Futures Contract
- Article photo, courtesy of CEPR
Futures contracts are one of the most widely used financial instruments, providing both speculators and hedgers with a powerful tool to manage price risks in various markets. Whether it's commodities like oil and wheat or financial assets such as currencies and stock indices, futures contracts allow market participants to agree on the price of an asset for delivery at a future date. This ability to trade on future expectations of price movements makes futures contracts an essential part of many trading strategies.
In this article, we’ll explore the fundamental concepts of futures contracts, including the structure of these agreements, how buyers and sellers interact in the market, and the roles of clearinghouses and margin requirements. You'll also learn how leverage works in futures trading, giving traders the opportunity to control large positions with relatively small investments. Finally, we'll touch on the process of liquidating a position and how market participants use futures contracts not only for speculation but also to reduce price risks.
By the end of this post, you’ll have a solid understanding of how futures contracts work, the risks and rewards they offer, and how they can be used to navigate today’s dynamic financial markets.
Basic Features of Futures Contracts
A futures contract is a legal agreement between a buyer and a seller. The key terms include:
- Buyer’s Agreement: The buyer agrees to purchase an underlying asset at a specified price at a future date.
- Seller’s Agreement: The seller agrees to deliver the underlying asset at the agreed price on that future date.
When entering a futures contract, no actual exchange of goods or money takes place. Instead, both parties commit to transacting in the future. The agreed-upon price is known as the futures price, and the date when the transaction occurs is the settlement date or delivery date. The asset being exchanged is called the underlying asset.
For instance, imagine Bob buys and Sally sells a futures contract where asset XYZ is the underlying asset, the settlement date is three months away, and the agreed futures price is $100. On the settlement date, Bob will pay Sally $100, and in return, Sally will deliver asset XYZ.
In futures trading:
- If you agree to buy in the future, you're in a long position.
- If you agree to sell in the future, you're in a short position.
The value of the futures contract fluctuates with market conditions. If the price of asset XYZ rises to $120, Bob (who is long) can sell the contract and realize a profit of $20. Conversely, Sally (who is short) would incur a $20 loss. However, if the price falls to $40, Sally profits by $60, while Bob loses $60. Thus, price movements determine gains or losses for each party, with long positions benefiting from price increases and short positions profiting from price decreases.
Liquidating a Position
Futures contracts can be settled in two ways:
- Before Settlement Date: Traders can close their position by taking an offsetting position in the same contract. For instance, if Bob initially buys a March futures contract, he can sell the same contract before the settlement date to close his position.
- At Settlement: If no offsetting trade is made before the settlement date, the parties perform the contract. For physical delivery contracts, the underlying asset is exchanged. In cash settlement contracts, no physical delivery takes place; instead, the contract is settled in cash based on the difference between the futures price and the settlement price determined by the exchange.
A useful indicator of market activity is open interest, which refers to the total number of outstanding contracts that have not yet been settled.
The Role of the Clearinghouse
Each futures exchange operates with an associated clearinghouse. The clearinghouse guarantees the performance of both parties in the contract, acting as an intermediary between buyers and sellers. This eliminates concerns about the financial solvency of the counterparty, as the clearinghouse assumes the counterparty's role. It also allows participants to liquidate positions independently of each other, ensuring that market stability is maintained.
Margin Requirements
When trading futures, participants are required to post a certain amount of collateral, known as initial margin, which serves as a deposit to guarantee the position. This margin is usually lower than the full value of the contract, allowing traders to leverage their investments. The maintenance margin sets the minimum equity level an investor must maintain in their account. If an account’s equity falls below this level, the trader must add more funds, referred to as variation margin.
Futures contracts are marked-to-market daily, meaning the exchange adjusts the value of the position based on the day’s settlement price. Gains and losses are immediately reflected in the investor's account.
For example, if the margin requirements for asset XYZ are as follows:
- Initial margin: $7 per contract
- Maintenance margin: $4 per contract
If Bob buys 500 contracts at a futures price of $100, he must post an initial margin of $3,500. If the value of his position declines and his equity falls below the maintenance margin of $2,000, he will need to deposit variation margin to bring his equity back to the initial margin level.
Leveraging Futures Contracts
One of the most powerful features of futures contracts is leverage. Leverage allows traders to control a large position with a relatively small amount of capital. For example, if Bob has $100 and wants to invest in asset XYZ, he could buy one unit of XYZ in the cash market. However, if the futures contract for asset XYZ requires only a 5% margin (or $5), Bob could purchase 20 futures contracts with his $100, amplifying his exposure to the price movement of XYZ.
While leverage can enhance gains, it also magnifies losses, which is why it's crucial for traders to manage their risks carefully. Futures markets are not solely for speculators; they also provide a valuable tool for hedgers who want to reduce price risk in their portfolios.
Conclusion
Futures contracts are a fundamental component of financial markets, offering a flexible and efficient way to speculate on or hedge against future price movements. By understanding the mechanics of futures trading, including margin requirements, the role of clearinghouses, and leveraging opportunities, market participants can make informed decisions and manage their risks effectively.
