Futures Contract

Trading Basics

Futures Contract

Brief Overview: A futures contract is an agreement to buy or sell a commodity or financial instrument at a certain time for a pre-defined price.

Full Overview: Futures contracts are important instruments that help buyers and sellers to exchange a commodity or financial instrument at a predetermined price and at a specified date. Traders can also take advantage of futures contracts, as they allow to speculate on the future price movements of the underlying asset.

Here, we’ll take a closer look at the specifics of futures contracts, how and where they’re traded, and how the futures market is regulated.

Futures Contracts Explained

A futures contract is an agreement to buy or sell a particular asset or security at a predetermined price and at a specified time in the future. Unlike forward contracts, futures contracts are standardised for both quantity and quality, which means that futures contracts can be easily traded on regulated exchanges.

For example, a futures contract on the British pound has a size of exactly GBP 62,500, a natural gas futures contract is 10,000 MMBtu (million British thermal units), a crude oil futures includes 1,000 US barrels, and a gold futures contract includes 100 fine troy ounces.

The underlying assets of futures contracts include physical commodities, like metals or energy products, instruments, like stocks, bonds, or currencies, and other types of financial instruments. If you hear somebody say that they bought gold futures, this actually means that they bought a futures contract on gold. In jargon, “futures” and “futures contract” refer to the same thing.

In a futures contract, there is an obligation for the buyer to buy and receive the underlying asset or security. Similarly, the seller of a futures contract is obliged to sell and deliver the underlying asset or security at the pre-specified terms of the contract (price and time), regardless of the current market price at the expiration date.

This obligation is a major difference between futures contracts and options. In options, the buyer has the possibility, but not an obligation, to buy the underlying asset of the option at the pre-specified terms. The difference between futures and forward contracts is that forward contracts are not standardised, i.e. they have customisable terms that are agreed upon between the counter-parties. As a result, forward contracts are not traded on regulated exchanges, but the OTC (over-the-counter) market.

Futures contracts allow trading on leverage, which is why they’re a favourite tool of investors and speculators to take advantage of directional price movements on the markets. Futures contracts are also often used by hedgers, such as large commercial companies, to hedge their exposure to a particular asset or security

For Example

A German car maker that sells cars in the United States might like to hedge its exposure to the US dollar, eliminating any negative consequences of large changes in the euro vs US dollar exchange rate.

Examples of a Futures Contract

The most actively-traded and most liquid futures contracts are those for oil. Oil prices are also very volatile, which is why producers and buyers of oil and other energy products may decide to be involved in the oil futures market to get more certainty about the price at which they can buy or sell.

Let’s say

A large oil producer expects to produce 500.000 barrels of oil over the year. The current market price of oil is $60 per barrel, but since oil is such a volatile product, the producer may decide to lock in the price at which they can sell their oil on the market.

Since futures are standardised contracts, each futures contract of oil is for 1,000 barrels on the Chicago Mercantile Exchange (CME). Therefore, the producer would need to sell 500 oil futures with an expiration date one year from today to lock in their selling price. Once the contract matures, the buyer of the oil futures has the obligation to buy and receive the oil from the producer at the specified price, while the producer is obliged to sell and deliver the oil at the specified terms.

Futures Market Regulation and Exchanges

The futures market is regulated by the Commodity Futures Trading Commission (CFTC), which was established by the US Congress in 1974. The main role of the CFTC is to ensure the integrity of the futures market and prevent fraud and abusive practices of participants engaged in futures trading.

Futures contracts are traded on regulated futures exchanges where a range of futures can be bought and sold, including commodities futures, interest rate futures, stock index futures, and currency futures, to name a few. Only members who are registered with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) have access to a regulated futures exchange. Those include mostly brokers and commercial traders.

Some of the largest futures exchanges include the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX). Another major exchange in the US is the International Exchange (ICE), founded in 2000.

Individual traders who want to trade futures contracts need to do so through a futures broker.

How to Trade Futures Contracts

Trading futures contracts is relatively easy. All you need to do is to open a trading account with a futures broker. The process of account opening is quite fast with most brokers. They will ask you about your previous futures trading experience and income in order to determine the amount of risk you’re able to take on.

Since futures can be traded on margin, many retail traders try to take advantage of future price movements with futures contracts.

Let’s say

That gold is currently trading at $1.200, and you believe that in three months the price of gold could reach $1.500. You could buy a futures contract on gold that covers 100 fine troy ounces, which gives you control of $120.000 worth of gold.
If you’re trading with 10:1 leverage, you would be able to buy the gold futures with only $12.000 in your trading account. If by the time of expiration gold is trading at a higher price, you would make a profit of $30.000 on that trade ($150.000 – $120.000) by selling the contract to another investor.

Retail traders and investors aren’t interested in taking physical delivery of the futures contract. That’s why you need to be aware of the expiration date of your contracts and sell them before they mature. Most contracts expire on the third Friday of each month, but some contracts also have different expiration dates. Check with your broker and the exchange the exact characteristics of the futures contracts you want to trade.

Key Takeaways

  • A futures contract is a legal agreement that obliges the buyer to buy and receive the underlying asset, and the seller to sell and deliver the asset, at a predetermined price and at a specified time.
  • Futures are standardised for quantity and quality and trade on regulated exchanges.
  • The underlying security of a futures contract can be anything from commodities, metals, stocks, interest rate contracts, currencies, etc.
  • Futures contracts can be traded on margin, making them an attractive instrument for traders and retail investors.
  • In the US, the futures market is regulated by the Commodity Futures Trading Commission (CFTC).

Final Words

Futures contracts are an important instrument that helps buyers and sellers to specify the exact price and delivery date of the underlying asset or financial instrument. It helps both producers and consumers to hedge against negative price fluctuations and traders to trade on directional price movements in the future.

If you’re interested in trading futures contracts, the first step is to find a broker that offers the markets you’re interested in. Since some futures have slightly different expiration dates, make sure to get acquainted with the contract you want to trade and avoid holding it at the expiration date, or you’ll have to take physical delivery of the underlying asset.

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