Exchange trading allows the use of instruments such as futures. By deferring settlement and using only a portion of the transaction amount, deal participants get additional opportunities for different strategies
What is a futures and how does it differ from other instruments
A futures is a type of derivative (sometimes called a “secondary”) financial instrument. Essentially, a futures is an agreement to buy or sell a primary instrument with deferred settlement. The primary or underlying instrument may be a security, the currency or raw materials.
A futures is an exchange-traded commodity. The futures price varies depending on the market situation. The other parameters are standard. They are the delivery time, the amount of goods in the lot, its quality or brand. Thus, the buyer and the seller of the futures undertake the obligation to fulfill the contract on the stipulated term. The value of the asset itself may change in the market by that time, but it cannot influence the terms and conditions of the transaction.
The investor buys a futures contract for 1 thousand barrels of Brent on 21.02.21. On the day of purchase he pays $59.44. By the time of delivery, the price of a barrel of oil may change, but the settlement will be made at the transaction price.
Unlike primary securities, futures do not have a standardized form of issue. Futures are not securities, but an agreement between two parties, but with the exchange participation. The stock exchange, acting as the organizer of the trade, sets the requirements for the contracts and obliges the parties to follow the specifications.
The official document of the futures must approve:
- its name;
- abbreviated designation;
- what type of contract it refers to – staged or settlement;
- the quantity of goods per contract (lot size);
- the date of the contract execution;
- price step.
A futures is a separate exchange-traded commodity. The value of the futures is not always equal to the price of its asset. The futures price, apart from the price of the underlying asset, is affected by various forecasts and risks of changes in the subject of the contract.
The ratio of the price of the underlying asset on the spot market to the price of that asset in the futures market may be either positive or negative:
- contango is referred to as a condition where the futures are more expensive than the underlying asset;
- A backwardation is the inverse, where the futures are cheaper than the underlying asset. In the case of backwardation, most investors expect the value of the asset itself in the underlying markets to fall soon;
- Also, contango and backwardation are referred to when comparing futures prices with different delivery terms. If the price of the June futures is higher than the April futures, that is, the longer-dated contract is trading at a higher value, it is a contango. The opposite situation is called backwardation.
Futures are traded with mandatory transaction security. This is usually a price-dependent deposit of 2-10% of the value of the futures asset. The collateral is insurance required by the exchange. Both parties to the transaction provide the collateral.
The exchange blocks this amount on the traders’ account as a sort of pledge securing the transaction. Moreover, the blocked some seller increases if the futures price goes up, and decreases accordingly if the futures price goes down. Therefore, if the seller has $1,000 blocked on the futures, the exchange can additionally block, for example, another $200 a week later, if the market price has risen. For the buyer, the situation is the opposite – his security increases if the price decreases. When the contract expires, the final calculations are made, taking into account the amount of the security.
Thus, it turns out that at the conclusion of the deal no payment is made, the two parties conclude an agreement, the exchange blocks the funds in their accounts until the execution of the contract. If the party keeps the futures contract until the closing date, then he will have to execute the contract – to deliver the asset, transfer the money or make the final recalculation.
If one of the parties refuses to fulfill the conditions, the exchange will be forced to fulfill its obligations. In this case, it will keep a part of the security, and the violator will face property claims. Such a situation is possible only with futures, on which real delivery of assets is obligatory. For futures, which only provide for netting (cash-settled futures), a cancellation is impossible in principle, and possible losses of the exchange are covered by the collateral.
Due to the guarantee coverage investors often choose futures trading, using it, in fact, as a “leverage”, because in order to make a deal it is necessary to have only up to 10% of the value of the underlying asset.
What are futures?
Contracts are divided into two types, depending on the nature of the fulfillment.
- A delivery futures implies that the contract is based on an asset that must be shipped and paid for at the end of the contract. That is, if the futures mean the delivery of 1,000 barrels of oil by a certain date, this type of contract is called a delivery contract.
