New to Futures trading? Learn the basics of how Futures contacts work.
How Futures contracts work
If one party has a physical asset and another requires it at a later date, futures contracts can be said to protect both the buyer and seller from future price volatility. The two parties agree to exchange money on a delivery date in the future at a price agreed at the time the contract is signed.
Closing out is where a futures contract is closed prior to the delivery date – a common practice. To reverse the initial contract, the original buyer becomes a seller of the same asset, at the same quantity.
Example: If you bought a contract for 10 barrels of Brent Crude, October 2014 delivery, to close the contract you would then sell a contract for 10 barrels of Brent Crude, October 2014 delivery.
Common assets used in trading Futures
In commerce, futures contracts offer companies a degree of certainty, which in turn allows them to more accurately forecast their financial models. This is known as hedging (i.e. off-setting risk).
Asset classes typically hedged using future contracts in financial markets are:
- Interest rates
- Currencies / Foreign Exchanges / Forex (FX)
Choose your motivation: Hedging versus Speculation
Futures contracts can offset some of the risk inherent in financial markets by agreeing the price of an asset well into the future – be that a currency, commodity or interest rate. Futures also give investors an added degree of visibility in their portfolio. However, in the investing world, futures are more likely to be used speculative.
Futures as a hedging strategy: Hedgers tend to use futures to help reduce or eliminate risk by insulating themselves against any future price movements.
Example: A multinational company may need to buy goods in one currency but sell them in another. An adverse shift in exchange rates could see profits wiped out, but a futures contract allows them to remove the risk here.
Futures as a speculative strategy: Speculators, enter into a futures contract on the belief that they can make money out of market volatility.
Example: If an investor thinks there might be a UK interest rise in the near future, they might want to speculate that GBP will become more valuable than USD. Interest rate rises aren’t guaranteed and neither is the fact that GBP would automatically become more valuable than USD.
So, rather than buy the underlying asset (GBP), the investor instead could take out a futures contract. The potential benefit is that if GBP doesn’t rise, the investor can sell the contract and only lose the marginal value of that contract (the cost of carry).
If GBP rises over above the price agreed in the futures contract, the buyer can then settle the contract, receive GBP at a cheaper than the market rate, and then sell GBP back into the market for a profit - or simply sell the contract on to another buyer for a better price than it cost to take the contract out.
Futures contracts are legally binding. They obligate the two parties involved to trade a particular type and amount of an asset at a predetermined price at some point in the future, assuming that the seller does not prematurely trade out of the position.
An option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell the underling currency at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfil the transaction – that is to sell or buy – if the buyer (owner) "exercises" the option. The buyer pays a premium to the seller for this right. The cost of the premium will reflect the value of the option.
With the spot FX, the underlying currencies are physically exchanged following the settlement date. The main difference between currency futures and spot FX is when the trading price is determined and when the physical exchange of the currency pair takes place.