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What is a Futures Contract?

Friday, November 16, 2018 | MarketBeat Staff
What is a Futures Contract?

If we’re a buyer, we generally enjoy paying less for something than what it is actually worth. And when we’re a seller, we enjoy receiving more for something than its current value. It’s one of the things that make bid sites so popular. They give buyers and sellers the ability to negotiate a price for an item that is only loosely based on its market value.

If you add a little more structure – and a lot more risk – you can begin to understand the futures market. The futures market is like a bid site in that buyers and sellers agree on a price for the future delivery of an item. But unlike a bid site, the price is not something that is negotiated between the two parties but rather is set by market forces.

Also, unlike a bid site where the time period between buying and selling is usually days, if not hours, the time period for a futures contract can be months. And during that time, the price of the underlying asset in the futures contract can change in value a lot – putting both the buyer and the seller at risk.

This article will define futures contracts and why they are attractive to buyers and sellers. The article will also go into detail about the structure of a futures contract including the key terms that every investor should know. The article will wrap up by defining how futures contracts are traded and why they carry significantly more risk than traditional trading.

What is a futures contract?

A futures contract, otherwise known as trading futures involves a buyer and a seller who enter a legally binding contract to trade a specified amount of an asset at a particular date for a specific price. Futures contracts frequently involve commodities such as oil, soybeans, and wheat as these are assets that tend to fluctuate in price from month to month and are subject to systematic risk. However, futures contracts have expanded in scope to include precious metals (gold, silver, etc.), currencies, and even stock market indices and Treasury bills.

A futures contract is considered a derivative trade since the price of the security is derived from one or more assets that make up the security. In a futures contract, the buyer holds a long position – meaning they agree to take receipt of an asset. The seller, by contrast, holds a short position – meaning they agree to deliver that asset.

 For a buyer and a seller, the benefit of entering into a futures contract is the same – price certainty – however, they are approaching it from different angles. The buyer is taking the role of a speculator – they are hoping that the price will increase from the price they negotiate, meaning the seller will take a loss since they will only be able to receive payment at the agreed upon price which would be less than they would get from selling on the open market. Conversely, the seller is trying to hedge his position and hoping that the price of the asset falls, thus ensuring a gain because the buyer will have to pay him the higher price.

For example, if the price of oil at the beginning of June is $65 per barrel, a seller who thinks that the hurricane season will be bad may accept a futures contract for September or October to sell 100 barrels of crude oil at a price of $75. Assuming he finds a buyer, the seller is now committed to receiving $7,500 from the buyer on the contract date regardless of the price in the market.  At this point, one of two scenarios could happen.

  1. If the price of oil goes up and closes at $80 per barrel. The seller has lost $500 ($5 x 100) because of the increased price. Subsequently, the buyer has profited by $500 because they have locked into a price that is lower than the current price.
  2. The price of oil only rises to $70 per barrel, the seller has gained $500 and the buyer has lost $500 because they are obligated to pay the seller at the rate of $75 per barrel.

But it’s not quite that simple. As we’ll show you there are some important differences between futures trading and traditional trading. Let’s start by describing how a futures contract is structured.

The structure of a futures contract

The futures market is regulated which ensures that the price of a futures contract is based on a mathematical model that takes into account one or more of the following factors:

  • Spot price (the current market price)
  • Risk-free rate of return
  • Time to maturity
  • Storage costs
  • Dividends
  • Dividend yields
  • Convenience yields (the premium for holding a physical asset as opposed to the futures contract)

Futures contracts are set at different intervals. In some cases, the price of a futures contract may be set for a year in the future. The important thing to remember is that the price of a futures contract is not set arbitrarily, but rather by market dynamics.

Terms to know regarding futures contracts

In addition to understanding the basic structure of a futures contract, it’s important to be familiar with key terms.

Contract Size– this refers to the amount of the asset that is covered by a futures contract. Futures contracts are standardized in terms of volume. As an example, one oil contract that is traded on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil.

Contract Value– this refers to the current price of the futures contract multiplied by the contract size. If a buyer or seller wanted to guarantee the price of a contract on 100,000 barrels of oil, they would be purchasing 100 contracts. If the price of one barrel is $60 and each contract was for 1,000 barrels. One contract is worth $60,000.