- A cash futures can be concluded for any assets, including indices, interest rates, and anything else that cannot be shipped or touched. In such a case, there is a recalculation of profits and losses at the end of the contract. The intangible nature of a futures contract allows it to be used for risk insurance on the stock market.
For example, if an investor anticipates that his shareholding will fall in value in the near future, he may sell a futures contract for the same shareholding at the current price. If his fears are justified, he will not be at a loss. The profit from a decrease in the futures price compensates for the loss from a decline in the stock price.Such schemes are called risk hedging. Sometimes an investor can even make a profit on it.
What is the difference between a futures contract and a forward contract?
We can say that the future is a stricter version of the forward, which is a postponed contract with certain obligations under it. The futures have some fundamental differences:
- a forward is always concluded for a real asset: raw materials, currencies or securities. Futures may be concluded for indices or interest rates;
- a forward does not only stipulate the delivery time and contract value but also other conditions, including the asset itself. That is, the futures are more standardized;
a forward is an over-the-counter transaction, while a futures contract can only be concluded on the stock exchange;
- Forwards are not insured against delivery failure, while futures are regulated by the exchange clearinghouse.
What is the difference between a futures and an option
Another instrument similar to a futures is an option. But whereas a future is a deferred contract for the delivery of the underlying asset, an option only gives the buyer the right, but not the obligation, to conclude the contract in the future.
The fundamental difference lies in the obligations between the seller and the buyer. Whereas in futures trading both parties have equal rights and obligations which they must fulfill at the end of the contract, in the case of an option, the seller must fulfill the terms and conditions and the buyer may ultimately not exercise the purchased right to conclude the transaction.
Another difference is that the option itself has its own price, which is essentially a premium to the seller, even if the transaction underlying the option ultimately fails. Futures, on the other hand, have no added value.
How to Trade Futures
Futures can be traded by professional market participants as well as by private investors with a broker. There are several strategies of futures trading; they depend on the aims pursued by the trader.
Futures can help insure the owner of an asset against adverse price changes because they fix the price and do not require immediate payment of the full transaction amount. Moreover, hedging is used not only with securities but also with real assets such as raw materials delivery or currency pairs, e.g. dollar-euro.
This futures trading strategy involves making multidirectional trades in futures in such a way that a profit is made on the difference in the buy and sell price. Arbitrage can take place at different times or on different platforms.
- Temporal arbitrage implies that a trader enters into futures contracts on one market but at different times.
Example. An investor bought stock futures, which later increased in value. After selling the futures he made a profit.
- Spatial arbitrage, on the other hand, consists of buying and selling futures at the same time in different markets.
Example. An investor, if there is a price difference, makes a deal to buy WTI crude oil futures in London in May and sell the May contract in New York.
- As a variation of spatial arbitrage, we can single out calendar arbitrage which consists in simultaneous purchase and sale of futures for the same instrument with different delivery terms.
Example. An investor may buy an April gold futures and sell a more expensive one for June. Such an operation has a benefit if the difference in price covers expected futures price fluctuations, which can increase the amount of collateral.
It should be noted that any speculative strategies should take into account the cost of broker and exchange commissions, which may offset the desired profits.
Long and short positions
In all cases, the trader can open long or short positions.
Long positions are focused on the prospect of growth in the value of the futures asset and, more importantly, the futures itself. The trader buys futures for the asset delivery and as the value of the futures grows, he can sell it without waiting for the end of the contract.
Short positions are speculation to the contrary. At the moment of the unfavorable forecast, the trader sells his futures and waits until its value falls even lower, then he buys it back at a lower price, thus benefiting from the difference between selling and buying. Unlike securities trading, long and short positions in futures are equally high risk. Such a trading strategy is recommended only for experienced investors.
Where to trade futures
The world futures exchanges are located in Chicago (Chicago Mercantile Exchange, Chicago Board Of Trade), New York (New York Mercantile Exchange), London (London International Financial Futures and Options Exchange, LME). Other major futures exchanges are Eurex, the French International Financial Futures Exchange (MATIF), the Singapore Exchange (SGX), and the Australian Stock Exchange (ASX).