Futures contracts are the backbone of financial trading, essential for managing price risks and riding market trends. In this guide, you’ll learn about the basics of futures contracts, their uses and the ecosystems they operate in.
The following sections will break down the complexities of these powerful agreements and outline the trading strategies and regulations that surround futures contracts.
Key Points
- Futures contracts are legally binding standardized agreements to buy or sell assets, used for hedging and speculation, with different market participants and types like commodity, currency, interest rate and index futures.
- Risk management is crucial in futures trading due to leverage and market volatility; traders use strategies like hedging with opposite positions, setting margin requirements and stop-loss orders to manage losses.
- Futures are regulated financial instruments, particularly by the CFTC in the US, to prevent fraud and fair trading; brokerage firms play a key role in facilitating trades and must follow regulatory standards and client interests.
Futures Contracts Explained
At the heart of many financial transactions, futures contracts are legally binding agreements where one party – the buyer or the seller – must buy or sell a specific commodity at a predetermined price on a date in the future.
They cover various commodities and financial assets – from corn to crude oil. What makes someone commit today to buy or sell at some point in the future?
The reason for entering into these commitments is mainly due to their main uses: as tools for hedging against market volatility and speculating on price movements.
For example, large food companies that rely heavily on corn are exposed to the impact of price and supply changes. To mitigate the risks of price increases due to supply shortages, these companies may use futures contracts as a hedge.
Farmers who grow corn can also use these agreements as a protective measure — selling through futures ensures profit even if market price drops when crop time comes.
Binding Agreements
Entering into a futures contract requires serious thought as it’s a legally binding agreement that binds both parties to the terms of the contract. Whether you’re a multinational company using the contract for hedging price risks or an individual speculator betting on price movements.
The legal enforceability of these contracts is key, providing the foundation of certainty and stability for them to work in the market.
Standardized
Futures contracts which can cover various commodities and financial instruments all have one thing in common, standardization. Traded on exchanges, every contract has standardized details such as:
- the grade
- the volume
- the delivery date
- the location of the commodity
This standardization brings consistency and clarity in futures trading and simplifies interactions in futures exchanges.
Whether it’s a contract for 5,000 bushels of corn or 1,000 barrels of crude oil, market participants know exactly what they’re getting into with each futures contract.
Futures Trading Universe
The futures market is a bustling place where different types of market participants are transacting. The arena is alive with big players hedging against price volatility to opportunistic speculators looking to make money from price movements.
These participants bring their own goals and strategies to the futures markets.
These many needs of market actors are met by the numerous contracts available in the futures market. Such contracts cover:
- Commodities
- Currencies
- Interest rates
- Indices
This offers multiple sectors to trade. Trading happens on major exchanges including but not limited to the Chicago Mercantile Exchange – institutions that provide a platform for trading and guarantee of contract settlement through affiliated clearinghouses.
Interest rate derivatives trading happens for individuals and companies to manage their exposure and also takes place at these venues where buyers and sellers meet amidst diverse participation, which is important given the changing economic landscape that affects borrowing costs globally.
Market Actors
Actors play different roles. Hedgers and speculators are the two main types in this space. The hedgers are big companies or individual producers who use futures contracts to stabilize the commodity prices they are dealing with.
For these entities, these contracts are strategic tools to mitigate risks from price movements and stabilize their business.
Speculators on the other hand take the very risks that hedgers try to avoid. This group are individuals or companies who want to profit from the price movements of futures contracts by using technical and fundamental analysis to identify trades.
In this space are arbitrageurs — smart traders who look for short term mispricings across related markets to make money from.
Types of Futures Contracts
There are many types of futures contracts available, each tied to different underlying assets to trade. Among the commodities, participants can trade:
- Agricultural commodities like grains, fiber crops, timber products, dairy products like milk, beverages like coffee, sweeteners like sugar and various livestock.
- Energy from crude oil to natural gas.
- Metals from precious like gold to industrial like steel and copper.
