What is futures trading?

Futures are contracts to buy or sell a specific underlying asset at a specified price on a future date. The underlying asset can be a commodity, security or other financial instrument. Futures trading requires a buyer to purchase the underlying asset at a set price on the expiration date, or a seller to sell the underlying asset at a set price, regardless of market prices.

Futures trading generally refers to futures where the underlying asset is a security in the stock market. The value of these contracts is based on the future value of individual company shares or a stock market index such as the S&P 500, Dow Jones Industrial Average or Nasdaq. [1] Futures trading on an exchange like the Chicago Mercantile Exchange can include underlying “assets” such as physical commodities, bonds, or weather events. [2]

Key Points

• Futures are derivatives, which are financial contracts whose value is derived from changes in the price of an underlying asset.
• Stock market futures trading obliges the buyer to buy a stock or group of stocks at a predetermined future date and price, and the seller to sell.
• Futures contracts hedge against price fluctuations in a company's stock, a group of stocks, or an index to help protect against losses due to adverse price changes.

Basic assets

Futures traders can lock in the price of the underlying asset. These contracts have an expiration date and a known fixed price. Stock futures have specific expiration dates, organized by month. The underlying assets of a futures contract may include: 3

• Commodity futures based on physical commodities such as crude oil, natural gas, corn and wheat
• Cryptocurrency futures based on the volatility of assets such as Bitcoin or Ethereum
• Currency futures including EUR and GBP
• Energy futures including crude oil, natural gas, gasoline and heating oil
• Stock futures based on stocks traded in the market and their group
• Interest rate futures to speculate on or hedge against future changes in interest rates on Treasury bonds and other bonds
• Precious metal futures for gold and silver
• Stock index futures based on the S&P 500 Index and other underlying assets

Important Note: The buyer of a futures contract must acquire the underlying stock or shares at expiration, not before expiration. Buyers of futures contracts can sell their positions before expiration. There is a difference between options and futures. American options give the holder the right, but not the obligation, to buy or sell the underlying asset at any time before the contract's expiration date. [4]

How futures trading works

Futures contracts are standardized in terms of quantity, quality and asset delivery, which makes trading on futures exchanges possible. They force buyers to purchase a stock or shares in an index on a predetermined date and price. [5] This ensures market transparency, enhances liquidity and contributes to accurate price formation.

Stock futures have specific expiration dates, organized on a monthly basis. For example, futures on major indices such as the S&P 500 may expire in March, June, September and December. [6] The contract that has recently expired is called the "front month contract" and typically has the most trading activity. As a contract approaches expiration, traders who want to maintain their positions often roll over to the next available contract month. Short-term traders will typically focus on front-month contracts, while long-term investors may focus on contracts that are further out. [1]

For example, when trading S&P 500 futures, a trader can purchase a futures contract agreeing to buy shares in the index at a set price six months from now. If the index rises, the futures contract will increase in value and traders can sell the contract at a profit before expiration. Selling futures is the exact opposite process. If a trader believes a stock will fall and sells a futures contract, and the market falls as expected, the trader can profit by buying back the contract at a lower price.

TIP: When settling a futures contract, the exact method depends on the asset. Physical delivery is the standard for commodities like oil, gold or wheat. However, for futures contracts based on stocks and stock indices, the settlement method is cash. [1]

Speculation

Futures contracts allow traders to speculate on commodity prices. A trader will make a profit if he purchases a futures contract and the price at expiration is higher than the original contract price. However, traders can also lose money if the commodity price falls below the purchase price specified in the futures contract. Before expiration, a futures contract - a long position - can be sold at the current price, thereby closing the position.

Investors can also take short speculative positions if they predict prices will fall. If the price falls, traders will take hedging positions to close their positions. The net difference will be settled at contract expiry. If the price of the underlying asset is lower than the contract price, the investor makes a profit; if the current price is higher than the contract price, the investor loses.

Suppose a trader selects a futures contract on the S&P 500. The index is 5,000 points and the delivery time of the futures contract is three months. Each contract is $50 at the index level, so one contract is worth$250,000 (5,000 points × $50). Without using leverage, a trader would need$250,000. In futures trading, traders only need to provide margin, which is a portion of the total value of the contract. [7] If the initial margin is 10% of the contract value, a trader only needs to deposit $25,000 (10$250,000) to enter a futures contract. If the index falls 10% to 4,500 points, the value of the futures contract will drop to $225,000 (4,500 points ×$50). The trader faces a loss of $25,000, which is equivalent to a 100% loss of the initial margin.

