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Futures

Futures

(TeachMeFinance.com is intended for educational purposes only. TeachMeFinance.com is an informational website, and should not be used as a substitute for professional financial, legal or medical advice. Please contact your attorney or accountant before making actual investment decisions. Also please read our disclaimer.)

Introduction

The futures market as it currently stands rose from humble beginnings. Futures trading began in the 18th century in Japan. It was originally designed for trading in silk and rice. In the 1850’s the Unites States developed a futures market to trade agricultural commodities including cotton, corn and wheat. A futures contract is an agreement between two parties to engage in a transaction involving physical commodities or financial instruments that will be delivered in the future at a pre-determined price. It is a kind of financial contract or derivative instrument. When a person buys a futures contract they are agreeing to buy a product from the seller at a set price. The product has not yet been produced. The futures market does not necessarily involve large deliveries of commodities as transactions are usually entered into by people wanting to speculate or hedge their risks. This means that physical goods are not always exchanged. This feature makes the financial instruments of the futures market popular for speculators as well as producers and consumers.

Investors generally agree that the futures market is an important hub of the financial world which allows for competition in trading in products, as well as being an outlet in which price risks can be managed. It is a very complicated and risky market but breaking it down and considering how it functions can help us to understand it. Futures are a useful trading tool for many different types of people. This information is designed to help you understand the way that the futures market functions, who uses this market, and what strategies work best when trading in futures.

A Brief History

The futures market in North America originated approximately 150 years ago. Before it began, farmers would physically bring their crops to market to sell their inventory. This system meant that they had no idea of the demand and, if they brought too much with them, any excess in supply would often be left to rot. Another problem was that goods made from crops that were out of season would become very expensive. To deal with these problems, central grain markets and a centralized marketplace were established as places for farmers to sell their products. They could either sell the commodities for immediate delivery (also known as spot trading) or they could sell for forward delivery. Contracts for forward delivery were the first type of what are now known as futures contracts. Forward contracts prevented a lot of wasted products and profits as well as stabilizing the supply and prices of off-season products.

The future market today has grown into a global marketplace that trades all sorts of products, not just agricultural commodities. Currencies and financial instruments are also traded on the futures market. Participants in the futures market include farmers, manufactures, importers, a exporters, and speculators. Technological advances mean that prices of various commodities can be communicated throughout the world connecting buyers and sellers from different countries.

How does the Futures Market Work?

The futures market connects buyers and sellers from all over the world and enables them to enter into futures contracts. The contracts can be agreed according to an open cry pricing system, or electronic bids and offers can be made. The contract specifies the price that is due to be paid and the date that the commodities will be delivered. Remember that futures contracts will usually end before the commodity is actually delivered.

What is a Futures Contract?

EXAMPLE: Say that you want to subscribe to cable television. You can find a suitable cable company and enter into an agreement with them to receive specific channels at a fixed price. This is just like a futures contract as you agree to receive the product (at a specified date and terms) sometime in the future. The price has been fixed and, even if the price of the product rises during the period, your rate will not be affected. In this way you are protected from the risk of a future price increase.

This is how futures work and it can be with any commodity at all. It enables buyers and sellers to secure prices so that they can guarantee sales and forecast production and profits.

EXAMPLE 2: A wheat farmer wants to lock in the price that he will sell next season’s crop. A baker also wants to secure the price that they will pay for the wheat so that they can work out their production capabilities and future profit. It benefits both the farmer and the baker to work out a futures contract to guarantee the delivery of a certain quantity of wheat at a fixed point in the future for a fixed price. They secure the price that they agree will be fair at the delivery time. It is the futures contract (and not the actual product, in this case the wheat) that is traded on the futures market.

The two parties in a futures contract are referred to by different terms. The party that agrees to sell and deliver the commodity (the farmer in the scenario above) is known as the short position. The party agrees to purchase and receive the commodity (the baker in the scenario above) is known as the long position. Every futures contract will have a long position and a short position. These terms will be used in the section dealing with strategies. A futures contract will specify all aspects of the transaction. This includes the amount of the commodity that is being traded, the quality of the commodity, the price per unit, the delivery date and the way that it will be delivered. The futures contract has a “price” and this is the price that the parties agree upon for the value of the commodity or financial instrument to be delivered. If the farmer and the baker enter an agreement for 6,000 bushels of grain for $5 per bushel, then this will be the “price” of the contract.