For traders who are more into financial markets than physical goods, there are three types of futures contracts they can look into.
- Currency futures: These allow individuals to hedge or speculate on currency movements between different currencies.
- Interest rate futures: Through these traders can get exposure to bond prices in finance.
- Index futures: These allow trading based on stock market indices that represent broader market trends.
These types of futures contracts offer ways for traders to get into financial markets by taking a futures position that is sensitive to futures prices while trading the very same futures.
Exchanges
Major exchanges like the Chicago Mercantile Exchange, ICE Futures U.S. and CBOE Futures Exchange are the platforms for futures trading.
These centralized markets bring together buyers and sellers who want to trade futures by ensuring that all contracts are standardized and trades are fair and orderly.
These exchanges work with clearinghouses which are third party intermediaries that guarantee the settlement of futures contracts when they expire.
Risk Management with Futures Contracts
Futures trading involves risks. Market uncertainty and price volatility can result to big losses.
That’s why risk management is a must for those who trade futures. Experienced traders use various strategies to manage risks including setting predetermined account level risk parameters and trade specific risk controls like stop-loss orders.
Risk management in futures trading also requires understanding of margins and leverage. Exchanges set margin requirements that allow traders to manage bigger positions with smaller capital.
Remember that while leverage can increase gains, it also increases potential losses so it’s important to use risk management techniques in your trading.
Hedging
Hedging is a risk management strategy where an individual takes an opposite position in securities that are correlated to protect against potential losses.
In the context of futures contracts, hedging means taking a position opposite to your current risk exposure. For example a grower who expects corn prices to go down before harvest season.
This grower can sell corn futures and lock in a good price. When the market price does go down, the profits from the futures can offset the losses from the lower market price.
Remember when using such strategies to choose the right futures contract and calculate the hedge ratio correctly. Only then can you be sure your hedge covers your specific risk exposure.
Margins and Leverage
Futures trading involves high leverage and margin. Remember:
- To enter a futures contract, traders must put up an initial margin which is a deposit.
- This initial margin allows traders to control a bigger position than what their actual capital can.
- While this can increase potential gains, it also increases potential losses.
- If the market moves against a trader’s position, they can lose more than what they deposited as initial margin.
Brokerage firms must provide documents that disclose the risks of trading futures so individuals know they can lose more than their initial investment. That’s why risk management is a must when trading futures.
Speculating with Futures Contracts
Futures contracts are not only used for hedging but also as financial instruments for speculation. In the futures market, speculators are traders who want to profit from price movements by buying low and selling high or vice versa, buying and selling at a later time. They use leverage to increase their gains.
Speculators use various methods to guide their trades including technical and fundamental analysis. They employ different strategies like going long or short based on their market view.
Technical and Fundamental Analysis
In the futures market, speculators use technical analysis as a strategy. This method uses past price and volume data to identify patterns and trends that could be future price movements in securities.
Fundamental analysis is another tool where the intrinsic value of a security is determined by checking its financials through financial statements. It gives an idea of the company’s earning capacity which helps speculators in making informed decisions on their trades. Usually a combination of both technical and fundamental analysis is used by speculators to get a complete view of the market.
Trading Strategies
Traders in the futures market use different ways to play expected price movements. They can go long on a futures contract if they think the price of the underlying asset will go up.
On the other hand if their analysis says the asset’s value will go down, they can short.
To limit their exposure to financial risk, speculators often use stop-loss orders as part of their strategy. These specific orders act as a safety net against losses from a losing trade by setting a limit to their losses.
Advanced Trade Management systems does this for you by automatically setting these stop-loss orders so traders can manage their risk better.
Futures Contracts vs. Other Financial Instruments
Futures contracts are part of the financial markets but stands out among many other trading instruments. They are different from stocks, options and forward contracts by their ownership rights, obligations of the parties involved and how they are traded.
To understand futures contracts you need to compare it to these other financial instruments.
Stocks represent an ownership in a company and their value is based on future profits and cash flows. Futures contracts value is based on the market price movement of the underlying asset and a firm agreement between the parties to buy or sell at a future date.