Hedge

Futures trading provides a hedge against price fluctuations in the underlying asset. [2] The goal is to protect against losses due to adverse price changes, not to speculate. Let's say a mutual fund manager is responsible for a $100 million portfolio that tracks the S&P 500. Given potential short-term market volatility, fund managers use S&P 500 futures contracts to hedge their portfolios against possible market declines.

Assuming the S&P 500 is at 5,000 points, each S&P 500 futures contract is based on the index multiplied by a multiplier, such as 250 per index point. Since the portfolio is similar to the S&P 500, the hedge ratio is assumed to be "one to one." The value of one futures contract hedge is 5,000 points × 250 = $1,250,000. To hedge a$100 million portfolio, the number of futures contracts required is the ratio of the portfolio value to the hedge value of each contract: $100,000,000 /$1,250,000 = approximately 80. Therefore, selling 80 futures contracts should effectively hedge the portfolio, with two possible outcomes:

• A 10% drop in the S&P 500 to 4,500 points in three months means the portfolio could lose about 10% of its value, or $10million\mathrm{.}However,thefuturescontractssoldbythefundmanagerwillincreaseinvalue,offsettingthisloss\mathrm{.}Theprofitpercontractis5,000-4,500po$125,000 = $10,000,000. This gain will effectively offset losses in the portfolio, protecting it from market downturns.
• The S&P 500 rose in three months. This means that the value of the portfolio will increase, but losses on the futures position will offset this gain. This is acceptable in this case because the main goal is to hedge downside risk.

Advantages and Disadvantages of Futures Trading

There are pros and cons to futures trading. Futures trading often involves leverage, and brokers require an initial margin, which is a small percentage of the contract's value. The amount depends on the contract size, the investor’s credit profile and the broker’s terms and conditions.

Futures contracts can be an important tool for hedging against price fluctuations. Companies can plan their budgets and protect potential profits against adverse price changes. However, futures contracts also have disadvantages. Due to the leverage used, investors face the risk of losing more than their initial deposit.

Advantages

• Potential speculative gains
• Effective hedging function
• Convenient transactions

Disadvantages

• Higher risk due to leverage
• Missing out on gains from price fluctuations when hedging
• Margin is a double-edged sword

Regulation of Futures: The futures market is regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency established by Congress in 1974. It is responsible for ensuring the price integrity of the futures market, including preventing abusive trading practices, fraud, and supervising brokerage companies involved in futures trading. [8]

Why choose to trade futures instead of stocks?

The benefit of trading futures instead of stocks is the high leverage, allowing investors to control an asset with a small amount of money. This also brings higher risks. Additionally, futures markets are nearly always open, providing the flexibility to trade outside of traditional market hours and respond quickly to global events.

Which is more profitable, futures or options?

The profitability of futures and options depends largely on the investor's strategy and risk tolerance. Futures tend to offer higher leverage and can be more profitable when predictions are correct, but they also come with higher risks. Options provide the security of a non-binding contract, limiting potential losses.

What happens if an investor holds a futures contract until expiration?

When stocks are the underlying asset, traders who hold a futures contract until expiration settle their positions in cash. Depending on the rise or fall of the underlying asset during the holding period, traders will pay or receive a cash settlement. However, in some cases, futures contracts require physical delivery. In this case, investors who hold the contract until expiry will receive the underlying asset.

Summary

As an investment vehicle, futures contracts provide opportunities for price speculation and risk hedging against potential market downside risks. However, they also have some disadvantages. Taking opposite positions when hedging may result in additional losses if market forecasts are inaccurate. Additionally, the daily settlement of futures prices introduces volatility such that the value of an investment can change significantly from one trading session to another.

References

[1] Jack D. Schwager and Mark Etzkorn. "A Complete Guide to the Futures Market: Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads, and Trading Principles." John Wiley & Sons, 2019. Chapter 1.

[2] Commodity Futures Trading Commission. "Basics of Futures Trading."

[3] CME Group. "CME Group All Products – Codes and Slate."

[4] CME Group. "Understanding the Difference: European vs. American Style Options."

[5] Charles Schwab. "The Basics of Trading Futures Contracts."

[6] CME Group. "S&P 500 Futures and Options on Futures."

[7] CME Group. "The Power of Leverage."

[8] Commodity Futures Trading Commission. "History of the CFTC."

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