A futures contract is very much similar to a forward contract where two parties agree to buy or sell an underlying asset at a specific price sometimes in the future. However, there are distinctions that we’ll discuss below. First, a futures contract is a legally binding agreement that allows two parties to buy or sell a standardized asset at a specific point in time. Second, the transaction is facilitated and settled through a futures exchange.
Futures Exchange
A futures exchange is where investors can buy or sell standardized futures contracts that are defined by the exchange. The most common type of contracts are in reference to commodity or financial instruments. Future exchanges are valued by investors as they make the transaction and the settlement process straight forward. Benefits of the exchange include but not limited to;
- Act as physical or electronic trading venue – Futures contract act as a place where parties can negotiate and agree to various types of contracts. They may do the negotiations strictly on the trading floor or through high speed, online, electronic trading.
- Standardize each contract – An exchange would standardize each futures contract by specifying the quantity, quality, physical delivery and location for the asset in question. All specifications would be identical for all parties transacting on a particular contract.
- Provide market and price data– Futures can be bought and sold on a daily basis. The exchanges would provide liquidity and enable investors to complete their buy or sell transactions.
- Provide settlement & delivery procedures – As each futures contract is standardized, the settlement and delivery location would be known ahead of time.
- Act as clearinghouses – Upon expiration or maturity of the contract, the exchange would act as a intermediary to help settle the contract by either taking delivery of the underlying asset or proceeding with a cash settlement.
- Assist in margin mechanism – Depending on the type of contract and underlying asset, it’s important to note that exchanges can issue margin calls as a way to manage credit and default risk.
The Chicago Board of Trade is one of the first and largest commodities exchanges in the world. They’ve developed a standardized agreement to a futures contract. For more information, refer to their official website here.
Futures Margin
As you recall, a futures contract is a standardized agreement between two parties agreeing to buy or sell an underlying asset at set price on or before the expiration date. When you open a futures position, the broker may require you to keep a certain amount of money on hand in order to ensure completion.
- Margin – This is a performance bond or good faith deposit that would ensure the contract performance and completion.
- Initial Margin – The minimum amount required to initiate the trade or a transaction.
- Maintenance Margin – The minimum amount required at all times in order to sustain a market position.
- Margin Call – When the margin level is lower than the maintenance margin.
Be aware that a securities margin is different than that of a futures margin.
Users of Futures Contracts
In a similar nature to forward contracts, future contracts are purchased by speculators and hedgers.
Speculators
The majority of futures contract are purchased by speculators who are betting on the direction of an underlying asset. Speculators may either be individuals or a firm.
- Individual Traders – With the emergence of electronic trading, more and more individuals are now managing their own investment portfolios. The speed and ease of buying and selling stocks have given individual traders greater access to markets that were once reserved for institutions.
- Trading Firms – Trading firms provide lending and capital resources to traders who are buying and selling securities. By providing capital, research and strategies, these firms charge a fee in a form of a commission.
- Portfolio Managers – Portfolio Managers who are responsible for managing people’s funds, either in a mutual fund, exchange traded fund or hedge fund, may engage in futures speculation or hedging. The goal of the portfolio managers is to decrease their correlation of a certain asset class to a negative or positive market downturn, depending on their investment philosophy. This is where future contracts would come in handy.
- Markets Makers – Market makers are trading firms whose goal is to provide liquidity to the markets. Market makers help facilitate large transactions and typically make a profit on the spread, known as the small difference between the bid and the ask of transactions.
Hedgers
Hedgers are individuals whose goal is not to make a profit but rather minimize their risk in changes of commodity prices, exchange rates, interest rates, etc. Hedgers often purchase futures contracts manage risks.
Wheat Hedger Example
Jim, a wheat farmer, is concerned that the wheat prices will drop towards the end of summer. He wants to make sure that he locks in the price of wheat today and does so by selling a wheat futures contract. When he harvests his wheat towards fall, the price of wheat would’ve gone down by at least $30. However, he has successfully offset this loss by a trading gain in the futures market. If the price of wheat increases in fall, then Jim would have had a trading loss on his futures contract but a gain when selling the price of wheat.
Types of Hedgers
- Buy-Side Hedgers – These type of hedgers work in the buy-side of the financial markets. They buy and invest in a number of securities for the purpose of fund management. These type of hedgers would be concerned about the rising prices of the underlying commodity
- Sell-Side Hedgers – Sell side hedgers would be concerned about the falling prices of the underlying commodity. Sell side is an investment banking term and a section of the financial markets that deal typically with creating, promotion and selling of publicly listed securities.
- Merchandisers – Merchandisers are parties who engage in the process of buying and selling commodities. Merchandisers use two types of hedges, a short hedge and a long hedge.
- Short Hedge – Short hedges are used to offset cash losses when prices fall. For example, a merchandiser would sell a futures contract when they’re concerned the underlying asset would fall.
- Long Hedge -Long hedges are used to offset cash losses when prices rise. They would buy futures contract when they believe prices would rise.
Forwards vs Futures
Investors should be aware that future contracts are not the same as forward contracts. Although both investment allow you to buy or sell an asset a specific time at a given price, it’s important to note that forward contracts do not trade on a standardized exchange as futures do but rather over the counter. Forward contracts are private agreements with terms agreed between the corresponding parties while future contracts are negotiated through the exchange.
In regards to settlement, future contracts settle everyday, making them highly liquid in comparison to forward contracts that settle upon maturity. The parties to a forward contract bear more risk considering that there is no clearinghouse that guarantees performance and completion of the contract. If a party to a forward contract were to default, they may be liable to lawsuits by the other party.
