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Definition of a futures contract
A futures contract is a standard financial agreement to buy or sell an asset in the future. A futures contract is NOT an asset. It conveys no ownership rights and does not pay dividends or accrue interest. A futures contract provides specific rights in the contract specifications the exchange lists.
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Commodity futures serve multiple purposes for market participants and are used for various reasons.
The distinction between physical delivery and cash settlement in futures contracts lies in how the contractual obligations are met at expiration. While physical delivery involves the actual transfer of the underlying asset, financial settlement settles the contract’s financial commitments through cash payments based on price differentials. The choice between physical delivery and financial settlement depends on the nature of the underlying asset, market preferences, and the specific requirements of the futures contract.
Physical delivery occurs when the parties involved in a futures contract fulfill their obligations by physically transferring the underlying asset from the seller to the buyer at the contract’s expiration. For futures contracts involving physical delivery, the buyer receives the actual physical commodity (such as gold, oil, or wheat) specified in the contract. At the same time, the seller delivers the commodity to the buyer at a specified location and time. You can always trade out of your physically delivered futures contract before expiration and not be obligated to take or make delivery.
Example: In a gold futures contract involving physical delivery, the seller would deliver a specified quantity of gold to the buyer upon contract expiration.
Cash settlement occurs when the parties involved in a futures contract settle the contract’s financial obligations in cash rather than physically exchanging the underlying asset.With cash settlement, the profit or loss on the futures contract is settled based on the difference between the contract price and the settlement price at expiration. No physical transfer of the underlying asset takes place. Many cash-settled futures contracts derivative the settlement price versus an index such as the Fastmarkets Lithium Hydroxide price. Like physically delivered futures contracts, you can trade out of your position at any time before expiration.
Example: In a Lithium Hydroxide futures contract involving cash settlement, the contract may be settled in cash based on the difference between the buying or selling price and the index value at expiration.
David Becker is the director of the risk solutions practice at Fastmarkets, located in New York. His role is to consult and provide customers with an assessment of commodity price risk and describe ways to mitigate exposure. He regularly runs training sessions on price hedging.
A liquid futures market will attract several different types of market participants. Commodity hedgers are market participants, such as producers, consumers, or investors, who use futures contracts to manage or mitigate the risks associated with price fluctuations in the underlying asset. Hedgers seek to protect themselves against adverse price movements that may impact their business operations or investment portfolios.
Speculators are traders who enter the futures market to profit from anticipated price movements in the underlying asset.
Market makers are traders or firms that provide liquidity to the futures market by continuously quoting bids and asking prices for various futures contracts. Market makers help maintain an orderly market by facilitating trading and ensuring that buy and sell orders can be executed efficiently. Examples are banks, trading companies, hedge funds and brokers.
Arbitrageurs capitalize on price discrepancies between related assets in different markets. By simultaneously buying and selling equivalent assets in different markets, arbitrageurs seek to profit from price differentials and exploit market inefficiencies to achieve risk-free returns.
Institutional investors, such as hedge funds, pension funds, and asset management firms, participate in the futures market to diversify their investment portfolios, hedge risks, and generate returns. Institutional investors often trade in large volumes and significantly impact market liquidity. For example, an ETF that holds futures contracts provides access to futures without owning a futures account.
Individual investors and traders who trade futures contracts through online brokerage platforms are known as retail traders. Retail traders engage in futures trading for various reasons, including speculation, portfolio diversification, and risk management.
Futures exchanges serve as the central marketplace where futures contracts are traded. They provide the infrastructure, rules, and regulations for futures trading, facilitate price discovery, and ensure the orderly execution of trades. Market participants interact with each other through the futures exchanges to buy and sell futures contracts.
The mechanics of futures trading involve several essential components and steps that govern buying and selling futures contracts on a futures exchange. Before engaging in futures trading, individuals or entities must open an account with a brokerage firm that offers access to futures markets. The broker is an intermediary between traders and the futures exchange, facilitating trade execution and providing various services.
Traders typically conduct market analysis to identify potential trading opportunities based on market trends, supply and demand dynamics, economic indicators, and technical analysis. This analysis helps traders make informed decisions on entering or exiting positions. Depending on their trading strategy, traders can place orders with their broker, such as market, limit, stop, or spread orders. Orders specify the quantity, contract specifications, and price at which the trader intends to buy or sell a futures contract.
To enter a futures position, traders must deposit an initial margin with their broker. The margin is collateral to cover potential losses and is determined based on the contract size and the underlying asset’s volatility. Once the order is placed, the broker executes the trade on the futures exchange on behalf of the trader. The trade is matched with a counterparty, and a position in the futures contract is established. Traders monitor their positions to track price movements, evaluate market conditions, and manage risk. They may adjust their positions, set stop-loss orders, or implement risk management strategies based on market developments.
Futures contracts can be settled through physical delivery of the underlying asset or financial settlement, depending on the contract specifications. Traders wishing to maintain exposure to the underlying asset beyond the current contract’s expiration can roll their positions by closing the expiring contract and opening a new one with a more extended maturity. Traders can close their futures positions before the contract expires by taking an opposite position to their initial trade. Closing the position locks in profits or losses and terminates the obligations associated with the futures contract.
Since a futures contract is not an asset, exchanges do not require full-value payment when a transaction occurs. Instead, a futures exchange requires a performance bond known as a margin. Margin refers to the amount of money a trader must deposit and maintain in their trading account to cover potential future contract losses. Margin requirements are set by the exchange where the futures contract is traded and serve as collateral to ensure that traders fulfill their financial obligations.
There are two main types of margins in futures trading.