Profit And Loss - Cash Settlement

When it comes to calculating profits and losses of a futures contract, it will depend on the way that the market for that particular contract fluctuates on a daily basis. Take the above example of the price of the wheat futures contract. Say that the day after the farmer and baker enter into the above futures contract (for $5 a bushel) the futures contracts dealing with wheat increase to $6 per bushel. This means that the holder of the short position (the farmer) will have made a loss of $1 per bushel because he is obliged to sell his wheat at $5 instead of $6 per bushel. The holder of the long position (the baker) has made a profit of $1 per bushel as he now has to pay less than the market value in the future for the wheat. This profit and loss is reflected in the accounts of the farmer and the baker on the day that the value changes. The farmer has $6000 deducted from his account ($1 for each of the 6,000 bushels) and the baker has $6,000 added to his account. These changes are made each time the market moves and the value of the commodity changes. Futures positions are updated with profits and losses being added or subtracted from the trader’s account on a daily basis. This makes the futures market different from the stock market. The stock market doesn’t realize the gains or losses that have occurred as a result of changing prices until the investor sells the stock. The daily adjustment of prices in the futures market means that most of the transactions that are taking place in this market are settled in cash. The actual commodity that is being traded will be purchased in the cash market. Prices of commodities tend to maintain similar values in the case and futures markets. When the futures contract for a commodity expires, the prices in each market merge into one. The futures contract is settled whenever either party decides to close their futures position.

Take the above example of the wheat farmer and the baker; if the contract was settled at the time that the price was $6 per bushel, the farmer loses $5000 and the baker profits by $5, 000. After this settlement the baker then needs to buy the wheat in the cash market for the current cash market value which will be $6 per bushel. This means that he has to spend a total of $30,000 (5,000 bushels at $6 each). But, the profits that he has made on the futures contract will be put towards the wheat purchase, meaning that he ends up paying the price that was agreed on in the futures contract. The purchase price of the wheat on the cash market ($30000) less the futures profit ($) equals $25, 000 which is the value of the original futures contract (5,000 bushels at $5 each). After closing the contract, the farmer can then sell his wheat for the cash market value of $6 per bushel. However, because of the loss that he has made on the futures contract, the real value will actually be $5 per bushel. His losses are offset by charging a higher price when selling in the cash market. This process is known as hedging.

From the above scenario it is easy to see how futures contracts are actually financial positions that can be traded by speculators. In the above example, the two parties may not necessarily have been a farmer and a baker, they could have been speculators. Speculators trade in the futures contracts without trading the commodities on the cash market when the contract expires. The speculator with the short position in the above example would have lost $5,000 and the speculator with the long position would have profited by the same amount.

The Futures Market is Important for the Economy

The futures market is a very active market and is central to global trade and commerce. This makes it a good place to gather information about the market and economic sentiment.

Price Discovery

Because the futures market is highly competitive, it can be used as a tool to determine prices. This is done by looking at the current and estimated future levels of supply and demand. There is a high degree of transparency in the futures market because it relies on the continuous availability of information from all over the world. A lot of different political, social and economic factors (such as war, weather, default on debts, deforestation, migration and land reclamation) can influence levels of supply and demand, which in turn affects current and future commodities prices. The way that this information is viewed by people means that commodities prices are constantly changing. This is referred to as price discovery.

Risk Reduction

People also use the futures market to reduce their risks involved in purchasing commodities. The fact that the price is fixed means that participants are able to determine the quantity that they need to trade. Because there is less risk, there is a reduced chance that traders will increase their prices to cover any losses made in the cash market. This reduces the final cost to the consumer.


The Players

There are two categories of players in futures. They are known as hedgers and speculators.

