Futures

Futures are a contract to buy or sell in the future a specific quantity of a commodity for delivery at a price that is determined at initiation of the contract. The contract obligates each party to fulfill the contract at the specified price that is used to assume or shift price risk. The contract may be satisfied by delivery or offset. Most futures contracts contemplate actual delivery of the commodity can take place to fulfill the contract. Some futures contracts require cash settlement in lieu of delivery, and most contracts are liquidated before the delivery date. A futures contract usually has a standardized date and month of delivery, quantity and price.

The price at which a futures contract trades in the futures market is known as the futures price. The date specified in the futures contract is known as the expiration date. The expiration date for all contracts in futures trading is usually the last Thursday of the respective month. Three series of futures contracts are available and have one-month, two-month and three-month expiry cycles. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. A futures contract can be offset prior to maturity by entering into an equal and opposite transaction. Majority of transactions in the futures trading are usually offset in this manner.

When futures’ trading was introduced, most of the trading was in agricultural commodities, such as corn and wheat. Today, futures trading cover a variety of non-agricultural commodities, including metals such as gold, silver, and copper and fossil fuels such as crude oil and natural gas. The most widely traded futures contracts are in financial instruments, such as interest rates, foreign currencies, and stock indexes.

The futures market is mainly designed for hedging and risk management. The main participants in the futures market are commercial or institutional users of the commodities. The participants are either hedgers or speculators. Hedgers want to increase the value of the commodities they trade in and limit, if possible any loss in value. Hedgers may use the commodity markets to take a position that will reduce the risk of financial loss in their assets due to a change in price. Speculators try to profit from changes in the price of the futures or option contract.

Futures’ trading is generally carried out on organized futures exchange in a wide variety of physical commodities such as grains, metals and petroleum products. The exchanges specify certain standard features of the contract in order to facilitate liquidity in futures trading. Standardized features include the amount of the commodity to be delivered (the contract size), delivery months, the last trading day, the delivery location or locations, and acceptable qualities or grades of the commodity. Standardization makes it possible for large numbers of market participants to trade the same instrument. While the exchange itself does not trade futures it provides and maintains the facilities where buyers and sellers meet. The exchange researches, develops and offers futures contracts to be traded and oversees the trading of its products and enforces trading-related rules and regulations. It monitors and enforces financial and ethical standards and also provides daily and historical data on the contracts traded under its auspices.

The futures deals made on an exchange are cleared through a clearing house. The clearing house acts as the buyer to all sellers and the seller to all buyers. A buyer/seller buying/selling a futures contract technically buys/sells it from the clearing house and not the party with whom the contract was executed on the trading floor.

A futures trader does not have to put up the entire value of the contract. He can post a margin that is generally between two percent and ten percent of the total value of the contract. Unlike the stock market where the margin is a down payment, in the futures market, margins are performance bonds designed to ensure that traders can meet their financial obligations.

At the time of entering into a futures position, the trader will be required to post initial margin. The margin amount will be specified by the exchange or clearing organization. The position is marked to the market daily. The margin amount will decline proportionately if the futures position loses value when the market moves against it. When the margin amount falls below the specified margin amount, the trader must post additional margin to bring the account up the initial margin level. If the futures position is profitable, the profits will be added to the margin account.

Futures play an important role in aiding the process of price discovery.  It also helps in the hedging of price risk in a commodity. A producer of a commodity benefits from futures contract because he can get an idea of the price likely to prevail and thereby help them quote a realistic price and hedge risk. They have the ability to extinguish positions through offset, rather than actual delivery of the commodity, and standardization of contract terms.

The increased leverage offered by futures contracts means less capital is required to control a significant position. Leverages in the futures market means having control over large amounts of commodities with comparatively small levels of capital. With a relatively small amount of cash, one can enter into a futures contract that is worth much more than what he initially has to pay (margin). The price changes are highly leveraged which means that a small change in a futures price can translate into a huge profit or loss. Futures positions are highly leveraged because the initial margins that are set by the exchanges are relatively small compared to the cash value of the contracts in question. The smaller the margin in relation to the cash value of the futures contract, the higher the leverage.

Futures contracts also offer tax benefits. They are taxed 60/40, which means that 60% of the gain is taxed at the maximum rate of 20% similar to long-term gains and the other 40% is taxed as ordinary income. Compared to other index based securities, the transaction fees for futures contracts is less. Futures trade 23½ hours a day, excluding the period from 4:15 pm to 4:45 pm Eastern Time. They trade from Sunday night until Friday afternoon.

