Futures contracts are an agreement in which the parties undertake to buy or sell an asset at a predetermined price on a specific date in the future.
They were the first financial derivatives used as a hedge against a bad harvest, bad weather, among others, but nowadays their main use is speculative.
The most important futures markets are in the United States, including: CME Futures, COMEX, CBOT, NYMEX, CBOE.
Trading Futures vs Options
The concept is the same as that of options contracts, since futures contracts depend on an underlying asset, which can be stocks, commodities, debt, indices, currencies, bitcoin, etc. The most important futures markets are in the United States and Europe.
Characteristics of futures
- They are standardised contracts, i.e. the underlying asset, the size of the contract, the maturity date and the way the contract is settled are agreed.
- High leverage.
- High profitability.
- Ideal for both upside and downside trading.
- There is no counterparty risk as the Clearing Houses linked to all exchanges where futures are traded ensure that contracts are always honoured.
- Every day there is a settlement of positions and recalculation of collateral. If the position is a winner or loser, we must provide more or less collateral, and these profits or losses are recorded in the broker’s account. The money that can be lost on futures trades can exceed the money deposited as collateral.
- It is always possible to liquidate an open contract.
- Requires a lot of experience, not recommended if you are a beginner, as they have a high risk.
- Not for small accounts, more capital is required.
Main uses of futures contracts
Speculating on the movement of the underlying asset
This is the main use of futures as the person buying them does not have an interest in owning the underlying asset but seeks to profit from the movement of the underlying asset. Therefore, it is very common for futures contracts not to be executed. They are rarely executed and the asset is awarded at the close of the contract to its holder, they are usually not allowed to expire: they are closed out early (by executing the opposite operation: if we sold it, to close it out we must buy and vice versa) or they are rolled over to a later date (known as “rollover”).
In the case of executing the contract, the following must be taken into account:
- The buyer is obliged to buy the underlying asset at the agreed price on the agreed date.
- The seller has the obligation to sell the underlying asset at the agreed price on the agreed date.
Important: if you decide to execute the contract, assuming you bought it, or forgot to close it or roll it over, you should be aware that your broker will call you to ask you where to send the underlying asset you bought. In this case, you have two options: pay a penalty and not receive the asset or receive it. The problem is that, for example, if the contract you bought is equivalent to 10 tonnes of soybeans, you will receive the 10 tonnes of soybeans. To avoid this, you must close it or roll it over.
Futures can be used as a hedge for a stock portfolio, as they can be sold short. We can then have these situations:
- The stocks in our portfolio go up instead of down, then we will be losing little money or gaining less, as whatever the futures used as a hedge lose, we will be gaining with a portfolio of stocks.
- The stocks in our portfolio go down instead of up, then the future will act as a buffer reducing the losses.