Basics
The Economic Purpose of the Futures Market
Many people think that futures markets are just about speculating or “gambling.” While it is true that futures markets can be used for speculating, that is not the primary reason for their existence. Futures markets are actually designed as vehicles for hedging and risk management, that is, to help people avoid “gambling” when they don’t want to. For example, a wheat farmer who plants a crop is, in effect, betting that the price of wheat won’t drop so low that the farmer would have been better off not planting at all. This bet is inherent to the farming business, but the farmer may prefer not to make it. The farmer can hedge this bet by selling a wheat futures contract. This document discusses how futures markets work and how they are used for both hedging and speculating.(CFTC)
What is a Futures Commodity Contract?
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The futures price, naturally, converges towards the settlement price on the delivery date.
A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. In other words, the owner of an options contract can exercise (to buy or sell) on or prior to the pre-determined settlement/expiration date. Both parties of a "futures contract" must exercise the contract (buy or sell) on the settlement date. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.
Futures vs. Forwards
While futures and forward contracts are both a contract to trade on a future date, key differences include:
- Futures are always traded on an exchange, whereas forwards always trade over-the-counter
- Futures are highly standardized, whereas each forward is unique
- The price at which the contract is finally settled is different:
- Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end)
- Forwards are settled at the forward price agreed on the trade date (i.e. at the start)
- The credit risk of futures is much lower than that of forwards:
- The profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero.
- The profit or loss on a forward contract is only realised at the time of settlement, so the credit exposure can keep increasing
- In case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty on a futures contract is chosen randomly by the exchange.
- In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls.
Standardization
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
- The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate.
- The type of settlement, either cash settlement or physical settlement.
- The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
- The currency in which the futures contract is quoted.
- The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the location where delivery must be made.
- The delivery month.
- The last trading date.
- Other details such as the commodity tick, the minimum permissible price fluctuation.
Margin
Main article: Margin (finance)
Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimise this risk, the exchange demands that contract owners post a form of collateral, in the US formally called performance bond, but commonly known as margin.
Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading.
Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing a price at the end of each day, called the "settlement" or mark-to-market price of the contract.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.
Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.
Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).
Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index.
Expiry is the time when the final prices of the future is determined. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t forward contract. For example, for most CME and CBOT contracts, at the expiry on December, the March futures become the nearest contract. This is an exciting time for arbitrage desks, as they will try to make rapid gains during the short period (normally 30 minutes) where the final prices are averaged from. At this moment the futures and the underlying assets are extremely liquid and any mispricing between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in
Pricing
The price of a future is determined via arbitrage arguments. The forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures.
Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by discounting the present value S(t) at time t to maturity T by the rate of risk-free return r.
or, with continuous compounding
F(t) = S(t)er(T-t)
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.
In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.
Futures contracts and exchanges
There are many different kinds of futures contract, reflecting the many different kinds of tradable assets of which they are derivatives. For information on futures markets in specific underlying commodity markets, Google these topics.
- Foreign exchange market
- Money market
- Bond market
- Equity index market
- Soft Commodities market
Trading on commodities began in
Contracts on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange(CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the
Chicago Mercantile Exchange -- financial futures and traditional commodities: lumber, live cattle, feeder cattle, boneless beef, boneless beef trimmings, lean hogs, frozen pork bellies, fresh pork bellies, Basic Formula Price milk, butter,
ICE Futures - the International Petroleum Exchange trades energy including crude oil, heating oil, natural gas and unleaded gas and merged with IntercontinentalExchange(ICE)to form ICE Futures.
Euronext.liffe
Futures exchange
Who trades futures?
Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.
Hedgers typically include producers and consumers of a commodity.
For example, in traditional commodities markets farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.
The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example.
Options on futures
In many cases, options are traded on futures. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. See the Black model, which is the most popular method for pricing these option contracts.
Futures Contract Regulations
All futures transactions in the
The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment, which has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as 'Commitments-Of-Traders'-Report, COT-Report or simply COTR. (From Wikipedia, the free encyclopedia)
Why Trade the Commodity Futures Market:
Efficiency - a large number of traders gather in the pits, allowing prices to be determined readily. The more readily prices are discovered, the more efficient are the markets. Furthermore, a large number of contracts traded increases the liquidity, and consequently the efficiency, of the market.
