Futures contracts are an important part of the financial market and a way that traders can make a quick gain—or a quick loss. These derivative assets are volatile and typically only experienced traders operate in futures. While futures contracts are highly standardized, it is important to fully understand all terms before becoming involved. If you are considering trading futures, a Priori derivatives lawyer can help you understand the underlying terms of your contractual obligations.
Understanding Futures Contracts
Futures contracts, commonly referred to as “futures," are agreements to buy or sell a particular commodity, financial instrument, or other underlying asset at a pre-determined price in the future. This price is payable upon delivery of the asset on a pre-established date. The quantity and quality of underlying assets, as well as the delivery date, are generally standardized to facilitate trading futures on exchanges.
Risk Mitigation and Futures Contracts
Futures contracts were initially established as a means of risk mitigation in trade -- e.g., companies that needed a certain good (for example, corn, wheat, oil, gold) could lock-in the price of that good at some future time. Prices of assets fluctuate, and by establishing the price upfront, it is more predictable, albeit slightly more risky if the price changes dramatically by the time of delivery. In addition, both parties to the contract put up initial cash in the form of a performance bond, known as the initial margin, to ensure that the cost of the assets will be covered no matter how the market changes in the interim.
This margins is often set as a percentage of the value of the futures contract. This percentage must be maintained throughout the life of the contract to guarantee the agreement. Over this time the price of the contract will vary and the parties can gain or lose money at the expense of the other.
Futures contracts are rarely simple exchanges between two parties instead, these responsibilities are traded on exchanges. Both the buyer and the seller usually liquidate their long and short positions before the contract expires, sometimes trading the positions many times over through multiple parties. These exchanges continue to occur until delivery. Every day at the close of an exchange, the current holders of the futures contract must settle any shortfall.
Because of the nature of the futures market, many traders are involved solely as a way to capitalize on the profit margin of the sale as the price fluctuates. Futures are traded endlessly on exchanges, and rarely operate in the same manner as traditional “contracts.” Instead, futures contracts operate much in the way public stocks trade on exchanges.
Trading Futures on Margin
Futures are often purchased “on margin,” which means that they are traded using money borrowed from brokers. For futures in a margin account, a certain amount of margin must be maintained. The exact amount will depend on the changing market value of the contracts. If your futures become a loss beyond a certain point, you will be required to put cash in through what is called a margin call or a maintenance call.
The Commodity Futures Trading Commission (CFTC) regulates futures contracts in the United States. Any trader in futures contracts must adhere to both the guidelines of the CFTC and the specific exchange or risk serious fines or even being banned from the exchange.
What’s the difference between hedgers and speculators in relation to futures?
Both hedgers and speculators operate in the futures market, but they purchase futures for very different reasons. Hedgers trade futures commodities to stabilize the revenues or costs of their business operations. Because of the nature of their main business, hedgers are exposed to the fluctuations of some group of commodities, and so trade futures in order to limit their exposure to those fluctuations.
Speculators, on the other hand, have little interest in taking possession of the underlying assets. Instead, these traders essentially place bets on the future prices of certain commodities hoping to make a profit on the change. These traders are often blamed for large price swings in markets, but they add significant liquidity to futures markets.
How much risk is involved in futures contracts?
Because of the unpredictable prices of the underlying assets of many futures, futures contracts can involve large amounts of risk.
How are futures settled?
Futures can be settled two ways: physical delivery and cash settlement. When a futures contract is settled by physical delivery, the actual goods are delivered on the specified date. This type of settlement is rare. More commonly, futures are cancelled out by purchasing a covering position, whether by buying a contract to cancel out an earlier sale (covering a short) or selling a contract to liquidate an earlier purchase (covering a long). Most futures are settled in cash. When the contract expires payment is made based on the underlying reference rate or the closing value of a stock market index.