Margin requirements can vary depending on the exchange, the asset being traded, and market conditions. The margin on futures differs from the margin on securities, which involves borrowing capital from a broker to borrow shares. Futures margin is a performance bond to ensure you have enough capital in your account to pay for losses. Futures exchanges will occasionally alter margin requirements based on volatility and liquidity.
The prices of futures contracts are determined by the market forces of supply and demand, as well as various factors that influence the perceived value of the underlying asset. The spot price is the current market price of the underlying asset at the time of the futures contract’s pricing. The relationship between the spot price and the futures price is influenced by factors such as interest rates, storage costs, the supply and demand for future assets, and dividends for financial assets.The time remaining until the futures contract’s expiration date, often called time value, influences the futures price. Time value is critical in determining the premium or discount of the futures price relative to the spot price.
Market participants’ perceptions of future market conditions, expected supply and demand for the underlying asset, geopolitical events, weather patterns, and economic factors influence supply and demand, which, in turn, impact futures prices. The cost of carry represents the cost of holding an asset from the present until the futures contract’s expiration. It includes storage, financing, insurance, and other carrying costs. The cost of carrying influences the relationship between spot prices and futures prices.
Market sentiment, investor expectations, and speculative activity can drive futures prices beyond the intrinsic value of the underlying asset. Speculators provide market liquidity and influence price movements based on their outlook and trading strategies. Arbitrageurs monitor price differentials between related assets in different markets to exploit arbitrage opportunities. This activity helps keep prices in line across markets and prevents significant price disparities. Economic indicators, central bank policies, inflation rates, currency exchange rates, and other macroeconomic factors can impact futures prices by influencing market sentiment, investor confidence, and overall market conditions.
There are several ways to execute futures trades, including open outcry and privately negotiated trades. The difference between open outcry and privately negotiated trades on a futures exchange lies in how trades are executed and the level of transparency and market visibility associated with each method.
Open outcry is a traditional method of executing trades on futures exchanges. Traders monitor bids and offers through an electronic exchange or sometimes gather in a physical trading pit or ring to place buy and sell orders by shouting and using hand signals to convey their intentions. Traders communicate their bids and ask prices openly, facilitating direct interaction and negotiation between buyers and sellers. Trading activity is visible to all participants. Open outcry trading offers high transparency as prices, volumes, and trade executions are visible to all market participants on the trading floor.
Privately negotiated trades, block trades, or off-exchange transactions involve executing futures contracts directly between parties outside the regular trading venue. Parties negotiate the terms of the trade bilaterally, including volume and price, often through over-the-counter (OTC) channels, away from the public trading floor. Once a deal is negotiated, the trade is posted and cleared through the exchange.
Regulation in the futures market is essential to ensure transparency, fairness, investor protection, market integrity, and efficient operation of futures exchanges. Governmental entities and regulatory bodies typically oversee and regulate the futures market to maintain a level playing field and minimize systemic risks. In the United States, the Commodity Futures Trading Commission (CFTC) is the primary regulatory authority responsible for overseeing and regulating the futures market. In the United Kingdom, the futures market is regulated by the Financial Conduct Authority (FCA). In Europe, the regulatory oversight of the futures market falls under the European Securities and Markets Authority (ESMA) jurisdiction. The regulatory oversight of the futures market in Singapore is carried out by the Monetary Authority of Singapore (MAS). In Norway, the regulatory oversight of the futures market and financial services industry is primarily the responsibility of the Financial Supervisory Authority of Norway (Finanstilsynet).
Regulatory oversight in the futures market is governed by rules, regulations, and guidelines defining market participants’ conduct, trading practices, risk management protocols, transparency requirements, and investor protection measures. Regulatory bodies conduct market surveillance to monitor trading activities, detect irregularities and manipulative practices, and ensure compliance with regulatory standards. Market surveillance helps preserve market integrity and prevent market abuse. Futures exchanges, brokers, and market participants must provide comprehensive and timely disclosures on trading rules, contract specifications, risk factors, fees, and other pertinent information to investors. Transparency is crucial for informed decision-making and investor protection. Regulations in the futures market encompass customer protection measures, such as separating customer funds from firm funds, maintaining adequate capital requirements, supervising customer accounts, and safeguarding against fraud or mismanagement of client assets. Market participants, including brokers, trading firms, and commodity pool operators, must register with regulatory authorities and comply with licensing, reporting, capital adequacy, and ethical standards to operate in the futures market. Regulatory bodies enforce regulations through inspections, investigations, enforcement actions, fines, and sanctions against non-compliant entities or individuals engaged in fraudulent, manipulative, or illegal activities in the futures market.
One of the primary uses of commodity futures is price hedging. Producers, consumers, and traders of commodities can use futures contracts to lock in prices for future delivery, thereby protecting themselves from adverse price movements. By entering into a futures contract, market participants can mitigate the risk of price fluctuations and ensure a more predictable cost or revenue stream.
Commodity futures enable market participants to manage and mitigate various risks associated with commodity price volatility. Using futures contracts, producers, consumers, and traders can protect themselves against adverse price movements that may impact their profitability or financial stability.
In futures trading, volume and open interest are key metrics that provide insights into market activity, liquidity, and investor sentiment.
Volume refers to the total number of contracts traded during a specific period, such as a trading session, day, week, or month. It represents the level of trading activity and liquidity in the market. Increasing trading volume typically indicates higher market participation, interest, and momentum. Traders commonly use volume analysis to confirm price movements, identify trends, and assess the strength of market moves.
Open interest represents the total number of outstanding futures contracts not offset by an opposite transaction (i.e., still “open” and not yet closed out). Open interest reflects the total number of active market positions, indicating the market participation level. Changes in open interest can provide insights into market sentiment and help gauge the sustainability of price trends.
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