Futures for Dummies

What are futures?

Futures are a form of standardized financial contract which oblige the buyer to purchase an asset of standardized quantity and quality (and the seller to sell the same asset) at a defined future date and price. The word “oblige” is important to note here – futures are derivatives in that there is an underlying asset in the transaction. However, they are not options. The futures contract obliges the buyer to buy the asset and the seller to sell the asset.

Futures contracts are generally used to hedge or speculate on the price movement of an underlying asset. The underlying is typically a commodity, in whose price the buyer has a material interest, so that they “buy in” the asset at a certain price in the future. An example is provided by commercial airlines which purchase futures contracts in oil. This allows them to buy in at a certain oil price and hedge against future  rises in its price, which would make flights unprofitable.

Futures are also used for speculation as well as for hedging; traders who believe that a price change will occur in an underlying asset can buy futures contracts which reflect this. For example, if a trader believed that a share will be priced at $120 on a specified date in the future (say, December 31, 2014), he or she can enter into a futures contract which obliged them to purchase the share for $100, thus allowing them to make a profit of $20 on December 31 if the share is priced at $120, as they expected.

This type of speculation in futures contracts is very common, evidenced by the fact that the delivery rate of the underlying asset outlined in futures contracts is very low. Many parties in futures contracts to long (buy) on a futures contract and go short (sell) on the same type of contract to offset the position. If the long and short positions perfectly offset each other – they occur on the same date, with the same asset – there is no requirement to ever even hold the asset. In this way, traders often seek to achieve arbitrage through futures contracts.

It follows that because so much speculation happens among traders in futures contracts, the near to their expiration, the contracts are usually more liquid (i.e. there are more contracts being bought and sold on the futures market). This volume of trading ensures less volatility (jumps in price) for traders and in theory at least, more reliable price information.

What makes futures unique?

Warren Buffet once notoriously referred to financial derivatives as “weapons of financial mass destruction,” but he was being unduly fair, if not on derivatives in general, then certainly futures. Futures are unique among derivatives in that each futures contract is underwritten by a futures exchange (more commonly known as a “clearing house.”). The exchange acts as an intermediary and minimizes the risk of default by either party.

How does the futures exchange minimize risk? It does this through a process known as “marking to market.” This process requires both parties to put up an initial amount of cash, which is referred to as the margin. And as the futures price will fluctuate on a daily basis, the difference in the price agreed-upon in the contract and that of the daily futures price is settled daily with the futures exchange (variation margin). The exchange draws money from one party’s margin account and puts it into the other’s account, so that each has received the relevant daily profit or loss.

If the margin account goes below a certain pre-determined value, the futures exchange makes what is known as a “margin call,” and the account owner (buyer or seller of a futures contract) is required to replenish the margin account. By requiring both parties to keep up to date with price fluctuations in the underlying asset, the futures exchange ensures that the amount exchanged at the delivery date is in fact, the spot price (i.e. that day’s price for the asset). On first inspection, these conditions are quite financially prudent and far from the “weapons of financial mass destruction,” they are sometimes referred to as.

However – some caution is required here. Futures are characterized by the ability to use very high leverage relative to other markets. A futures contract requires that an investor only has to put up a small fraction of the value of the contract as “margin.” This allows the trader to trade a much larger amount of the underlying asset than if they were to buy it outright (on the commodities market, for example). This leverage ties in potentially huge risks, but also, on the downside, potentially huge losses.

As a result of the leverage, small fluctuations in the price of the futures contract are multiplied for the buyer and seller, giving them a high-risk profile in investment terms. For example, in anticipation of a rise in corn prices, suppose you buy a futures contract with a margin deposit of $10,000 for an index currently standing at 250. The value of the contract is $100 times the index, meaning every point fluctuation in the index will mean a concurrent fluctuation of $100 in profit or loss. The arithmetic of this operation means that speculators stand to lose or gain huge amounts.

Finally, in theory at least, futures are thought to be fairer than other types of investment (such as shares), because “inside information” is more difficult to achieve. Futures exchanges are highly transparent markets with open trading pits with buyers and sellers. Official market reports are released daily, providing greater transparency to all participants. Compare that to the pricing of shares, where numerous academic studies have shown that significant price moves often occur before an official market announcement by the company (thus clearly suggesting insider trading).

Futures Contracts and Exchanges

Generally, derivatives such as options and forward contracts just need two parties to a transaction (a buyer and a seller) and an underlying asset to take place. Futures contracts are more specific, demanding as they do a futures exchange to play the role of intermediary in the transaction. However, this, the scope of potential futures contracts that can be written is quite enormous, reflecting the vast range of tradable assets available.

