A futures contract is a type of obligation whereby the parties agree to transfer to each other a certain set of financial assets or commodities in the future at a predetermined price.
But futures trading does not mean that all market participants receive or supply goods – buyers and sellers of futures mainly use them for hedging and speculation, and not for exchanging real supplies. That is why futures are widely used not only by producers and consumers of raw materials but also by speculators.
The futures market is of great importance to the economy. It provides active competition between buyers and sellers and, more importantly, helps manage price risk. By its nature, the futures market is extremely liquid, risky and complex, but its work can be understood by breaking into pieces.
Futures are not suitable for risk-averse investors, but they bring great benefits to a wide range of people and companies. From this article, you will learn how the futures market functions, who works on it and what strategies it applies.
The futures market is a centralized platform for buyers and sellers from around the world. Here they meet and conclude futures contracts. Previously, futures prices were set on stock exchanges, now operations are mostly carried out electronically. The main characteristics of the contract – the price and delivery date. But, as mentioned earlier, almost all futures contracts do without the actual delivery of the underlying asset.
Let’s say you decide to connect cable TV. As a buyer, you sign a contract with a company, according to which it undertakes to provide a viewing of a certain number of channels for a previously known monthly fee for the next year. The contract with the company is similar to a futures contract – you agreed to receive the product in the future at a fixed price and on known conditions. Even if the cost of a subscription to cable television grows in a year, you will still pay for the service at the old price. By signing a contract with the company, you protected yourself from the risk of price increases.
The futures market works similarly. Only instead of cable companies, it gathers producers and consumers of various commodities and other assets. For example, a farmer is interested in fixing the price for the next cereal crop, and the bakery is trying to determine the price of a potential purchase to determine how much bread can be baked and with what profit.
Thus, a farmer and a bakery can conclude a futures contract for the supply of 5,000 bushels of grain in June for $ 4 per bushel (a unit of volume in the American system of measures equal to 35.23 liters). By signing the contract, each of the parties fixes the price, which is considered fair in June. It is these contracts – and not the grain itself – that are traded on the futures market.
So, a futures contract is an agreement between two parties to a transaction. The seller takes a short position and undertakes to put an asset, the buyer takes a long one and undertakes to buy an asset. In the example above, the farmer is the seller, the bakery is the buyer. We will discuss the prospects of long and short positions in more detail in the strategies section; for the time being, it is important to understand that each contract includes two positions.
The characteristics of each future are known in advance the quantity and quality of the underlying asset, the unit price, the date, and the delivery method. The “value” of a futures contract is the future agreed price of the underlying asset. For example, in our example, the contract value is 5 thousand bushels of grain at $ 4 per bushel.
Gains and losses on a futures contract depend on market dynamics and are calculated daily. For example, the next day wheat went up to $ 5. The farmer lost $ 1 per bushel as the selling price increased. The bakery made a profit of $ 1 per bushel because the price it is obliged to pay is lower than the market.
At the end of the day, 5 thousand dollars ($ 1 * 5 thousand bushels) are debited from the farmer’s account, and the same amount goes to the bakery’s account. As prices change, these numbers are adjusted accordingly. Unlike the stock market, the balance of futures positions is calculated daily – the profits and losses from trading operations are immediately credited to the trader’s account. In the stock market, capital gains or losses are not counted until the investor closes his position.
Since the accounts of the participants are adjusted every day, most transactions on the futures market are recorded in cash, and the goods themselves are bought on the spot market. Prices in both markets usually move in parallel and are the same at the expiration date of the futures. When one of the parties decides to close its position, the contract will be redeemed. If the price of wheat at that time is $ 5 per bushel, the farmer will lose 5 thousand dollars, and the bakery will earn the same amount.
But after paying off a futures contract, the bakery will still need grain to bake bread, so it will buy it in the required amount on the spot market, paying $ 25 thousand ($ 5 * 5 thousand bushels). Taking into account the $ 5 thousand received under a futures contract, the bakery costs $ 20 thousand. The farmer will sell his grain on the spot market at $ 5 per bushel, however, taking into account the loss on futures, its revenue will be the same 20 thousand dollars. In other words, the farmer’s loss on the futures market is covered by a higher spot price – this is called “hedging”.
A futures contract is a kind of financial instrument. Now it is easy to imagine that both parties to the transaction are occupied not by a farmer with a bakery, but by speculators. In this case, the seller will lose 5 thousand dollars, and the buyer will earn the same amount. That is, after the expiration of the contract, neither the one nor the other will go to the spot market to buy or sell the underlying asset.
Since the futures market is both very active and important for world trade, it is a good source of valuable market information and information about investor sentiment.
Pricing Because of the high competition, the futures market has become an important economic tool in determining current and future prices based on supply and demand. Prices in the futures market depend on a continuous flow of information from around the world and require high openness. Factors such as weather conditions, military conflicts, defaults, refugee flows, land reclamation and deforestation can have a significant impact on supply and demand, and, as a result, on current and future commodity prices. All this information and the attitude of investors towards it constantly affects prices. This process is known as “pricing”.
Risk reduction. Futures markets also reduce trading risks. This is because the participants know in advance how much money they need to buy and how much they will receive when selling. Futures can reduce costs and reduce the risk that manufacturers inflate prices to the final buyer.