Futures - what is it?

Parties that enter into a futures contract agree to deliver a specific asset at a specific point in the future.

For example, in February you buy 1 May futures contract for oil - this means that in May they will bring you 1 barrel of oil at the price indicated in the contact. No matter what the price will be in May, you will receive oil at February prices.

But if you do not have an oil well or infrastructure for storing physical assets, this does not mean that you cannot trade futures. That is why there are futures of two types:

  • Physical delivery. In this case, the underlying asset will need to be physically delivered by a certain date at a certain price.
  • Cash settlement. This type of futures contract does not oblige physical delivery.

According to CME statistics, more than 95% of futures are traded without physical delivery.

The history of futures

The history of futures contracts is very long. It is believed that the first mention of this type of transaction is described in the “Politics” of Aristotle (3rd century BC) regarding the harvest of olives.

It is known for certain that futures contracts were concluded in 1710 on the rice exchange in Osaka (Japan).

In North America, futures trading has spread since the mid-19th century. Mostly, these were food futures and precious metals.

In the 1970s, futures for assets such as stock indices and mortgage-backed securities appeared in the world. Since the early 1980s, oil futures have become available.

In December 2017, the Bitcoin futures trading began on the Chicago Exchange.

Modern futures

At the moment, futures are an integral part of the financial world. Those sections of the futures trading exchange are called derivatives sections.

To assess the scale of trade in derivatives markets, we present the following table from the Swiss Bank for International Settlements (BIS). According to this authoritative source, the daily global turnover in futures markets is about $ 7 trillion.

How to deal with futures?

A futures contract is classified as a derivative financial instrument.

Therefore, in the terminology of exchange trading, futures are a type of derivatives.

What does derivative mean? This means that the price in the futures contract is a derived value, which is calculated based on the price of the underlying asset.

It turns out that the price of the futures per share is “tied” to the share price in the spot market. Thus, the futures price in real trading almost completely repeats the dynamics of fluctuations in the price of the underlying asset.

In addition to price, the specification of a standard futures contract includes:

  • Full and abbreviated name of the contract.
  • Expiration date. This is the moment in time when a fixed-term contract is no longer valid. It can no longer be bought/sold, and contract holders must settle. In other words, futures have maturity. As a rule, mass expiration of futures occurs once a quarter;
  • the type of the contract (Physical delivery or cash settlement), and delivery date, if the contract means physical delivery);
  • the currency of the contract, the minimum price change, the cost of the minimum step.

How are futures contracts used?

The initial use of futures is hedging, or more simply, insurance against unwanted scenarios. Imagine a car manufacturer. It delivers products to the world market, and after its sale receives the national currency into the account. The amount of revenue may depend heavily on fluctuations in the exchange rate of the national currency against the dollar, for example. Therefore, the manufacturer can be insured and open a position in the futures market.

  • If the rate is favorable, the producer will receive a greater amount of currency, but a loss on the futures contract.
  • If the rate is unprofitable, the producer will receive a smaller amount of currency, but the lack of revenue is offset by profit on the futures contract.

But in the modern financial world, futures are mostly used as a speculative and/or investment tool. This is due to the benefits of futures:

  • 24/5 trading. Markets usually close only on weekends.
  • high volatility and liquidity;
  • the possibility of attracting additional capital through margin lending (leverage);
  • low commissions.

Therefore, more and more investors and traders are using derivatives markets to apply their strategies and obtain appropriate benefits.