Hedgers

A hedger is someone who trades in the futures market in order to guarantee the price of a particular commodity that will be sold in the cash market at some point in the future. Hedgers can include importers, exporters, farmers, and manufacturers. They use the futures market to protect themselves against the risk of fluctuating prices. The long position holder (the party who will buy the commodity) is attempting to lock in the lowest price that they can. The short position holder (the party who will sell the commodity) is trying to secure the highest possible price. The advantage for both parties is that the futures contract gives them both certainty relating to the price. Hedging with futures contracts is also a good way of securing a sufficient margin between the production costs and the retail value of a particular product.

EXAMPLE – A jeweler needs to purchase enough silver six months in the future to make products that have already been advertised at set prices. The jeweler would be in a very difficult position if the price of silver were to rise in the next six months as the prices of the products have already been set. The additional cost cannot be added to the retail cost so it would have to be absorbed by the jeweler. To prevent this from occurring, the jeweler needs to hedge his risk against a silver price increase. To do this he would need to purchase a futures contract that would be settled in six months time at a set price. Say that he got a price of $6 per ounce. If the cash market price of silver increased to $7 after six months then the jeweler would have avoided the price rise. However, if the cash market price of silver declined during that period, then he would have been in a better position if he didn’t enter into the futures contract. Because silver is a very volatile market, the futures contract is a good way for the jeweler to protect himself from risk.

Basically, hedging refers to the attempt to reduce risks by securing the prices of future transactions. Someone buying a futures contract in securities can hedge against futures increased in equity. If the equity price has increased when the contract expires, the contract can be closed at the increased value. Hedgers can also go short in a futures contract to hedge against a future decrease in stock prices. For example, a potato farmer can hedge against a future decrease in the prices of French fries. A restaurant can hedge against a future rise in the price of potatoes. A company that anticipates that it will need a loan in the future can hedge against higher interest rates, and a coffee shop can hedge against futures increases in the prices of coffee beans.

Speculators

Speculators are not using the futures market to reduce risk but are aiming to derive a benefit from the risky nature of the market itself. Whereas hedgers are aiming to protect themselves from price changes, speculators are aiming to profit from these changes. They increase the risks that they take on the futures market in order to maximize their profits. A speculator in the futures market will usually buy a contract at a low price with hopes of selling it at a higher price at some point in the future. They will usually be buying this type of futures contract from a hedger that is selling a low priced contract because lower prices are anticipated in the future. The speculator is not actually interested in purchasing the commodity involved in the contract. They are only interested in using the market to profit from the rising and declining prices of futures contracts.

Hedgers and speculators can be differentiated as follows:

The Hedger:
  • In the short position the hedger is looking to secure a price to guard against the risk of lower prices in the future.
  • In the long position the hedger is looking to secure a price to guard against the risk of higher prices in the future.

The Speculator:
  • In the short position the speculator is looking to secure a price in anticipation of lower prices in the future.
  • In the long position the speculator is looking to secure a price in anticipation of higher prices in the future.

Because the futures market is rapid in its response to the constant flow of information, speculators and hedgers are able to work together and benefit from the market. When the expiration of a contract gets close, the information about the commodity involved will become more solid. This creates an accurate picture of the true supply and demand and the price of that particular commodity.

Regulatory Bodies

The Commodity Futures Trading Commission (also known as the CFTC) is responsible for regulating the futures market in the United States. The CFTC is not a government agency. The National Futures Association (NFA) also regulates the market. The NFA is a self-regulatory agency that is authorized by Congress. It is subject to supervision by the CFTC. A broker or firm that wants to trade in futures contracts must be registered with the CFTC and the NFA. If there is any illegal activity on the futures market, the CFTC is able to initiate criminal proceedings against the person involved via the Department of Justice. A violation of the NFA’s code of conduct can lead to a person or company being permanently banned from participating in the futures market. Investors that want to trade in futures must become familiar with these regulations. It is also very important that the brokers or firms used by investors are appropriately licensed.

It is imperative that investors know their rights. If there is any conflict with brokers or brokering firms, an investor may seek arbitration with the NFA and compensation from the CFTC.

