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What are Futures Contracts?

Updated: Mar 26, 2023



In the world of finance, futures contracts are a vital instrument for investors, traders, and businesses to manage risk and speculate on the future prices of various assets. This article will provide an in-depth look at futures contracts, their types, mechanics, and the roles of hedgers and speculators. We'll also discuss the differences between futures contracts and forward contracts, the factors influencing futures prices, and the major futures exchanges. Finally, we'll wrap up with the risks and rewards involved in futures trading.



What are Futures Contracts?

A futures contract is a standardised, legally binding agreement between two parties to buy or sell a specific asset at a predetermined price on a future date. These contracts can be traded on an exchange, making them more transparent and accessible compared to other financial instruments, like forward contracts. Futures contracts can be used for hedging, speculating, or arbitrage purposes and can involve a wide range of assets, such as commodities, currencies, and financial instruments.



Types of Futures Contracts

Futures contracts can be categorised into several types based on the underlying asset:

  1. Agricultural Futures: These contracts involve agricultural products, such as grains, livestock, and soft commodities like coffee, sugar, and cotton.

  2. Energy Futures: Energy futures cover crude oil, natural gas, gasoline, and other energy-related products.

  3. Metal Futures: Metal futures include contracts for precious metals like gold and silver, as well as industrial metals like copper and aluminium.

  4. Currency Futures: Currency futures involve the exchange of one currency for another at a future date, allowing participants to hedge or speculate on foreign exchange rate movements.

  5. Financial Futures: Financial futures encompass contracts based on interest rates, stock indices, and other financial instruments.



Mechanics of Futures Contract

Futures contracts have several key features that make them unique:

  1. Standardisation: Futures contracts are standardised in terms of contract size, expiration dates, and other terms to facilitate trading on an exchange.

  2. Trading on Exchange: Futures contracts are traded on regulated exchanges, which provide transparency, liquidity, and a centralised marketplace for participants.

  3. Margin Requirements: To trade futures, participants must deposit an initial margin, which is a percentage of the contract's value, to cover potential losses that may occur during the contract period. Additionally, a maintenance margin may be required to ensure sufficient funds remain in the account to cover potential losses.



Hedgers and Speculators in Futures Trading

Participants in futures markets can generally be divided into two categories:

  1. Hedgers: Hedgers use futures contracts to manage their exposure to price risk associated with the underlying asset. For example, a farmer may use agricultural futures to lock in a price for their crops, while an oil producer may use energy futures to hedge against fluctuations in oil prices.

  2. Speculators: Speculators seek to profit from price movements in the futures market by taking positions based on their expectations of future price changes. They do not have a direct interest in the underlying asset but are willing to assume the price risk in exchange for potential profit.



Trading Futures Contracts

  1. Entering a Futures Contract: To initiate a futures position, a participant must either buy (go long) or sell (go short) a futures contract on the exchange. This establishes an obligation for the buyer to take delivery of the underlying asset at the specified price on the expiration date, while the seller is obligated to deliver the asset.

  2. Closing a Futures Position: Participants can close their futures positions before the expiration date by taking an offsetting position. For example, if a trader initially bought a futures contract, they can sell a contract with the same terms to close their position, eliminating their obligation to take delivery of the underlying asset.



Futures Contract vs. Forward Contract

While both futures and forward contracts involve an agreement to buy or sell an asset at a future date, there are key differences between the two:

  1. Standardisation and Trading Venue: Futures contracts are standardised and traded on regulated exchanges, while forward contracts are customised agreements between two parties that are traded over the counter (OTC).

  2. Margin Requirements: Futures contracts require participants to post an initial margin and may also require a maintenance margin, whereas forward contracts typically do not have margin requirements.



Factors Influencing Futures Prices

Several factors can impact futures prices, including:

  1. Spot Price: The current price of the underlying asset in the spot market.

  2. Risk-free Rate of Return: The rate of return on a risk-free investment, such as government bonds.

  3. Storage Costs: The costs associated with storing the underlying asset until the contract's expiration date.

  4. Dividends: Cash payments made by companies to their shareholders, which can impact the valuation of stock index futures.

  5. Convenience Yields: The benefits derived from holding the physical asset, such as the ability to meet immediate delivery needs.



Major Futures Exchanges

  1. Chicago Mercantile Exchange (CME): The CME is one of the largest and most diverse futures exchanges globally, offering contracts on a wide range of assets, including agricultural products, energy, metals, and financial instruments.

  2. Commodity Futures Trading Commission (CFTC): The CFTC is the primary regulator of futures markets in the United States, responsible for ensuring the integrity and transparency of futures trading.



Risks and Rewards in Futures Trading

  1. Profit and Loss Scenarios: The profit or loss on a futures position depends on the difference between the contract price and the underlying asset's price at the time the position is closed. Participants can potentially earn significant profits if their market predictions are correct, but they can also incur substantial losses if they are incorrect.

  2. Maintenance Margin: If a participant's margin balance falls below the required maintenance margin, they will receive a margin call, requiring them to deposit additional funds or close their position.



Conclusion

Futures contracts are a versatile financial instrument that can be used for hedging, speculation, or arbitrage purposes. They provide a standardised and transparent way to trade a wide range of assets on regulated exchanges. Understanding the mechanics of futures contracts, the roles of hedgers and speculators, and the factors influencing futures prices is crucial for anyone looking to participate in these markets. While trading futures can offer significant profit potential, it also carries risks, so it's essential to manage your exposure and maintain adequate margin levels.



FAQs

What is the primary purpose of a futures contract?

The primary purpose of a futures contract is to allow participants to manage their exposure to price risk associated with the underlying asset, speculate on future price movements, or engage in arbitrage opportunities.


How do futures contracts differ from forward contracts?

Futures contracts are standardised and traded on regulated exchanges, while forward contracts are customised agreements between two parties that are traded over the counter (OTC). Additionally, futures contracts require participants to post margin, whereas forward contracts typically do not have margin requirements.


Who are the main participants in futures markets?

The main participants in futures markets are hedgers, who use futures contracts to manage price risk, and speculators, who seek to profit from price movements in the market.


Can I trade futures contracts without taking delivery of the underlying asset?

Yes, most participants in futures markets close their positions before the expiration date by taking an offsetting position, eliminating their obligation to take or make delivery of the underlying asset.


What factors influence futures prices?

Factors influencing futures prices include the spot price of the underlying asset, the risk-free rate of return, storage costs, dividends, and convenience yields.



 


About the Author



Spitty, the founder of Spitfire Traders, is a full-time crypto, forex, and stock trader with years of experience under his belt. His passion for trading led him to develop a successful career, and now, he is dedicated to sharing his knowledge with others as an educator. Spitty is a firm believer in confluence trading, focusing on technical analysis without relying on fundamentals or news events. He also steers clear of indicators and breakout strategies, emphasising the importance of price action and risk management.



As a seasoned trader, Spitty is committed to helping his students become consistently profitable full-time traders. Through Spitfire Traders, he offers a comprehensive course and mentorship program, providing the necessary tools and guidance for aspiring traders to succeed in the markets. With a no-nonsense approach to trading and a keen eye for spotting valuable opportunities, Spitty continues to inspire and support the next generation of traders on their journey towards financial freedom.


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