Liquidity - refers to the ability to move quickly in or out of a commodity market at or near the last purchase price, and is related to the number of participants in the commodities market. The more liquid the market, the faster and more easily trades can be executed at or near specific prices.
Easy Access - anyone who needs to transfer risk, or is willing to accept risk, has a readily accessible meeting place in which to do so. For every buyer there is a seller.
Storability is not required - Markets for the future delivery of commodities are not limited to commodities that can be stored. As long as there are definable standards of quality, price information is fairly accessible, and there is broadly based production, a futures contract is viable; for example, live cattle, which must be slaughtered within certain weight parameters, T-Bills, and stock indexes, which are intangible.
These features arise from the inherent characteristics of a futures contract. A futures contract is a legally enforceable agreement to take delivery on a long position or make delivery on a short position. If you believe a given commodity market is bullish (will go up), you buy a futures contract or "go long". If you believe a given commodity market is bearish (will go down), you sell a futures contract or "go short". The ability to take or make delivery assures the integrity of the commodities market. It is not necessary to hold the contract until the delivery period which would require taking or making delivery.
The central theme of commodity futures markets is standardization. The industry evolved in the pursuit of efficiency, and to limit deception and fraud. Futures contracts are standardized with regard to commodity, quantity, quality and point of delivery. The delivery dates are standardized within each delivery month; i.e., there is a range of days during which all contracts must be performed. (CTO.com)
Why Commodity Prices Change
The commodity cost of carry (storage, interest and insurance) explains the basic relationship of cash to futures pricing, but it does not explain many less certain factors that can affect futures pricing such as seasonal influences and other unpredictable events.
As for Interest-rate and currency futures - those based on T-bonds, T-bills, Eurodollars and the five major currencies - the biggest influences are the policies and trading activities of the Federal Reserve, U.S. Treasury and foreign central banks, all of which affect interest rates.
Stock indexes are affected by whatever influences the stock market as a whole. Interest rates certainly play a major role - higher interest rates usually hurt the stock market. Other effects include the overall prospects for corporate earnings and corporate tax policies that help or hurt big business.
Futures trading provides a way to establish a form of price knowledge leading to continuous price discovery. Futures prices reflect not only current cash prices, but also expectations of future prices and general economic factors.
Improve Your Odds in Commodity Trading
There are several courses of action, you as a trader, can take to improve your chances of success in the commodity markets.
1 - Visit a broker's office. You can learn a great deal by watching brokers do their work. If you have the opportunity to watch your broker work, do so. You'll get to see exactly how orders are entered, time stamped, and reported back to the broker and customers. This will further your understanding of different types of orders, when they are used, and how to use them.
2 - Ask questions. Be sure to ask questions. If you know other traders, use them as resources to learn more. If you open a trading account, ask your broker questions. You'll learn more by asking questions than you will from any book. Best of all, the answers usually won't cost you anything.
3 - Read some of the trade publications. While such regular reading as the Wall Street Journal will keep you informed on current events, it is also helpful to regularly read trade publications such as Futures Magazine. It may not be a good idea to take anything you read in these publications too seriously, but it is a good idea to keep informed on industry trends and events.
4 - Do your own research. If you have some market ideas of your own, don't be afraid to test them. Home computer systems, historical futures data, and analytical software are so reasonably priced nowadays that systems testing is not as expensive a proposition as it was in the past. If you have ideas about trading systems that merit further investigation and development and if you have the funds to pursue this direction, then you should do so.
5 - Consider taking a job as a runner. Many successful traders and brokers have started as runners on the trading floor of one or more futures exchanges. The experience has been valuable in spite of the poor salary usually earned by runners. If you have the opportunity to take such a job, you'll learn more in two weeks on the floor than you can in several years of academic studies. This is perhaps the single best way to get an education in the futures industry. If you have the financial means to support yourself while you take a runner's job, then by all means do so. (CTS.com)
