A futures contract is a standardised agreement between two parties – the buyer and the seller – to exchange an agreed quantity and quality of a specified asset – gold, oil, bonds, livestock, wheat, sugar, cash etc - on an arranged date in the future (the delivery date) at an agreed location.
Importantly, the price which the buyer will pay and that the seller will receive in the future is pre-determined when the contract is signed.
Each futures contract is between two parties – a buyer and a seller. As such it’s very common to hear the terms “long” and “short” used when it comes to trading futures. The party to the contract which is accepting delivery of the asset is long (the buyer), while the party delivering is short (the seller).
How are futures applied to markets?
Futures contracts offer the chance for an investor to know the price they will pay for an asset at an agreed date in the future. In the simplest terms, the price you pay for a futures contract is usually the spot price (the cost of the underlying asset today) plus or minus the cost of carry (how much it will cost the seller to hold onto the asset until the delivery date). That is assuming there are no other charges.
Example: For instance, if the current price of gold in the cash market is $1,300, a futures contract with delivery in December might be $1,380. The cost of carry is therefore $80.
Futures markets, however, are not always the perfect crystal ball. They do not necessarily accurately reflect future spot prices. But investors can close out a futures contract at any time prior to the contract's delivery date, subject to a willing counterparty being found – this is a common occurrence in futures trading.
Why consider Futures?
- The nature of a futures contracts means that investors have a greater degree of certainty over their investment. An element of risk in terms of future price volatility may be removed.
- As well as using a futures contract to hedge their risk against wild swings in foreign exchange markets, investors may also use them to speculate on and consider any potential market volatility.
- Whether you are a large institution or an individual trader everyone is on equal footing when it comes to pricing futures – the best price wins. It is therefore more of a level playing field for all participants.
- Futures markets are liquid, which is sometimes not the case in other standard markets such as spot commodities.
- If traded correctly investors can use leverage to make a lot of money at relatively low risk.
A brief history of Futures contracts
Formal futures contracts have been around for almost 200 years - beginning with farmers in Chicago in the mid-1800s who wanted certainty over the price of their goods. Fed up with being at the mercy of unscrupulous dealers, farmers began agreeing futures contracts on their produce, which gave the farmers (sellers) certainty over the price they could expect for their produce, while the dealers (buyers) who distributed the goods knew their costs up front.
Over time this practice evolved. Dealers (buyers) began selling their contracts on if they found they no longer needed the produce the farmer was delivering. Farmers (sellers) could do the same too. If they couldn’t deliver the commodity they would sell their part of the contract to another farmer who could.
Supply and demand
The value of these futures contracts therefore began to rise and fall depending on supply and demand. In the years when farmers enjoyed a bumper crop the price at which they could sell their contract would fall due to increased produce in the supply chain. During a bad crop, farmers with produce to sell could command a higher price as supply was reduced.
The value of the futures contract was derived from the demand and availability of the underlying value of the asset. This is how the futures market place, as we know it today, operates.
The risks of Futures
Risk for buyers: If you are a buyer there is a risk that the price of the underlying asset will fall or, even worse, become worthless.
Example: If you agreed to buy 100 barrels of oil at $100 for delivery in three-month’s time and the oil price slumped to $20 because of over-supply, then in theory you would be losing $8,000. The buyer would of course attempt to sell the contract before this happens, but could still incur a loss as the value of the contract would fall in-line with the depreciation of the underlying asset.
Risk for sellers: A seller of a futures contract could in theory be liable to infinite losses if the value of the asset they are selling keeps rising. That is because if the buyer of the asset holds the futures contract to delivery date, then the seller would need to buy the underlying asset in order to honour the Futures contract.
This is unlikely to happen as the seller would attempt to offset that risk, but it should be considered.
Example: This is less of a concern with FX futures but it’s easier to see the risk with something like wheat, where a particularly bad harvest can see prices skyrocket.