Characteristics

The calculation of gains and losses made on the futures market occurs a little differently to the stock exchange. Here is a brief explanation of the concepts used:

Margins

The definition of “margin” is different in the futures market and the stock market. In the stock market, margin refers to the money that is borrowed for the purpose of buying securities. In futures, the margin is an initial “good faith” deposit that a market participant is required to make into their account before they will be permitted to enter into a contract. This amount is used to cover any daily losses that may occur. The futures exchange specifies the minimum sum of money that is required as the initial deposit for each futures contract. This is known as the initial margin. This amount is refunded (with the gains or losses of the contract) at the time that the contract is closed. The amount of money that is held in the margin account will vary each day according to market fluctuations. The minimum initial margin set by the exchange will usually be between 5-10% of the value of the contract. This amount is reviewed frequently. If the market is particularly volatile, then the exchange will usually increase the required initial margin.

There is also a “maintenance margin”. This refers to the lowest amount that is permitted in an account before it is required to be topped up. If a margin account loses money consistently and it reaches the maintenance level, then the responsible broker will make a margin call. This involves the owner of the account making a deposit so as to replenish it to the initial amount.

EXAMPLE: Assume that you have entered into a futures contract with a $2000 initial margin, and a $800 maintenance margin. A series of declining prices in the market has meant that your account has reduced to $500. Your broker would then make a margin call and ask you to deposit a minimum of $1500 in the account. This would restore the value of the account to the $2000 initial margin.

An important point to note is that funds normally need to be delivered immediately after a margin call. If this is not done, the broker may be able to liquidate your entire position to cover the losses that they have incurred.

Leverage

When dealing with the futures market, leverage refers to controlling commodities with very large cash values while paying relatively small amounts of capital. Put simply, it refers to situations where you can pay a small initial margin to enter into a futures contract that is valued at much more than you have paid. People say that price changes in the futures market are leveraged to a much greater extent than other types of investments. This means that a small variation in the price of a futures contract can result in large profits or losses for the people involved. The high leverage exists because the initial margins are only a small percentage of the cash market value of the futures contracts. This makes the futures market a double-edged sword because it is very useful for traders, but can also be extremely risky. Where a futures contract has a small the initial margin (as a percentage of the value of the contract), it will have high leverage.

EXAMPLE: Assume that you purchase the long position of a futures contract where the commodity involved is 30,000 pounds of coffee, and that the initial margin for this contract is $5,000. The actual value of the coffee however, is $50,000. This will be viewed as an investment with very high leverage. The inherent risks of the futures market become more obvious when you understand the ways that leverage works. A highly leveraged investment will produce either huge profits or huge losses. Leverage means that even a small variation of the value of a futures contract will translate into very large gains or losses when compared with the initial margin that has been invested.

EXAMPLE: Assume that there is an anticipated rise of stock prices and, in order to capitalize on this, you purchase a futures contract. The index currently stands at 1300 and your initial margin is $10,000. The contract price is the index multiplied by $250, so upon entering into the contract it is valued at $325,000 ($250 x 1300). This means that whenever the index gains or loses a point, the account will be credited or debited by $250. Say that after 2 months the index was now standing at 1365. This would mean that you have earned $16,250 ($250 x 65). This is a profit of 162% on the initial margin! However, if the index lost 65 points then you would lose $16,250 and you would need to pay an additional $6,250 in order to cover your losses. These huge changes (either positive or negative) are brought about by only a 5% change in the index. In some cases the change to profit or loss can be more than the initial margin. This illustrates the riskiness of leverage. Even if a commodity does not seem to be very volatile in terms of its value, small changes can translate into huge profits and losses for the investor. This is due to the high leverage and small initial margins that exist in futures contracts.


Pricing and Limits

Competitive price discovery plays a large role in influencing futures contracts. Prices used in futures contracts are expressed in the same way as they are in the cash market. For example, they are quoted in dollar/cent value or per the relevant unit depending on the commodity (ounce, barrel, index point and so on). One important characteristic of futures contract prices is that there is a set minimum that restricts their movement. The futures exchange sets these minimums and they are referred to as “ticks”. An example may be a minimum that restricts the movement of the price of a bushel of grain (in either direction) to a quarter of a cent in one day. Investors need to understand the way that minimum prices will influence futures contracts.

EXAMPLE: Assume that a particular grain contract uses the minimum set above (one quarter of a cent). A futures contract for 2,000 bushels of grain would have a minimum of $500 ( 2,000 bushels x 0.25 cents). This means that the contract could earn or lose $500 each day.

