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Futures are financial contracts that require the buyer to purchase an asset (and the seller to sell an asset) at a specified price at a future date. Futures are also referred to as futures contracts. Futures are an excellent way for commodity companies to stabilise their prices and thus their operational and financial performance. Futures (exchange-traded) and forwards (over-the-counter) are financial futures transactions that require trading at a specified time and price and were initially used to limit price risks.
Read also: Futures vs CFDs, What is the difference?
Fundamentals of Futures
Futures offer the ability to “set” prices or costs well in advance, which in turn enables traders to better plan, smooth out cash flows and communicate more securely with shareholders.
Futures trading is a zero-sum game. This means that if someone earns a million dollars, someone else loses a million dollars. Because futures contracts can be bought on margin, futures traders have an incredible leverage effect that allows them to trade thousands or millions of dollars worth of contracts with very little own money.
Assets commonly traded in futures contracts include commodities, stocks and bonds. Cereals, precious metals, electricity, oil and natural gas are traditional examples of commodities. However, among today’s commodity markets are also foreign currencies, emission credits and specific financial instruments.
There are two types of futures traders that can be found: hedgers and speculators. Hedgers usually do not seek to make a profit by trading commodities, but try to stabilise the costs or revenues of their business operations. Their profits or losses are usually offset to some extent by a corresponding loss or gain in the relevant market for the underlying physical commodity.
Speculators are typically not interested in taking possession of the underlying assets. They mainly rely on the future prices of certain commodities. So if you disagree with the consensus that wheat prices will fall, you could buy a futures contract. If your prediction is correct and wheat prices are rising, you can make money by selling the futures contract (which is now worth much more) before it expires. Speculators are often blamed for large price fluctuations, but they also provide liquidity for the futures market.
Futures contracts are standardised, i.e. they specify the quality, quantity and delivery of the underlying commodity so that prices mean the same for everyone in the market. For example, each type of crude oil (e.g. pale, sweet crude oil) must meet the same quality requirements, so that pale, sweet crude oil from one producer does not differ from another and the buyer of pale, sweet crude oil of the future knows exactly what he is getting.
Futures exchanges rely on clearing members to manage payments between buyers and sellers. These are usually large banks and financial services companies. Clearing Members guarantee all trading and therefore require traders to make bona fide deposits (so-called margins). This is to ensure that the trader has sufficient funds to deal with potential losses and is not in default. The risk borne by clearing members further supports the strict quality, quantity and delivery specifications of futures contracts.
The Commodity Futures Trading Commission (CFTC) actively regulates the trading of commodity futures by implementing the Commodity Exchange Act of 1974 and the Commodity Futures Modernization Act of 2000. The CFTC is there to ensure the competitiveness, efficiency and integrity of commodity futures markets and protects against manipulation, abusive trading and fraud.
There are several futures exchanges. The most common are the New York Mercantile Exchange, the Chicago Mercantile Exchange, the Chicago Board of Options Exchange, the Chicago Climate Futures Exchange, the Chicago Board of Trade, the Minneapolis Grain Exchange as well as the Kansas City Board of Trade.
The difference between Futures and Forwards
A forward contract is an individual contract between two parties to buy or sell an asset at a specified price and at a future date. A forward contract may be used for hedging or speculation but is particularly suitable for hedging due to its non-standardised nature. Unlike standard futures contracts, a forward contract can be adjusted to any commodity, any amount and any delivery date. Futures can be settled on a cash or delivery basis. Forward contracts are not traded on a central exchange and are therefore regarded as over-the-counter (OTC) instruments. While the OTC character facilitates the adjustment of conditions, the absence of a central clearing house also leads to higher default risk. As a result, forward contracts are not as easily accessible to retail investors as forward contracts.
The futures market is huge as many of the world’s largest companies use it to hedge currency and interest rate risks. However, since the details of forward transactions are limited to buyers and sellers and are not known to the public, it is difficult to estimate the size of this market. Due to the large and unregulated market for futures contracts, the market can, in the worst case be vulnerable to a cascading series of defaults. While banks and financial institutions mitigate this risk by being very cautious when selecting counterparties, there is a possibility of a massive default.
Another risk arising from the non-standard nature of futures is that they are settled on the settlement date and are not marketable like futures. What if the forward rate set in the contract differs significantly from the spot rate at the time of settlement? In this case, the financial institution that has concluded the forward contract is exposed to a higher risk in the event of default or non-payment by the customer than if the contract were regularly valued at market price.
Steff has been actively researching the financial services, trading and Forex industries for several years.
While putting numerous brokers and providers to the test, he understood that the markets and offers can be very different, complex and often confusing. This lead him to do exhaustive research and provide the best information for the average Joe trader.