An introduction to Futures
We shall first define what a futures contract is; a future is an agreement between a buyer and seller that obliges the buyer to purchase a particular asset (FX, commodities and other financial instruments) from the seller. The price, quantity and date of the contract is pre-determined, in other words you are buying or selling a good which is fixed in quantity and price on a particular date. These contracts are traded on a futures exchange (CME, ICE, LME etc.); the exchange acts as a middle man. Futures contracts are used to reduce risk for both parties (seller and buyer) or for speculative purposes. A futures contract should not be confused with a forward contract which is used in options. Futures contracts are highly standardised – quantities, prices, dates, margins, deliveries and cash elements as well as times for trading (usually on an exchange).
Let there be a coffee shop called A and a farmer called B. A goes to B to buy coffee at $130 per ton at a specific future date as A believes that the price of coffee will rise due to an increase in worldwide coffee consumption. B believes that price of coffee will drop due to farmers becoming interested in the higher rate returning crop. This then leads to both of them setting out a contract that will protect them. In a way they are hedging the market.
There are two delivery options; physical delivery and cash settlement, the former being less common. These are used mainly in commodities and the delivery takes place at large warehouses situated around the world. A cash settlement is a settlement between two parties; one party called C will pay party D (profit) and C will make a loss when the contract expires. C and D can be used interchangeably.
Just like any financial instrument you can go short or long on future contracts, which enables speculation. These speculators are not looking to offset risk but want to rapidly cash-in on current market prices. In addition, spread-bettors can also benefit by spread betting on futures.
There a few flaws. When you first look at futures, what if the seller does not have enough crops at that particular date due to a natural disaster? Since this is a legally binding contract the seller must give the exact quantity that is stated in the contract and to do this he may have to buy the required quantity from another farmer.
The exchange wants to protect both the buyer and seller and so the buyer and seller must create some margin. This is required to open a long or short position in the market and is calculated for defaults as well (initial and variation margin). You will also need additional money to keep the trade active so if the asset falls in price and falls below the maintenance level, you will need to acquire additional funds to prop it back up to the original margin level (variation margin) This is known as a margin call. You will have the option to terminate the contract or fund the account back to original margin levels. These margin levels vary from exchange to exchange. Also note, that just like any other financial instrument future contracts involve risk and losses can exceed your initial deposit.
CFDs, spread betting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary.
Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.