What Are Futures

What Are Futures

Futures are futures contracts (from the English word future) — agreements made now for a transaction to occur in the future. These are derivative financial instruments. Therefore, they have an underlying asset. The definition can be formulated as follows: futures are contracts in which the parties agree to buy or sell a certain quantity or volume of an asset in the future at agreed-upon prices, which are specified when the contract is concluded. Both parties have rights and obligations. Every futures contract implies the presence of an underlying asset or instrument that the parties agreed to buy or sell. The quote for a future is determined based on the spot price of this underlying asset. This is the price at which the asset is "traded here and now." For example, on 20.08.2019, the spot price of gold is approximately $1501, while at the same time, December futures on CME are trading at $1510, and February futures at $1514 (we will explain this price difference a bit below). The underlying asset can be many things, ranging from commodities like oil, gold, or bitcoin, to foreign currencies, stocks, or stock indices.

Weekly Chart of Gold Futures

Types of Futures

There are two types of futures:

• Delivery Futures — when a real commodity serves as the asset, and it is delivered to the holder of the contract. When purchasing such a future, the price and time of delivery of the commodity to the buyer are specified. The exchange monitors the fulfillment of obligations, and in case of violations, it can impose significant fines.
• Cash Settlement Futures — when all parameters of the contract (price, quantity, time) are defined, but the actual asset is not delivered. The "money-to-money" scheme. In this case, the buyer either receives a profit in money or a loss. It is very similar to CFDs.

Where Futures Are Traded

There are specialized exchanges where futures trading takes place. The main and most significant ones are commodity exchanges such as CME in Chicago, NYMEX in New York, and the Intercontinental Exchange ICE. Exchanges are also organized in the capitals of some major countries: London (LIFFE), Paris (MATIF), Moscow (MOEX), and Singapore (SGX). Futures charts are provided to clients when trading on these exchanges. Some commodity exchanges trade only certain commodities, such as wheat, soybeans, or cotton.

How to Start Trading

To begin trading, a trader must choose an exchange, enter into an agreement with it, and deposit funds into their account. To calculate the deposit size, it is necessary to consider the exchange’s requirements for margin collateral.

For example, let’s look at the Crude Oil Futures contract conditions on the CME exchange. The contract parameters are valid as of the time of writing. The unit of measurement for one contract is $1000, and the price of one tick (0.01) is $10. The margin requirements for contracts with different expiration dates vary. To trade the closest contracts, the account must have at least $3650, and this applies only to intraday trading. For the most distant oil futures, $2300 is sufficient. Also, for purchasing one contract, a commission of $2-2.5 per contract is charged.

For comparison, let’s look at the conditions for trading oil derivatives through the US stock exchange. In this case, trading ETFs (USO, BNO) is used. The minimum account size starts at $700, and the maximum commission for trading 100 shares is $1.4.

What is Contango and Backwardation

In the above example with gold, we saw the price divergence between spot and futures — the futures were more expensive, and the further the expiration date, the higher the price. This phenomenon is called contango. If there is an inverse relationship, it is called backwardation. This price difference is explained by storage, delivery costs, and the expected future demand, which are factored into the contract price. Another feature is the alignment of the futures and spot prices on the expiration date of the contract.

Graphical Representation of Contango and Backwardation

Features of Futures Trading — Strengths and Weaknesses

Advantages of trading include:

• Low exchange fees
• The possibility of hedging risks
• The ability to obtain leverage and, as a result, the potential for higher profits.

Disadvantages of futures trading:

• Time limitations that arise upon contract expiration;
• High risks due to leveraged trading.

Futures on Indices

It is easy to guess that futures exist for all the largest stock indices. For example, for the US market, these are futures on the S&P500 index, while for the Russian stock market, they are futures on the RTS index, also known as "rishka." When it comes to trading SPY, it is much easier to trade it on the primary market through the appropriate ETF, such as SPY. However, there are also many different ETFs based on S&P500 that specialize in specific characteristics of the companies in that index. There are also inverse ETFs, which are convenient for shorting the index.