Introduction to Futures and Futures Trading

A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the delivery does not occur; instead, before the contract expires, the holder usually "squares their position" by paying or receiving the difference between the current market price of the underlying asset and the price stipulated in the contract.

Unlike options, futures contracts convey an obligation to buy. The risk to the holder is unlimited. Because the payoff pattern is symmetrical, the risk to the seller is unlimited as well.

Dollars lost and gained by each party on a futures contract are equal and opposite. In other words, futures trading is a zero-sum proposition.

Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. Futures are distinguished from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. Also, in order to insure that payment will occur, futures have a margin requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed.

Futures are a risky investment vehicle that are usually appropriate only for advanced investors and institutions. Individual investors should be extremely careful about investing in futures and in most cases beginning investors should avoid them.

Trading in futures is regulated by the Commodity Futures Trading Commission (CFTC). The CFTC exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market.

Futures Trading

Futures contracts are purchased when the investor expects the price of the underlying security to rise. This is known as going long. Because he has purchased the obligation to buy goods at the current price, the holder will profit if the price goes up, allowing him to sell his futures contract for a profit or take delivery of the goods on the future date at the lower price.

The opposite of going long is going short. In this case, the holder acquires the obligation to sell the underlying commodity at the current price. He will profit if the price declines before the future date.

Hedgers trade futures for the purpose of keeping price risk in check. Because the price for a future transaction can be set in the present, the fluctuations in the interim can be avoided. If the price goes up, the holder will be buying at a discount. If the price goes down, he will miss out on the new lower price. Hedging with futures can even be used to protect against unfavorable interest rate adjustments.

While hedgers attempt to avoid risk, speculators seek it out in the hope of turning a profit when prices fluctuate. Speculators trade purely for the purpose of making a profit and never intend to take delivery on goods. Like options, futures contracts can also be used to create spreads that profit from price fluctuations.

Accounts used to trade futures must be settled with respect to the margin on a daily basis. Gains and losses are tallied on the day that they occur. Margin accounts that fall below a certain level must be credited with additional funds.

Settling Futures Contracts

Futures contracts are usually not settled with physical delivery. The purchase or sale of an offsetting position can be used to settle an existing position, allowing the speculator or hedger to realize profits or losses from the original contract. At this point the margin balance is returned to the holder with interest along with any additional gains, or the margin balance plus interest serves as a credit toward the holder's loss. Cash settlement is used for contracts like stock index futures that obviously cannot result in delivery.

The purpose of the delivery option is to insure that the futures price and the cash price of good converge at the expiration date. If this were not true, the good would be available at two different prices at the same time. Traders could then make a risk-free profit by purchasing goods in the market with the lower price and selling in the market with the higher price. That strategy is called arbitrage. It allows some traders to profit from very small differences in price at the time of expiration.

Pricing Futures

Futures prices are presented in the same format as cash market prices. Therefore, they are listed in dollars and cents per quantity. When these prices change, they must change by at least a certain minimum amount, called the tick. The tick is set by the exchange.

Prices are also subject to a maximum daily change. These limits are also determined by the exchange. Once a limit is reached, no trading is allowed on the other side of that limit for the duration of the session. Both lower and upper limits are in effect. Limits were instituted to guard against particularly drastic fluctuations in the market.

In addition to these limits, there is also a maximum number of contracts for a given commodity per person. This limit serves to prevent one investor from gaining such great influence over the price that he can begin to control it.
By InvestorGuide Staff

Copyrighted 2020. Content published with author's permission.

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