What is a ‘Futures Contract'?
Futures contracts can be used by hedgers and by those who speculate. Producers or buyers of a commodity of an underlying asset are able to hedge or lock in a price at which the underlying asset can be bought or sold.
Retail traders and portfolio managers can position themselves to potential profit by the price movement of the underlying asset.
Futures contracts are available for a variety of different assets. These include stock exchange indexes, currencies and commodities.
Futures contracts which are bought and sold over exchanges are standardized.
A futures contract is a derivative. A derivative “derives” its value from the movement in price of another instrument. A derivative bases its value on the changes in the price of the instrument that it is based upon. As an example, the value of a derivative can be linked to an instrument such as gold. Gold futures are based upon the price of the underlying commodity gold.
“A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts are standardized to facilitate trading on a futures exchange and, depending on the underlying asset being traded, detail the quality and quantity of the commodity.” Source: Investopedia.com. Investopedia Definition of Futures
Standardized contracts have specifications such as:
- the unit of measurement,
- the type of settlement which can be physical or cash,
- the currency unit the contract for which it is denominated,
- the currency of the contract for which it is quoted,
- and the quality or grade of the particular instrument (for instance the grade of oil or fuel).
Futures contacts can either be cash settled, or may call for the physical delivery of the underlying. A retail trader is probably not interested in delivering or receiving the physical asset of the underlying. The retail trader is usually more interested in securing a profit from the movement in the price of the underlying commodity.
Some brokerages will automatically close a futures contract before it expires. This prevents taking physical delivery of the commodity. If you are going to use futures contracts, please check with your brokerage to see if they implement this practice which can protect you.
Some cash settled contracts at the CME Group are found here: CME Cash Settled Contracts. It is important for you to know whether the futures contract is settled in cash or the physical. As stated before, if you as an investor allow a futures contract to expire, you could be looking for a place to store the physical of the commodity which the contract represents.
It's important to fully understand the physical delivery futures contracts. Here are the guidelines published at CME: CME Futures Delivery Guidelines
Some popular liquid futures contracts are;
- S&P 500 E mini(ES)
- 10 Year T-Notes(ZN)
- Crude Oil(CL)
- 5-Year Treasury Notes(ZF)
- EuroFx (6E)
- 30-Year T-Bonds(ZB)
- Japanese Yen(6J)
- 2-Year T-Notes(ZT)
Futures contracts are unlike stocks…
A stock has the potential to hold its value indefinitely. As long as the price of the stock does not go to zero, stock will have some value. A futures contract is finite; it will expire according to its pre-determined time. After expiration, a futures contract will no longer retain any value.
Hedgers can use futures contracts as a method to manage their business
At one time, futures were used primarily to give farmers a hedge against fluctuations in the price of the product they produced. A futures contract could give them the ability to remove some of the price risk, due to the potential fluctuations in the value of their product.
To illustrate, let's say we have a farmer who is a producer of corn. We also have a manufacturer who would like to use corn to manufacture canned corn.
If you are a farmer/producer, you most probably are worried about one thing – a drop in the value of your commodity, which in this case is corn.
When the farmer is planting his crop, he is concerned about the price he will get for his corn when the corn ripens at a future date. The farmer wants to get the best price possible, so he can create profit for his business. He runs the risk of the price of corn dropping between the time he plants the corn and when it is harvested then brought to market.
The farmer and the manufacturer are able to use futures to protect themselves …
The farmer and the manufacturer enter an agreement. The agreement is in the form of a futures contract. The farmer wants to get 4 cents per bushel for his corn, three months in the future when his crop will be harvested, which will allow him to make a profit. The farmer agrees to sell his corn to the manufacturer of canned corn for 4 cents per bushel. The manufacturer has determined buying corn today at 4 cents per bushel, which will be available three months in the future, will net a profit for his company.
If the price of the corn rises to 5 cents per bushel in three months, the farmer in a sense will lose 1 cent per bushel. The farmer agreed to sell the corn for 4 cents per bushel at a specific date. The manufacturer will be happy because he is getting the corn for a 1 cent per bushel discount.
The manufacturer had a greater benefit, but both parties should be happy because they should make a profit according to their projected cost analysis. In a sense, both parties have won.
The futures contract reduced the risk of the farmer/producer and the manufacturer because they will be able to close the contract at the end of the three month period, at the price of 4 cents per bushel.
Leverage and Futures
It is important to understand that trading futures is not for everyone. Because futures are used for speculation as well as a portfolio hedge for investors, they can carry the potential for large losses.
Leverage allows a trader to enter a position in futures that is worth much more than the up-front margin requirement.
Leverage is represented as a ratio. For example, let's say that the leverage on a particular futures position is 20:1. This means that if you have $5,000 in your trading account, you could enter a futures position that is worth 20 times that amount, or $100,000.
Leverage makes it possible to trade larger positions. It may appear tempting for some newer traders. It's important to remember that leverage magnifies BOTH profits and losses.
If you plan to trade futures, be sure to have a complete understanding of how your broker handles the margin and leverage requirements.
Wrapping up futures contracts…
A speculator/investor can use futures contracts to create potential profits. Speculators/investors can place educated bets on the price of the futures contract going up or down. Most futures contracts are exited before expiration. For instance, a buyer of a futures contract can sell the contract before expiration so he is no longer in the position.
Futures contracts span a wide array of different assets. For example, there is corn, wheat, coffee, oil, gas, gold, silver, bonds, and stocks.
Hedgers can use futures to protect themselves from future fluctuations in the price of a underlying asset. They do this by locking a specific price at a specific time. A hedger in the futures market can have a plan to buy or sell a commodity such as corn. The hedger will then buy or sell a futures contract to secure and lock in a particular price. The price at which the hedger buys the futures contract locks in that price which protects the hedger from rising or falling prices.
It is important to determine how much money you have to invest. Some futures contracts require more capital than others.
If you need to monitor your futures contract often it’s important to trade a futures contract which corresponds with the times you are available. Futures for the most part have certain times of the day when there is more activity. If you are trading a contract which is more active when you are available, it can be to your advantage. Usually there are better fills and more liquidity when there is more volume.
If you need to hedge against the volatility in the market, futures could offer protection.
There are many strategies used by experienced traders who trade futures both for hedging and speculation. Aeromir is a great place to learn.
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