverage Work in Futures Trading?

Leverage allows traders to control a large amount of the underlying asset with a relatively small amount of capital, known as “margin.” In futures contracts, leverage is used to amplify the potential returns from changes in the underlying asset’s price. It is a double-edged sword that can significantly increase both potential profits and potential losses. When traders enter a futures contract, they must deposit a fraction of the contract’s total value, typically 5% to 15%, with their broker. This is known as the initial margin. Because traders only put down a fraction of the total value, they can gain exposure to a large position without committing the total amount of capital upfront.

However, leverage also increases risk. If the market moves against the position, traders could face margin calls, requiring more funds to be deposited. If these margin requirements are not met, the position may be closed at a loss. Therefore, while leverage can magnify gains, it can also magnify losses, sometimes exceeding the initial investment.

The Bottom Line

Futures trading allows investors to lock in prices for commodities, currencies, and financial instruments months or even years in advance, providing a critical tool for managing price risk and speculation. While futures were limited to commodities when first introduced, they now cover a wide range of events and market moves, enabling investors to hedge against unfavorable market shifts or the chance to profit from price volatility without requiring the physical exchange of the underlying asset.

Traders should carefully consider their risk tolerance and engage in futures judiciously, employing risk management strategies such as stop-loss orders to protect against significant losses.



Source link

Scroll to Top