Futures Definition, Participants, Trading Mechanics, and Types

These two types of derivatives contract function in much the same way, but the main difference is that futures are exchange-traded and have standardized contract specifications. These exchanges are highly regulated and provide transparent contract and pricing data. Forwards, in contrast, trade over the counter (OTC) with terms and contract specifications customized by the two parties involved.

Only experienced investors who aren’t risk-averse should consider trading futures. Moreover, futures trading isn’t ideal for retirement savings or investors who prefer the buy-and-hold strategy. The Futures Industry Association (FIA) estimates that 6.97 billion futures contracts were traded in 2007, an increase of nearly 32% over the 2006 figure.

For stocks, short selling usually has higher margin requirements than long positions. But with futures, the margin requirement is the same for both long and short positions. This means that the investor can risk less of their cash on hand for short-selling positions with futures than with stocks. Today, futures are usually electronically traded and most often used by speculative traders who want to hedge against inflation risk. Products such as energies, stock market indexes, and traditional investments are now available as futures contracts. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure the performance of the term of the contract.

Futures are contracts where two parties agree to exchange a specific quantity of a commodity or other underlying asset for a predetermined price at a future time. These contracts were initially created to help businesses navigate unexpected costs. Futures markets enable parties to hedge, speculate, or perform price discovery and delivery all through a standardized mechanism. Those participating in the futures market range from producers and consumers managing risk to speculators and firms placing sophisticated bets. Futures can be traded before the expiration date, as the investors are only obligated to buy or sell by the set expiration date. Typically, traders close out their positions prior to the expiration date based on potential profit or limit losses.

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We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own. Their activities promote price efficiency by ensuring that prices in different markets remain aligned. Arbitrageurs are participants who look for price discrepancies between markets or related products.

Exchanges

1. Futures contracts detail the asset quality, quantity, delivery timeline, and other specifications to aid trading.
2. Futures and stock trading have certain things in common, but the former has additional considerations like leverage and also expiry dates.
3. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires.
4. Therefore, if someone wanted to lock in a price (selling or buying) on 100,000 barrels of oil, they would need to buy/sell 100 contracts.

Although futures contracts are oriented towards a future time point, their main purpose is to mitigate the risk of default by either party in the intervening period. In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. Future contracts are priced based on the current market price of the underlying asset, called the spot price, plus the expected volatility, cost of carry, and interest rates. Futures prices can also be affected by the commodity type, such as the price for commodity futures versus futures for interest-bearing assets. When the deliverable asset exists in plentiful supply or may be freely created, then the price of a futures contract is determined via arbitrage arguments.

The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. The index is 5,000 points, and the futures contract is for delivery in three months. Each contract is $50 times the index level, so one is worth $250k (5,000 points × $50).

If you can’t maintain it, your broker may force you to liquidate at a loss. Futures contracts can be traced back to the 17th century when they began as an informal arrangement between merchants and farmers to lock prices for future crop deliveries. These agreements offered both parties protection against price fluctuations. Eventually, how to become an database administrator this led to the first organized futures exchange in 1710 in Osaka, Japan, to facilitate rice trading. Futures contracts are critical for businesses dependent on certain input goods.

Exchange for Related Position

Finally, the CFTC, like any government agency, is subject to lobbying and political pressure, and regulators often face pushback from industry players who chafe at many regulations meant to protect investors and consumers. The CFTC, an independent federal agency, is the U.S.’s primary regulator for futures trading. The CFTC establishes rules, monitors market activity, and enforces regulations to prevent manipulation and ensure a fair and transparent marketplace.

Fast forward to the 19th century, the rise of agricultural hubs in the US fueled the development of formal futures markets. Cities like Chicago became centers for agricultural trade, and the Chicago Board of Trade (CBOT) emerged in 1848 to trade corn, wheat, and other grains. If a position involves an exchange-traded product, the amount or percentage of the initial margin is set by the exchange concerned. The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1,000).

The reverse, where the price of a commodity for future delivery is lower than the expected spot price is known as backwardation. Similarly, markets are said to be inverted when futures prices are below the current spot price and far-dated futures are priced below near-dated futures. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. The futures markets are regulated by the Commodity Futures Trading Commission (CFTC).

They may use futures contracts to lock in a price they will sell at, and volatile trading strategies for the options market then deliver the oil to the buyer when the futures contract expires. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

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Before expiration, the futures contract—the long position—can be sold at the current price, closing the long position. A futures contract is similar to a forwards contract, where a buyer and seller agree to set a price and quantity of a product for delivery at a later how to buy stocks without a broker date. Since many commodity prices tend to move in predictable patterns, it is possible to make a profit by trading futures, even if one does not have a direct interest in the underlying commodity. Traders and fund managers use futures to bet on the price of the underlying asset.

This is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). In this scenario, there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts.

One more aspect of futures trading that might attract interested parties is the fact that these contracts make use of leverage, which can potentially amplify returns. However, investors should keep in mind that harnessing leverage can also increase potential losses. This aspect differentiates futures from options, since an options contract gives the holder the right, but not the obligation, to purchase an underlying asset at a set price during a predetermined time frame. A 2024 analysis by CFTC economists found that typical retail futures traders only execute a handful of total trades spanning a few days each. The researchers also found that retail traders often go against market momentum, entering long positions when prices have recently fallen or going short after upward runs.