In the US, futures exchanges are legally known as a “designated contract market”. It is an auction market which is highly regulated, technical and complex. It is the only place where one can trade futures and options on futures which offer the right, but not the obligation, to buy or sell an underlying futures contract at a particular price. Most futures exchanges practice intense self-regulation, monitoring their employees and the trading practices that occur in their facilities. While most futures exchanges practice intense self-regulation, monitoring their employees and the trading practices that occur in their facilities, they are also subject to a great deal of regulation. They are monitored by the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA), the Securities and Exchange Commission (SEC), the Federal Reserve Board, and the U.S. Treasury Board. These agencies look after the public interest, ensure fair practice and monitor the process of price discovery that occurs in futures trading. Violations of exchange rules can result in substantial fines, as well as suspension or revocation of trading privileges. The CFTC has the power to seek criminal prosecution through the Department of Justice in cases of illegal activity, while violations against the NFA's business ethics and code of conduct can permanently bar a company or a person from dealing on the futures exchange. A broker and/or firm must be registered with the CFTC in order to issue or buy or sell futures contracts. Futures brokers must also be registered with the NFA and the CFTC in order to conduct business.

In the US, there are currently 13 registered futures exchanges. However not all are hosting active trading. Most U.S. exchanges remain not-for-profit, private membership organizations, but a number of them are actively weighing the advantages of changing to stock corporations. The largest by volume is the CME. The CME is also the first US futures exchange to become a for-profit corporation, after revising its original private membership structure and a becoming publicly traded company in 2002.

Worldwide, there are more than 50 futures exchanges. They are structured in a number of different ways. While some are owned by groups of banks or by a stock exchange holding company, other exchanges, or their holding companies, are publicly listed on a stock exchange, similar to CME.

The exchanges set the minimum amount by which the prices on futures contracts can move. The minimum amount is known as ticks. Futures prices also have a price change limit that determines the prices between which the contracts can trade on a daily basis. The price change limit is added to and subtracted from the previous day's close and the results remain the upper and lower price boundary for the day. The exchange can if it feels necessary, revise this price limit. There are instances where the exchanges have abolished daily price limits in the month that the contract expires because trading is often volatile during this month, as sellers and buyers try to obtain the best price possible before the expiration of the contract.

The CTFC and the futures exchanges impose limits known as position limit on the total amount of contracts or units of a commodity in which any single person can invest. This is done to ensure that no one person can control the market price for a particular commodity.

A trader must be able to anticipate the timing of price changes. An adverse price change may, in the short run result in a greater loss than one is willing to accept in the hope of eventually being proven right in the long run. When to buy or sell a futures contract can be as important as deciding what futures contract to buy or sell. 

When a commodity trader buys a futures contract, he will lose if the price declines. His risk is theoretically limited only by the price of the commodity going to zero. If he sells, he will lose if the price goes up. The risk is theoretically unlimited because there is no absolute ceiling on how high the price of the commodity can go. It is not possible to guarantee a particular loss limit amount. It is possible to lose the principal investment and more while investing in futures. The trader can offset his position when the trade is going against him to limit his loss.

Conservative traders use spreads to minimize risks. Spreads involve the purchase of one futures contract and the sale of a different futures contract in the hope of profiting from a widening or narrowing of the price difference. The loss from a spread can however be as great as or even greater than that which might be incurred in having an outright futures position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures prices, and it is possible to experience losses on both of the futures contracts involved.

There is no guarantee that at all times, a liquid market will exist for offsetting a futures contract that a trader has previously bought or sold. This holds true if a futures price has increased or decreased by the maximum allowable daily limit and there is no one presently willing to buy the futures contract the trader wants to sell or sell the futures contract the trader wants to buy. Some contracts and some delivery months tend to be more actively traded and liquid than others.

Futures traders often use stop orders to limit the amount they may lose if the futures price moves against their position. A stop order is an order, placed with the broker, to buy or sell a particular futures contract at the market price if and when the price reaches a specified level. But there is guarantee, however, that it will be possible under all market conditions to execute the order at the price specified. An active, volatile market may result in the market price declining or rising so rapidly that there is no opportunity to liquidate one’s position at the designated stop price. The broker's only obligation then is to execute the order at the best available price. If the prices have risen or fallen by the maximum daily limit, and there is presently no trading in the contract it may not be possible to execute the order at any price. The markets may be lock limit for more than one day, resulting in substantial losses to futures traders who may find it impossible to liquidate losing futures positions.

For even more information visit: http://en.wikipedia.org/wiki/Futures_contract

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