The term “futures” is self-explanatory – these contracts are settled in the future.
So, what is a futures contract? It is the contract that requires delivery of certain assets at a definite price in the future. A buyer of a futures contract is obliged to purchase an asset on a predetermined day, while a seller, in its turn, is obliged to sell it. Both obligations are applicable to the standard quantity of assets and are to be fulfilled in the future at a price which was agreed at the moment of purchase.
In other words, a futures contract should be settled on the date specified in the contract. The futures for delivery of everyday goods are the most common. These are the contracts for:
- crude oil
Types of futures
There are two types of futures:
- the ones which call for physical delivery of the asset
- the ones which do not require it.
The first type is used in the real sector of economy. For example, farmers enter into a futures contract in order to sell their goods at a favorable price in the future. Buyers need to conclude a contract to make sure that they will be able to purchase the goods. Thus, the parties insure themselves against contingencies in the market.
The second type of a futures contract is usually used by traders who want to profit from price fluctuations, but they do not intend to buy the underlying asset itself. For example, if investors buy oil futures for $48 per barrel and the price rises to $56 per barrel, then they gain $8. On the other hand, they can lose the same $8 if the price moves down to $40. Traders don’t have to store or transport an asset, if they buy it. They can settle the contract with a few mouse clicks.
Where are futures contracts traded?
Futures contracts are traded on futures exchanges. Here are the most famous commodity and futures exchanges:
- The New York Merchantile Exchange (NYMEX)
- The Chicago Board of Trade (CBOT)
- Chicago Mercantile Exchange (CME)
- International Petroleum Exchange (IPE)
- London International Financial Futures Exchange (LIFFE)
- London Metals Exchange (LME)
Specifics of futures trading
Futures trading is similar to forex trading. The principles of technical and fundamental analysis are also applied on futures markets: traders use indicators, charts and place orders in the same way as they do on Forex. Moreover, these tools were initially intended for trading on the futures markets which appeared earlier than the foreign exchange. However, futures trading has some key distinctions.
- First of all, a trade on Forex can last to the end of time. In other words, when traders buy the GBP/USD pair, for example, they can keep the deal open for months or even for years. Futures traders don’t have such an opportunity. A futures contract has an expiration date, so if an investor does not close a position, it will be closed automatically at the latest price fixed on the last trading day. So, one should always keep in mind the expiration date and buy a longer-dated contract at the right time.
- The futures code comprises several symbols. The first symbols indicate the underlying asset (gold, oil, cotton, and so on), the next symbols show the month and the year of delivery. For example, NGQ0 is a futures for delivery of gas in August (NG — Natural Gas, Q — August).
These are special symbols denoting the months of delivery:
- January - F
- February - G
- March - H
- April - J
- May - K
- June - M
- July - N
- August - Q
- September - U
- October - V
- November - X
- December - Z
Forex is an off-exchange market where quotes are provided by banks and dealers. That’s why prices can differ depending on a broker. At the same time, futures trading is executed on exchange markets, so prices are fixed and can’t vary as they are determined by certain buyers and sellers. Each quote has its value and volume. Websites of the exchanges provide accurate quotes for the previous trading session. That’s why all futures brokers have similar quotes.
The volume of futures contracts is standardized; the exchange establishes the quality and quantity of the underlying asset. For example, pork belly futures (PB) stipulate delivery of 40K pounds of pork bellies; gold futures provide for delivery of 100 troy ounce of gold with fineness of 995 or higher; an oil futures contract calls for delivery of 1K barrels of crude oil. The futures quotes are universal and common for the whole world.
How to buy a futures contract?
To buy a futures contract, you need to register a trading account with a broker and deposit it with a sum which will be sufficient to make a purchase. This sum is a sort of insurance against contracts depreciation.
Depending on what exchange you choose and regardless of the underlying asset, the deposited sum should be 2-10% of the asset’s value. This sum is called the initial margin. It is calculated with the help of the SPAN system that is based on the assessment of changes in price of the underlying asset.
Apart from the initial margin, there is also a maintenance margin — the sum required to maintain open trades. For example, if investors want to buy or sell futures for Brent crude benchmark, they need to have an initial margin of $4,000 and a maintenance margin of $2,000.
After trades close at an expiration date, the electronic systems which process orders calculate profit and loss automatically.
What is an expiration date of futures?
An expiration date is the day when terms of a contract should be performed. On this day a futures contract becomes invalid.
Expiration dates differ depending on underlying asset. Thus, a futures contract for the S&P 500 index expires four times a year: in March, June, September, and December.
An expiration date is easy to be followed as it is indicated in the futures specifications.
When an expiration date comes nearer, many traders and investors close their deals and wait for a new trade cycle to start. It happens as the market becomes manageable and the price dynamic is unpredictable at the moment of expiration. Some traders think that at that very moment big players enter the market and set the tone of the trend.
How to use a futures to hedge a position?
Investors often use futures contracts to hedge positions as it is an effective method to insure them against price fluctuations. However, while this hedging reduces risks, it can also lead to a decrease in profit. There two type of hedging:
- a buying hedge
- a selling hedge.
A buying hedge, also called a long hedge, insures traders against possible increases in the price of an underlying asset.
A selling hedge (or a short hedge) means that traders sell futures contracts in order to mitigate risks of a possible decrease in commodity prices.
How to make money by trading futures?
There is nothing new about profiting from trading futures: you need to buy a contract at a lower price and sell it at a higher price. Then you can buy this contract once again when its price falls, and after that sell it.
This is a well-known method that is used to gain profits from trading other tools such as stocks, bonds, currencies and options.
The futures contracts with the closest expiration date are considered to be the most profitable. They are more attractive to investors as their liquidity is higher. Prices for such futures are close to real and sharp swings are unlikely.
Futures trading seems to be a rather complicated process at first glance, but actually you will find it easy if you practice a lot and explore the market specifics. Trading requires vast knowledge, so read books, take training courses, and attend webinars. Try and you will make it! Good luck!