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What Are Futures?
Futures is an investment channel that has always been a popular asset class amongst investors and traders due to the attractive returns and other benefits it offers. It is operational in several markets; particularly the financial and commodity market, involving the trade of financial instruments and commodities. Futures are used by experienced investors and traders since it is instrumental for speculative trading and hedging. We at Financial Education believe that having knowledge of every available asset class in the financial market is crucial to becoming a successful investor. While futures offer several advantages, they can be a risky investment instrument if one does not have proper knowledge of how they function. In this article, we shall explore what futures are and how you as an investor can use this asset class to your advantage. So, let’s get started.
What are Futures?
Futures are trading transactions that involve the buying or selling of specified quantities of assets, be it financial instruments of commodity assets, at a fixed price and a set date. They are derivative financial contracts, implying that the transactions to be done are hinged on a predetermined price and therefore cannot be influenced by future price fluctuations or the current market price as at when the time of expiration is due. A futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument.
What Is The Futures Market?
The futures market is the platform where futures trading is done. It is used by investors to trade large quantities of various assets. The futures market is global and one that is digitalized, so it operates in a 24-hour schedule, although subject to time zones. A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts that lock in the future delivery of a commodity or security at a price set today.
Examples of futures markets are the New York Mercantile Exchange (NYMEX), the Kansas City Board of Trade, the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), Chicago Board Options Exchange (CBOE), and the Minneapolis Grain Exchange.
Some of the asset classes traded in the futures market include:
- Precious metal futures such as copper, silver, and gold.
- Equity futures such as Dow Jones Futures, S&P 500 Futures, NASDAQ Futures, and more.
- Currency futures such as the British pounds (£), Euro (€).
- Commodities such as crude oil, corn, cocoa, coffee, etc.
The futures market conducts its trading through exchanges such as the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYME), or the Intercontinental Exchange (ICE).
The common commodity, currency, and index futures traded are gold, crude oil, copper, particularly; 5000 troy ounces silver (SI) future, 1000 barrels crude oil (CL) futures, 100 troy ounces gold (GC) futures, Euro to U.S dollar (6E) futures, E-mini Dow Jones Industrial Average (YM) futures, British pounds to U.S. dollars (6B), E-mini S&P 500 (ES) index futures, and more.
How Do Futures Contract Work?
A futures contract is a legal agreement between a buyer and a seller to trade assets at a future date and a particular price. Futures permits investors to secure or lock down a particular asset’s price for the purchase or sales of the asset against future fluctuations in its price.
A buyer stands to benefit from a futures contract if the current market price of the traded asset happens to be higher than the already fixed price since the individual would only be obligated to pay the amount as initially agreed, and not the current price. But in a scenario where the price of the asset declines, the buyer will have to pay the agreed-upon amount regardless of the current market scenario.
For example, a manufacturing company can decide to buy a June silver futures contract (SI) worth 3000 troy ounces. The company is to buy the 3000 troy ounces of silver at the agreed price on the set expiration date, regardless of the current market condition at the time of the expiration. And the seller is mandated to fulfill the end of the agreement by supplying the silver futures whether the price is honorable or not.
The expiration date in futures market contracts is seen as the final day an investor can trade a contract. Beyond that day, the contract will end either through physical delivery or settlement in cash. The expiration date usually falls on the third week of the contractual month, mostly on a Friday, but then the date varies among different contracts.
In futures contracts, there is something called a tick. It is the least price fluctuation a futures contract can maintain at any particular time in the day. Each tick has its monetary worth which is termed the tick value, which varies by contract. Every tick represents a profit or a loss to the trader having a futures contract.
Several tick sizes vary across the futures contract and instruments traded in the market. For instance, E-mini S&P 500 (ES) tick movement increases by $0.25 or it is worth $12.5 per contract and crude oil (CL) ticks at $0.01 increment or its worth are $10 per contract.
Say, a trader wants to buy a crude oil contract. This means that, if the current price of the contract is $32575 and a trader desires to get the oil, the trader would have to increase the bid by $10, which is the tick value of crude oil, thus, offering $32585. Some other index futures can have tick movements worth as low as $5.
Stock Futures Trading
Although commodities are the most viable assets traded in the futures market, stock futures still have their waves in the market. Stock futures permit an individual to trade company stocks and shares of exchange-traded funds (ETF’s). For instance, an individual can decide to hedge S&P 500 futures contracts. If there is a fall in the stock price, the individual will make a small profit, complimenting the exposure to the future index. If the same individual has more trust in his futures position, he can decide to purchase a long-term contract, with the expectation of a larger profit if the stock futures move according to the speculation of the trader.
History & Purpose of Futures
Futures trading has been in existence as far back as the time agricultural trading began to thrive, though the term ‘futures’ had not yet been coined. Commodity trade was the mainstay of futures trading from the beginning as it was centered on agricultural produce. As trading progressed, traders sought ways to make more sales while securing storage and preservation for their goods. This brought about the futures agreement, where the buyer and seller agree on a set price for a particular commodity anticipating the sell-off date.
