A futures contract is a financial derivative that tracks the price of the underlying asset. This means, futures contracts don’t have an intrinsic value per se, but derive their value from the price of an asset to which they’re linked (hence the name derivative).
Futures contracts are basically an agreement between a buyer and a seller to buy or sell the underlying asset at a specified price and date in the future. Unlike forward contracts, futures contracts are standardized in quantity and quality.
For example, futures contracts on Brent crude, which are one of the most purchased futures contracts are basically an agreement between a buyer and a seller to buy or sell the underlying asset at a specified price and date in the future.
Unlike forward contracts, futures contracts are standardized in quantity and quality. Popular futures contracts, represent strictly 1,000 barrels of Brent crude of a certain quality. A seller of this futures contract needs to deliver the underlying asset – crude oil – to the buyer at the specified price and date of the contract.
However, most of the futures contracts expire without any delivery taking place – the majority are settled in cash. It’s estimated that only 2% of all futures contract are physically settled. The reason for this is that futures contracts are heavily traded by financial speculators, who have the main objective to profit on the price changes of the underlying instrument and aren’t interested in the instrument itself.
In addition, even farmers who hedge against changes in the prices of agricultural products find it more convenient to settle the contract in cash than to organize a physical delivery, which carries transportation and storage costs among others.
History of the Futures Market
The origins of futures contracts are linked to farmers and their needs to hedge against the risk of price changes of agricultural products. For example, a farmer could reduce his risk by arranging a futures contract of corn – which represents 5,000 bushels – so he knew in advance at which price he could sell his products. The counterparty of the futures contract, on the other hand, knew in advance his costs.
Structure of the Future Market
While agricultural products dominated the futures market a few decades ago, modern futures contracts can track a wide variety of assets and commodities. For example, there are futures markets for precious metals like gold, platinum and silver; foodstuffs like coffee; currencies like US dollar, GB pound sterling, euro and Japanese yen; market indices like S&P 500, Dow Jones and FTSE 250; and energy commodities like Brent crude, natural gas, and biofuel.
Almost all futures contracts are settled in cash, because most participants in the futures market either speculate or try to hedge their risk.
In addition, all futures contracts have an expiration date, after which their life and obligations based on the contract cease to exist. Obviously, the longer you hold a futures contract the more change there is to be right on your market direction.
However, this comes with a premium – the longer the expiration date from today, the more the futures contract usually costs. In addition, contracts with longer expiration dates are also less traded than contracts which expire soon, meaning they’re less liquid.
On the contrary, futures contracts that are nearer to expiration usually have a greater trading volume (meaning they’re more liquid) and a lower price.
This is best shown by an example. The following table shows gold futures traded on the CME. Notice how the price increases for longer expiration dates, while the volume diminishes. The CME website is also a good place to find detailed specifications for each futures contract.
For example, gold futures represent 100 troy ounces of gold, and are denominated in US dollars. The product code is GC and the commodity (gold) is a deliverable commodity.
Choosing a Futures Broker
If you’re determined to start trading on the futures market, the first thing you need to do is to open a brokerage account. If you’re looking for trading advice and a high level of customer support, you can go directly with a full-service broker. However, be aware that these kind of brokers also charge higher fees. The other solution is to open an account with a discount broker.
Many discount brokers offer trading on futures contracts, but you need to be careful which broker to choose. Think about your trading style, the broker’s fee structure, its trading platforms and general customer support when making the decision with which broker to go.
Advantages of Futures Trading
There are few significant advantages to futures trading compared with other investments.
- Futures contracts are leveraged
If you decide to trade on the futures market, you have the possibility to make leveraged trades. This means, you can open a much larger position than the size your trading account, by putting aside a small collateral called “margin”. Your broker calculated the margin requirement automatically, so you don’t have to worry about it yourself. Once you close your position, the margin will be deposited back to your account. However, trading on leverage carries also a larger risk of losing money, as it magnifies both your profits and losses.
- Futures contracts are very liquid
Most of the futures contracts are very liquid and have a large amount of potential buyers and sellers in the market. More liquid assets are less volatile, as you can find potential buyers very quickly if you’re selling a futures contract; and potential sellers if you’re buying a futures contract. This is especially true for contracts that are near their expiration date.
- Commission are lower compared to other investments
When trading on the futures market, brokers usually charge lower commissions compared to other markets. You can basically open a trade paying just a $5 fee with some discount brokers. This is especially important if you’re a scalper or day-trader who opens many trades in a relatively short period of time.
Trading on futures contracts has many advantages for traders who know how to interpret them correctly, but they also need to be aware of the risks associated with leveraged trades and lower liquidity for contracts that have a distant expiration date.