There is also a limit set on the upper and lower prices that the contract can trade at. These boundaries are set on a daily basis. The upper and lower values are calculated by adding and subtracting the price change limit with the value of the contract at close on the previous day.

EXAMPLE: Assume that the price change limit for silver is $0.25 per ounce. If silver closed yesterday with a value of $6 then the upper price limit of silver today is $6.25 and the lower price limit is $5.75. If any futures contract dealing with silver reaches either of these boundaries during a day then the futures exchange will shut down all silver trading. New boundaries are calculated each day based on the value of silver at close on the previous day. The daily price is able to rise or fall by no more than $0.25 until it finds an equilibrium.

The fact that trading is closed when a commodity reaches the daily limit means that there may be some situations in which liquidation of a futures contract is not possible at a particular time. The futures exchange has the power to change price limits when necessary. They will frequently abolish price limits during the month of a contract’s expiration (this period is also known as delivery or the “spot” month). They do this because this is the most volatile trading period as each party is trying to get the best price before close.

The futures exchange and the CTFC also sets a limit on the amount of contracts or units in a particular commodity that one person is permitted to invest in. This is to reduce the possibility of unfair advantages when one person is able to control the market price. These are commonly referred to as position limits.

Strategies

Futures contracts are essentially based on attempting to predict the future value of a particular commodity or index. Speculators use a variety of strategies to benefit from rising and falling prices in the futures market. The most popular strategies used are going long or short, and spreads.

Going Long

Going long refers to entering into a futures contract to purchase and receive the particular commodity at a fixed price. Investors engaging in this strategy are attempting to profit due to price increases in the commodity in the future.

EXAMPLE: An investor buys a futures contract in June for 2000 ounces of gold at $250 an ounce. Delivery is due in September. The total price of the contract is $500,000 and the initial margin is $2,000. This investor is going long as they are anticipating that the value of gold will increase between June and September. Let’s say that the price of gold in August has risen to $252 per ounce. The investor can then sell the contract to realize the profit. The price of the contract is now $504,000 meaning that the investor can make a profit of $4,000. Given that this contract was highly leveraged (with an initial margin of only $2,000) the investor has made a profit of 200%. This is an example of successfully going long. However, remember that the investor would have had a 200% loss if they price of gold had dropped by $2 per ounce. Also bear in mind that if the margin fell below the maintenance margin at any time while the investor held the contract, he or she would have had to pay margin calls and this would also have affected the profit or loss.

Going Short

Going short refers to entering a futures contract to sell and deliver a commodity for a fixed price. An investor who uses this strategy is hoping to profit from decreasing prices. If a speculator sells high at a certain time, they can then repurchase the contract at a future date for a lower price and make a profit.

EXAMPLE: An investor researched the market and concluded that the price of oil would decline during the following six months. To make a profit she could sell an oil contract now at a high price and then re-purchase the same contract in six months time at the lower price. Speculators use going short to benefit from a declining market. Assume that this investor held an oil contract of 2000 barrels valued at $30 per barrel (so the total value is $60,000) with an initial margin of $3,000. She sold this contract in May for $60,000. In March the price of oil had fallen to $25 per barrel. She could then repurchase the contract for $50,000 and make a $10,000 profit. The going short strategy could still have ended in a large loss if the investor had made different decisions.

Spreads

The two strategies outlined above (going long and going short) both involve investing in contracts with the hope of profiting from changing prices in the future. “Spreads” is a different strategy. Spreads refers to the situation where an investor purchases two contracts dealing with the same commodity and attempts to benefit from a difference in price between them. This is a much more conservative approach to futures trading because it is less risky than going long or going short. Some of the different forms of spreads include:

Calendar Spread – An investor is simultaneously buying and selling futures contracts in the same commodity with identical prices but different expirations.

Inter-market Spread –An investor has two contracts that expire in the same month but they deal with two different products. In one market they go long and in another they go short.

Inter-Exchange Spread –An investor creates positions in two or more futures exchanges. For example, they enter into futures contracts in futures exchanges in both London and Chicago.






About the author

Mark McCracken

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".

Copyright © 2011 by Mark McCracken , All Rights Reserved