Options are different from futures because while both are about underlying assets, the main difference is in the risk exposure: options give buyers not only the potential to profit but also the discretion, they can exercise if profitable but have no obligation to transact on the asset unlike the binding commitment in futures contracts.
Stocks
Both stocks and futures contracts are financial instruments that are traded in the market. They are fundamentally different. Stocks represents a portion of a company’s ownership which gives stockholders the right to dividends and claim on the company’s assets and earnings.
On the other hand futures contracts has no connection with dividends and is a contractual agreement to buy or sell an asset at a future date. Because of these inherent differences between them, stocks and futures contracts are used for different investment strategies.
Options
Like futures contracts, options contracts value is based on an underlying asset. The difference is in the rights they give. When you own an options contract you have the right but not the obligation to buy or sell the underlying asset. So you have the discretion to exercise this option based on its profitability.
There are two types of options contracts: puts and calls. Puts give you the right to sell and calls give you the right to buy the underlying asset at a fixed price until a certain expiration date.
Forward Contracts
Forward contracts are similar to futures contracts where parties agree to buy or sell an asset at a future date.
Unlike exchange traded futures, forward contracts are private agreements tailored to the specific needs of the parties involved and not standardized like futures contracts. Because of their non-public nature forward contracts have more counterparty risk than standardized futures contracts.
Regulatory Environment
The futures market is heavily regulated and has standards to ensure fairness and integrity. Futures trading and options on futures in the US is overseen by two main regulatory bodies, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).
To protect the public from fraudulent activities these bodies impose rules against fraud, manipulation and improper practices on commodity and financial futures and options sales.
They also aim to create markets for futures and options that are competitive, open and transparently operated on sound financial principles. Brokerage firms in this sector must comply with their rules which includes business integrity through capital adequacy requirements and strict record keeping protocols and margin requirements as well as reporting requirements.
CFTC
In the US, futures contracts is overseen by the Commodity Futures Trading Commission (CFTC). This agency is responsible to protect consumers from fraud, manipulation and harmful practices in commodity and financial futures and options. It also aims to create transparent and competitive markets for trading these instruments.
With authority over commodity futures trading, CFTC enforces the rules outlined in Title 17 of the Code of Federal Regulations. It supervises intermediary entities in the derivatives market by requiring them to register with the National Futures Association.
Brokerage Firms
In futures trading, brokerage firms are important. In the US to trade futures, firms must be registered as broker-dealers or merchants with the Commodity Futures Trading Commission (CFTC) and comply with its rules on capital and margin requirements, business standards and record keeping and reporting requirements.
As intermediaries for individuals in the futures market they are responsible for:
- Trading client accounts
- Protecting client interests
- Providing access to current market information and full support
- Conflict resolution services
They must disclose all fees and commissions and other charges to their clients.
Conclusion
In summary, futures contracts is for anyone in the financial markets. These contracts are binding agreements to hedge against price volatility or speculate on price movements.
While there are risks involved, with proper risk management techniques like hedging and leverage management can reduce losses. And understanding the regulatory environment and the players in the market.
Whether you’re a corn farmer looking to lock in a price or a speculator looking to make money from price movements, futures contracts has many opportunities. Happy trading!
FAQs
What is the difference between a forward contract and a futures contract?
Forward contracts result in physical delivery of the underlying asset when they expire, whereas futures contracts are marked to market daily and do not result in physical delivery.
That’s the main difference between the two.
What are the 4 types of futures contracts?
There are 4 types of futures contracts, which are commodity futures, currency futures, index futures and stock futures.
What is a futures contract example?
A futures contract is a commitment to buy or sell a specific amount of an underlying asset on a specific date at a fixed price.
The asset can be oil or agricultural commodities.
What is a futures contract?
A futures contract is a financial instrument that is a binding agreement where parties agree to buy or sell a standardized asset at a specific time either on a specific date or within a specific month. Used for speculation and hedging.