Investors are trading futures to speculate or hedge on the price direction of a security or commodity. In doing so, traders are purchasing a futures contract.
Futures, also known as futures contracts, are defined as derivative financial contract that urges investors to buy or sell an asset at a preset date and price. Hence, the buyer must purchase, or the seller must sell the involved asset at the predetermined price, regardless of the current market price at the expiration date.
These contracts are identified by their expiration months. For instance, a September coffee futures contract expires in September.
There are different types of futures available for trading. It includes commodity futures (crude oil, natural gas, corn, wheat, etc.), stock index futures (S&P 500 index, Nasdaq 100 index, Dow 30 index, etc.), currency futures (EUR, GBP, USD, etc.), precious metal futures (gold and silver), and US Treasury futures for bonds and other financial securities.
Furthermore, traders must note the distinction between American-style and European options. The former gives the holder the right to buy or sell the underlying asset at any time before the contract expires. Meanwhile, the latter only gives the holder the right to exercise at the expiration date.
Moreover, buyers are obligated to take possession of the asset of its financial equivalent at the time of expiration and not any time before. Also, they can sell their position at any time before the expiration date and be free of their obligations. In this way, buyers of both options and futures contracts can benefit from a leverage holder’s position closing the expiration date.
Investors must know several key factors about futures contracts before trading to help them determine their position size and manage risk. These elements include contract size, contract value, and tick size. As an example, the popular E-mini S&P 500 futures contract by the CME will be used below.
Firstly, the contract size is the deliverable quality of the asset that underlies the futures contract. For instance, the E-mini S&P 500 is $50 times the price of the S&P 500 index.
Consequently, the contract value is calculated by simply multiplying the contract size by the current price. For example, an investor holds a single contract of the E-mini S&P 500, and the underlying index is trading at $4,800.000. It means that the contract is equivalent to $240,000.00 ($50 multiplied by $4,800.00).
Subsequently, the tick size is the smallest amount that the futures contracts’ price can fluctuate. For instance, the E-mini S&P 500 has a tick size equal to one-quarter of an index point. Since one index point is equivalent to $50 in the E-mini, one tick is equal to $12.50 ($50 divided by 4).
Futures contract for Speculation
Traders are using a futures contract to speculate on the commodity’s price direction.
If an investor bought a futures contract and the commodity’s price increased and is trading higher than the original contract’s price at the expiration date, then he would make a profit.
Before expiration, the futures contract would be sold at the current price, and the long position made by the investors would be closed.
Then, the difference between the two prices would be settled by cash in the trader’s brokerage account, and there would be no physical product to be changed hands.
Yet, the investor could also lose if the asset’s price traded was lower than the purchase price specified in the futures contract.
Furthermore, speculators could take a short speculative position if they think that the underlying asset’s price would fluctuate.
If it tumbled, the investors needed to take an offsetting position to close the contract. Then, the net difference would be settled at the future expiration date.
The trader would gain profits if the underlying commodity’s price came in below the contract’s cost. However, a loss would take place if the current price was above the contract’s price.
Futures for Hedging
Moreover, futures contracts could be used to hedge the price movement of the underlying asset. The traders’ main aim is to prevent losses from a possible unfavorable price alteration instead of speculating.
Most investors that enter hedges are companies that are producing the commodity.
As an example, corn farmers are using futures to lock in a specific price for selling their crops. In doing so, they are reducing the risk and guaranteeing that they will get the fixed price.
Positively, farmers would have a gain on the hedge to offset losses from selling the maize at the market if the price of the crop plummeted.
Since the gain and loss are offsetting each other, the hedging process of futures locks in an acceptable market price.
The Commodity Futures Trading Commission, or CFTC, is the government agency that regulates the futures markets. It is a federal agency established by Congress in 1974 to fortify the integrity of futures market pricing. Included in its duties is the prevention of abusive trading practices and fraud. Also, it regulates the brokerage companies that are engaged in futures trading.
Advantages and Disadvantages of Futures Trading
Futures are being traded on margin, which allows investors to regulate bigger positions with a little initial payment. However, it could be taken negatively once the asset’s price moves in unintended. Therefore, traders need to be aware that they could lose more than their initial investment when trading futures contracts.
One of the advantages that investors could benefit from is that they could trade futures on everything from stock indexes to orange juice, which helps in providing a diversified portfolio across multiple asset classes.
Futures trading allows investors to take advantage of opportunities 24 hours a day. For instance, an investor would like to go to long futures contracts on the Nasdaq 100 index if several tech giant stocks have reported better than expected earnings after the stock market closes.
Another advantage for investors is that they could use futures trading to safeguard their unrealized profits or minimize possible losses. The broad selection of available futures assets allows traders to take a cost-effective hedge against the wider market or specific sectors and individual commodities.
Lastly, most futures contracts contain an expiration date that investors need to monitor. As the contract approaches its expiry, its price may swiftly lose value or even become worthless. To counter this, traders often roll forward their futures contracts to a longer-dated one as the expiry date comes nearer.