The range of underlying assets includes, but is not limited to:

·         Commodities (agricultural and otherwise)

·         Shares

·         Fixed-rate securities

·         Debt instruments

·         Electricity

·         Currencies

·         Interest Rates

·         Market Indices

Meanwhile, the list of futures exchanges where transactions can occur is also significant. There are currently over 90 exchanges worldwide and more are likely to follow. The largest and most well-known such exchange is the Chicago Mercantile Exchange (CME), which was first opened its doors in the latter half of the 19^th century. From its beginnings as a futures exchange for wheat traders, the exchange now deals with interest rate derivatives, agriculture, indices and metals. Europe’s largest exchanges are the Intercontinental Exchange (ICE Futures Europe) and NYSE Euronext.

A Brief History of Futures

Futures contracts often become mixed up with forward contracts in the telling of their history. Recall that the main distinguishing factor of a futures contract is the clearing house, the first of which was thought to be the Dojima Rice Market in Japan. So, although contracts tying in prices existed between farmers hundreds of years ago, the non-participation of a clearing house in these transactions means that they more closely resembled forwards contracts than futures.

Although futures exchanges are now complex organizations trading in billions of dollars each day, they arose – as is often the case - from very simple needs. Before the arrival of the CME in Chicago in the mid-1800s, farmers would grow their crops as best they could, before bringing them to the market in the hope of selling their entire inventory. But without any price indicators, their supply often vastly exceeded the demand, creating huge waste in their production quotas.

The arrival of central grain markets in the mid-1800s meant that farmers could now bring their inventory to market and sell them at the immediately available price (spot trading) or for forward delivery (forward contracts – which eventually became futures contracts, once a clearing house became involved). The result was a system which provided farmers with more stability, less volatility in the marketplace, more efficient production frontiers and the relative security of a clearing house.

When the benefits of these transactions became apparent, the scope of what could the underlying could be quickly grew. Agricultural commodities shortly became metal commodities and in the 1970s, contracts on financial instruments were introduced by the Chicago Mercantile Exchange. These in turn overtook commodities in terms of trading volume. As the market became large in scale and scope, the establishment of exchanges followed with close to 100 currently in operation globally.

Futures Market Regulation

The futures market clearly could not function without tight regulation. Although the clearing house makes transactions more watertight than they would otherwise be on an OTC (over-the-counter) market. The high level of growth experienced by the futures market can be at least in part attributed to the level of trust and confidence that investors have in the marketplace.

Trading of futures in the United States is regulated by a number of bodies, each with a specific area of authority. The first and most prominent is known as the Commodity Futures Trading Commission (CFTC), which was founded in 1974. It is a federal regulatory agency and as such, can seek criminal prosecution where it deems it necessary. The National Futures Association (NFA) is a self-regulatory body of futures associations, which seeks to develop rules, programs and services that enhance the futures trade. Finally, the US futures and clearing organizations are the clearing houses themselves, which regulate futures traders. Although under the supervision of the previous two organizations, they still have the power to issue fines and suspend trading privileges of their members where misdemeanours have taken place.

In the United Kingdom, the futures industry is regulated by the Futures and Options Association (FOA), which in turn is regulated by the Futures Industry Association (FIA), a European-wide regulatory body. Like their American counterparts, these bodies are constantly looking at ways of reducing risk and improving structures to make the futures markets run more smoothly for all stakeholders.

Market Players

Just as the futures market is no longer farmers bringing bushels of corn to the Chicago Mercantile Exchange, so the typical futures trader typically has more complex motives and trading patterns. Most trading is done through computer platforms provided by the clearing houses to their members, who in turn allow non-members to write contracts.

Typically, traders are divided between hedgers and speculators. Hedgers use futures to manage their price risk (as in the case of airlines purchasing fuel, mentioned earlier), while speculators are purely in the market to achieve profits on trading. Although the term “speculation” has taken on negative connotations in recent years, their participation provides the market with increased liquidity, which allows hedgers to enter the market with more confidence. The somewhat symbiotic relationship that exists in the market between the two can broadly be summarized as follows:

Trader	Short	Long
Hedgers	Buy in a price now to protect against declining prices in a specified time frame	Buy in a price now to protect against rising prices in a specified time frame.
Speculators	Buy in a price now in anticipation of declining prices in a specified time frame	Buy in a price now in anticipation of rising prices in a specified time frame.

Note the distinction that exists between hedgers and speculators as defined by the table: hedgers buy in a price “to protect against,” while speculators buy in a price “in anticipation of.” Both are ultimately concerned with where the price of the underlying asset is going, but for subtly different reasons. Beyond these definitions of traders, there are several ways in which the market players can be categorized: individual traders, portfolio managers, proprietary trading firms, hedge funds, market makers and others.