Futures were introduced into the United States in the 1800s. The futures trading brought to rise the establishment of exchange houses such as the Chicago Board of Trade (CBOT) in the USA, founded in 1848. As confidence in futures trade grew across boards, more participants were attracted to the market and it expanded beyond the trade of agricultural commodities to the trade of precious metals, company stocks, and other asset classes.
The futures market was organized for several purposes, one of which was aimed at providing information on the future economic state giving rise to forecasted market expectations. The forecast of the futures market is considered to have more credibility and efficiency than individual analysis. With such information, competitive and profit-oriented investors can make well-informed analytical decisions.
The futures market is also found purposeful in the acquisition of capital for companies. Firms can leverage short-term loans from exchangers in terms of margin to purchase raw materials for production. Futures contracts stand as collateral for companies to improve on their inventories.
Advantages & Disadvantages of Futures
The futures markets and their contracts are quite attractive but at the same time equally risky. The cons can almost equate to its pros due to its speculative inclinations.
Pros of Futures
Futures contracts can be wonderful for the following reasons:
Futures do not require you to use a huge amount of capital for entering a trade or position. It permits you to deposit a portion of the total required capital, also known as margin since you can leverage on exchange brokers. This feature of trading on margin or leverage is a great way to accumulate huge profits without deploying a large part of your capital.
2. Standardized contract
Futures contracts are standardized in their operation. The agreement made by the parties cannot be breached except on legal grounds, therefore, it is non-negotiable.
3. Price Lockdown / Hedging
Traders or companies can use futures contracts to secure a favorable price for the purchase or sale of an asset, against future price fluctuations. This allows hedging and protection of existing investments and positions.
4. Time Flexibility
Futures trading time is flexible to a degree, as the trading time for index futures varies quite a bit. Although the stock futures market is majorly in session from Monday to Friday, between 9:00 am to 4:30 pm every day.
Still, some futures are alternated in their trading time. To cite an example, E-mini NASDAQ 100 futures are not only traded on the general weekdays but also during weekends; trading from Sunday to Friday; from 6:00 pm to 5:00 pm, taking a short recess from 4:15 pm to 4:30 pm.
Futures aid traders to speculate the activities of assets and their market prices for profitable investments. This allows investors and traders to benefit from their analysis and predictions for any asset class like commodities, currency, or stocks.
Futures contracts operate within a time limit. That is, the contract has an expiring date upon which all deals should be closed, declaring the profit or loss of both the parties involved. This enables traders to make proper financial analyses before entering into any futures stock trade or contract.
Futures contract do not necessarily require physical assets delivery between parties, as it mostly involves the transfer of liquid or cash transactions. An exception may occur when the expiration date matures.
Contracts in futures markets are tradable, that is; a party can decide to trade or transfer the contract to a third party at any given point, thereby dissolving oneself from the initial agreement.
Cons of Futures
Amidst the several advantages of futures contracts, it holds underlying limitations, some of which are:
- Although hedging or price lockdown appears to be favorable, it can also be detrimental if the price fluctuation goes against one’s speculations. The implication of this is that the investor stands a chance of losing the amount invested, requiring more funds for supplementary and margin calls.
- On the other hand, the investor can lose out on favorable future prices, since a fixed contractual price has already been agreed on in the contract.
- In the case of leveraging, an investor stands a chance of being indebted to the exchange brokers, if the trade turns out to be a loss. Since a good portion of the invested funds come from the broker and margin requirements need to be fulfilled regardless of a profit or loss.
What is Leverage?
Leveraging or leverage is a common trading mechanism in the futures market. It is when an investor requests an amount that is more than his deposited funds for trading with an expectation to earn profit and make a refund. It could be seen as a loan request for borrowing. Leverage goes along with margin, which states the stipulated minimum amount an investor must have before making use of leverage.
For example, a trader might want to trade the S&P 500 futures contract which is worth $300,000. To trade this future, the investor is expected to have a minimum of $10,000 which serves as the margin. If the investor does not have this amount as an initial deposit, the investor is not considered credible enough to take leverage for the S&P 500 futures. On the other hand, if the investor deposits $10,000, the individual is fit to seek leverage and trade the $300,000 worth of futures.
Leverage can be quite risky, the chances of getting a profit to that of a loss are 50:50. The more the leverage, the more the risk. The founder of Financial Education, Jeremy Lefebvre, believes that leverage is a double-edged sword, which if used carefully can help in creating huge wealth, but on the other hand, it can cause huge losses if used improperly. The chances of getting rich within a short time equate to the speed at which one can become indebted and poor, especially if a trader takes leverage that is more than his net capital without making proper financial analysis and analyzing his trades or investments.
Futures indeed are an interesting market to trade-in. Investors who are quite experienced can make a fortune out of it and at the same time, unskilled market participants can become perpetually indebted. Assets ranging from commodities to currencies, stock futures, and indexes are traded in the futures market having their own unique operation, timing, margin, and leverage. Companies and traders with the right information can make a profit from this financial platform. However, before making any investment decision, always check the current market conditions and other factors that might affect the value of an asset class, as investments in the financial market are subject to market risk. If you liked this article, make sure to visit Jeremy Lefebvre’s YouTube channel “Financial Education” for more such informative content! Happy investing!