Futures: Definition and Use
A futures is a derivative financial contract which imposes an obligation on the parties to transact an asset at a future date and price which are predetermined. The price is unaltered, irrespective of the current market price at the expiration date. The underlying assets can be physical commodities or financial instruments. The quantity of the underlying instrument is specified in the futures contract. The latter is standardized, to facilitate trading on a futures exchange. These derivative can be used for both hedging and speculative purposes.
A futures enables a trader to set the price of the underlying asset. The set price and the set expiration date are known upfront. The identification of expiration is by month.
Types of Futures Contracts
Here are the most common types of futures contracts:
- Commodity futures: based on commodities like crude oil, natural gas, wheat, corn, etc.
- Stock index futures: based on indices like the S&P 500, the NASDAQ100, the DAX30, etc.
- Currency futures: having currency pairs, like EUR/USD, GBP/USD, USD/JPY, etc., as an underlying asset.
- Precious metal futures: based on precious metals like gold, silver, platinum, etc.
- US treasury futures: having bonds as an underlying asset.
Futures must be distinguished from options. An options contract provides its holder with the right to purchase or sell the asset at contract expiration. Unlike it, a futures contract obligates its holder to fulfill the contract terms.
Pros and Cons of Futures
The main advantages of futures are:
- They can be used by investors to speculate on the underlying asset’s price.
- A company can hedge the prices of raw materials or products it sells, and thus obtain protection against unfavorable price movements.
- The requirement for trading a futures contract with a broker is only to make a deposit of a part of the contract’s market value (the required margin).
The main disadvantages of futures are:
- Investors and speculators run the risk of losing more than the initial margin and even more than the invested amount, due to the fact that leverage is used in futures.
- When a company decides to hedge with a futures contract, it may also miss favorable price movements.
How to Use Futures
The use of leverage allows an individual entering into a trade to provide just a part of the contract value. Instead of the 100% amount of the contract value, the broker would demand an initial margin amount. The latter is only a fraction of the total value. It can vary, in conformity with the contract size, depending on the investor’s creditworthiness and on the terms and conditions set by the broker.
The exchange where the trading is done determines whether the contract is to be physically delivered, or settled in cash. In physical delivery, the price of a commodity needed for production is hedged, or locked in. But the majority of futures contracts involve traders speculating on the price, so they are closed out or netted with cash settlement.
If a trader bought a futures contract, and the price of the commodity rose, thus trading above the purchase price at expiration, that would mean a profit. Prior to expiration, the buy trade (long position) would be offset with a sell trade for the same amount at the current market price. That would be the closing of the long position. The price difference would be settled in cash and sent to the investor’s brokerage account. There would be no physical product changing hands. But if the commodity price was lower compared to the purchase price, the trader would incur a loss.
Besides a long position, a speculator could take a short, or sell, speculative position. If the decline does occur, the trader would assume an offsetting position, to close the contract. The net difference would again be resolved at (or before) contract expiration. An investor would realise a profit in the event the underlying asset’s price was below the one which he initially shorted the futures at. Conversely, there would be a loss if the close price was above the price which the initial trade was executed at.
It should be underscored that when trading is on margin, the position could be much larger respective to the amount in the brokerage account. Thus, the use of leverage can result in higher profits, but also in bitter losses.
Imagine a trader who has an account balance of $5,000 and opens a $50,000 worth crude oil position. Should the price of oil move against him, he can incur losses that far exceed the account’s $5,000 balance. In this case, the broker would make a margin call requiring additional funds be deposited to cover the market losses. Failure to cover the required funds for margin would result in the broker liquidating the position at the prevailing market price.
Futures are also often used for hedging the price movement of underlying assets. The goal in this case is not to speculate, but to prevent losses occurring due to potentially unfavorable price fluctuations. A host of companies going into hedges are using, and in many instances, producing the underlying asset.
For example, a corn farmer 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 company would have a gain on the hedge to offset losses from selling the corn at a lower market price, and vice versa. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable price for the farmer.