Tick Size– this is the minimum fluctuation or the minimum value that a contract can move. For oil, the tick size is one cent per barrel. For gold, it is 10 cents per ounce.

Tick Value– this is simply the tick size multiplied by the contract size. The tick value for 1 oil contract would be 1,000 x .01 = $10

Limit Move– this is a trigger that is imposed on some commodity futures to help control prices and margin flows during periods of high volatility. For example, cattle futures have a daily limit move of three cents per pound. If the one contract is 40,000 pounds, trading on a contract will stop if the value of the contract moves by $1,200 in one day.

Contract Month– this tells investors what month the contract will expire. As we mentioned above, futures contracts are frequently set months or even a year or more in advance. Each month has a designated letter.

First Notice Day– this is the first day, the owner of the futures contract (the buyer) may have to take physical delivery of the commodity specified in the futures contract.

Pit Trading Hours– the times that an exchange is open for active trading.

Electronic Trading Hours– the times when contracts are available for buyers and sellers to make transactions on an exchange’s electronic platform.

Basis– this is the differential between the cash price for a commodity and its futures price.

Convergence– this is the process of the price of an asset being traded in the futures market moving to the same level as cash prices for the commodity during the period between the first notice day and the delivery period.

Trading a futures contract is riskier than traditional trading

In traditional stock trading, actual shares of a company are changing hands. So when a buyer goes to an exchange and purchases 100 shares of Home Depot stock, they are receiving the 100 shares. If the trade is set for a time in the future, such as an options contract, any gains and losses are not realized until the shares are sold.

However, when it comes to most futures contracts, the seller (unless it is the actual manufacturer or producer) does not physically possess the asset being traded. And the buyer doesn’t really want the asset. In the case of a commodity, it’s unlikely that a buyer is looking to stockpile hundreds or thousands of barrels of oil. They are looking to move money around and hopefully profit from the transaction. However, futures positions are settled on a daily basis. This means that if a buyer enters into a futures contract for crude oil in August with a closing date of October, the price must be settled each day. This means profits and losses are determined by daily movements of that market.

This brings into focus another key difference between futures contracts and traditional trading which is trading on the margin. Futures contracts are sold at high volumes. In our earlier example, if an investor was looking to buy a single contract for 1,000 barrels of oil priced at $60 per barrel, they would not have to pay their broker $60,000 up front. Rather, they would most likely only be required to open a margin account that would allow them to enter into the futures contract for only a few thousand dollars. This initial margin is typically higher than the maintenance margin for the asset.

But because futures contracts are settled on a daily basis, it is possible for the price of the asset particularly when it’s a volatile asset such as commodities or precious metals to make substantial moves when this occurs the value of the asset can fall below the maintenance margin. In this case, a margin call is initiated which requires the contract holder to put money into their margin account to bring it back up to the required level.

Futures contracts have a high degree of volatility and are less liquid (i.e. the market of sellers is not as vast) than stock, bonds, or forex traders. In some cases, a currency can double or be cut in half in a short period of time.

The bottom line on futures contracts

Futures contracts are an efficient way for markets to move large volumes of assets. Although most often associated with commodities, there are futures contracts for a variety of assets including precious metals, currencies and traditional stocks and bonds.

When engaging in a futures contract both the buyer and seller are looking for price certainty. In the case of the buyer, they are hoping to lock in a price that will actually close higher, so they will only have to pay the lower price they agreed to. In the case of the seller, they are agreeing to accept a price in the hopes that the price may actually close lower so that they will be receiving more than the market value of the asset when the contract expires.

Futures trading is a highly regulated, and also highly risky market. The price of a futures contract is based on mathematical models that take into consideration one or more fundamentals related to the asset. Each contract has a similar structure, but the specific details of each can vary so it is important that investor understand the terms associated with futures contracts.

Trading futures is different and riskier than traditional stock trading. Not only does it require a high-risk tolerance, but it also requires a high degree of liquidity to cover the minimum margin requirements if necessary.

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