A futures contract or simply futures is a standardized contract to buy or sell a certain underlying asset at a certain date in the future, at a specified price. The underlying asset can be a commodity like gold, silver, crude oil and rice or financial instruments stocks, bonds, indices, interest rates, currencies and other derivatives.
Futures contracts are primarily used as instruments for hedging and speculation. Hedging is like taking an insurance to protect against the price risk associated with one’s physical market position. While hedgers enter the futures market to dispose the risk, speculators accept the risk to make profit.
Hedging is done by taking an equal and opposite position in futures market to that of in the physical market. Suppose that you are a farmer and you expect to harvest one tons of Barley within three months. But you believe that the current spot market price of Barley is satisfactory and if the price declines, it could affect your returns. So you want to lock in the price after three months. You can do this by taking a short position for 1 tons of Barley in futures market. That means you sell futures contact on Barley equivalent to the value of your production. This will give you a profit if the price of Barley futures goes down, which in turn depends on the spot price of Barley. Thus you can compensate your loss incurring from selling your barley production in the spot market by the profit you made in the futures market.
The opposite can be also done if you need 1 tons of Barley for a purpose three months later and you fear that the price may go up from current levels. In order to hedge against this risk, you can take an equivalent long position in the futures market. If prices go up after the maturity of the contract, your profit in futures market will compensate for the loss occurred in buying the commodity from the spot market at higher a price.
The major advantage is that for doing these futures market transactions, you do not need to pay the full price of 1 tons of Barley, you can do the futures trade usually with about 4% of the total contract value. This amount is known as “initial margin.” Each day, your account is “marked-to-market “to reflect the daily price changes. That means, if the value of your contract goes up, the equivalent amount is added to your account. If it goes down, it subtracted from your account. If the margin goes below the required “maintenance level”, you need to invest more money. This is known as a “margin call.”
Another aspect of the futures market should be also noticed. If one takes a long or short position in the futures market, he needs to take an equal and opposite position before the expiry period of the contract unless he wants the underlying asset delivered. That means if he buys one July Barley contract, he needs to sell one July Barley contract. This process is known as “offsetting.” This is usually done when the first contract nears maturity and at that time the futures price will reflect the price change in the underlying commodity.
Even though you are hedging like the above hypothetical example, you need to “offset” your position before the contract matures. On the expiry date, a final mark-to-market settlement adjustment is made and the difference is given to the trader in cash.
World over, it is estimated that only 3% of the futures contracts taking place involves physical delivery. The rest of the contracts are “offset” as mentioned earlier. In some futures contracts like index futures, physical delivery is not possible as the underlying asset is a stock market index. In this case, the only option is cash settlement.
The role played by speculators is extremely important in the functioning of a futures market. If they do not exist, hedgers can not hedge their positions because there is no one to take the risk. Speculators have no intention of taking or making the delivery of commodities and they have usually no connection with the production of the commodities. They trade in the market to profit from the price changes of commodities. Speculators are not making blind bets. They analyze the commodity market and find opportunities to make profit from the possible changes in price.
Futures market Vs Stock market
The most important difference between futures market and stock market is that stocks represent part ownership in a business concern, while futures are only contracts which obligate to receive or deliver a commodity in the future. Stocks are also bought and held for a longtime when compared to futures contracts, in which the holding period ranges from minutes to months.
Another difference is that in futures market, very high leverage is possible as one can buy contracts at around 5% of the contract value by paying the initial margin. In stock market when you operate a margin account, the maximum leverage will not go above more than 50% of the total value of the portfolio.
In futures market, you can go short as easy as going long. That means you can profit from the decline just like profiting from the rise in price. But in stock market, shorting has some restrictions, including the ones set by regulators.
In addition, futures price will never decline to zero because the price of the underlying commodity will never go to zero. But stocks may become essentially worthless if the underlying company goes bankrupt.
Like in the trading of stocks, “buy low and sell high” is the most used strategy in the futures market. Since you can short-sell very easily in the futures market, “sell high and buy low” approach can also be used. But to use these strategies successfully, one must anticipate the movements in futures price. Usually, traders use two methods to forecast futures prices namely, fundamental analysis and technical analysis.
Fundamental analysis involves the study of supply and demand information about the underlying commodity as it affects the futures price. For example, to predict gold futures price a fundamental analyst studies the supply and demand information and the forces affecting gold price.
Technical analysis gives not much importance to the fundamental information. Instead, it studies the price behavior and tries to find patterns that can help to forecast price. They use different types of charts to analyze the price behavior.
Since both fundamental analysis and technical analysis have their own limitations, some traders use a combination of both.
In addition to most common long and short strategies, sophisticated traders can use strategies like arbitrage and spread trading.
Arbitrage is the simultaneous purchase of same commodities in different markets to profit from price difference. For example, if gold is trading in London market at an equivalent price of Rs.15000/10 grams and in Mumbai market at Rs.15225/10 grams, one trader with access to both markets can buy gold from London market and sell it on Mumbai market simultaneously to pocket the Rs.225/10 grams profit. Usually, these types of price discrepancies rarely exist in real markets and if they do, it is a risk free opportunity to exploit.
Spread trading refers to the purchase and sale of two different but related futures contracts to profit from price relationship. For example, you find that gold and silver futures prices rise and fall together, but you also find that the rise in silver price will be slower relative to gold and the fall in silver price will be faster relative to gold. In this situation, you can take a long position in gold and short position in silver. If the prices go up, your gain from gold will be greater than the loss from silver and if prices go down, your gain from silver will be greater than loss from gold.
Other uses of Futures
Futures contracts on indices can be used by fund managers to hedge against their portfolio risk, if the portfolio nearly or closely resembles the target index. Today, commodity futures are considered as an important asset class to diversify a portfolio. It has been proved though studies that the inclusion of a sufficiently diverse commodity futures portion in a portfolio made up of conventional assets like stocks and bonds can reduce overall risk.