The futures market is among the most vibrant financial markets, attracting the interest of both retail and institutional investors. Today, market participants use futures contracts for various purposes, including speculating and hedging their portfolios. However, traders and investors need to know what a futures contract is and be aware of all its intricacies to navigate it successfully. This guide will explore how futures contracts work and what you should know when engaging in futures trading. It also tracks the market’s history and closes with some fun facts about futures contracts.
A futures contract is a legal agreement that gives the owner the right and the obligation to buy or sell an underlying asset for a pre-determined price at a particular date. This provides the buyer and the seller with a guarantee that they can lock a trade ahead of time and protect themselves from uncertainty.
Why would someone need that? Here is an example. Let’s say John is a wheat producer. Each season he has to find buyers for his production once it is harvested. On the other side, we have Mike – he owns a bakery. His goal is to avoid supply disruptions by securing his future deliveries ahead of time. By using a futures contract, John and Mike can guarantee a future exchange of a certain amount of the commodity for a particular sum and at a pre-determined date.
This brings both sides the peace of mind that they will get what they want and when they want it. The farmer ensures a stable price and a guarantee that he will sell his production. On the other hand, the buyer secures his delivery and plans his business costs in advance, ensuring an efficient hedge against potential future price swings.
Today, futures contracts are popular among various market participants, including businesses, organizations, retail and institutional investors. Companies from the aviation and shipping industries, for example, can buy futures on oil to ensure a fixed price in advance and avoid potential volatility in the future. On the other hand, retail investors use futures contracts mainly for speculation as they rarely have a genuine intention to acquire the underlying asset.
How do Futures Contracts Work?
Futures contracts can be traded on regulated exchanges and over-the-counter (OTC).
Exchange-traded futures contracts are standardized. This means their characteristics are set in stone. Based on the underlying asset, standardization can specify details like quality, quantity, delivery time, and more.
Each exchange can have its own standardization methodology. The idea of futures standardization is to ensure that contracts’ specifications are identical for all counterparties. That way, the buyer and the seller can easily transfer the contract ownership if needed.
On the other hand, counterpar1ties that trade futures contracts OTC can customize their terms.
It is also worth noting that futures contracts are leveraged. Alternatively, the buyer isn’t required to pay the total amount upfront. Instead, he pays a percentage of the total value of the assets in the futures contract, which is called an initial margin.
Here is an example – let’s say that the current price of the WTI futures is $80. The total present value of the contract is equal to its size (1,000 barrels) multiplied by the current price ($80) or $80,000. The initial margin serves as a deposit so that the buyer doesn’t have to pay the whole amount upfront and usually doesn’t go above 10% – 12% of the contract’s notional or cash value.
A futures transaction can involve several parties. Aside from the buyer and the seller, these also include the exchange that lists the contract for trading, the broker that facilitates the trading, a clearinghouse, etc.
How Do Futures Contracts Mitigate The Counterparty Risks?
The futures markets are regulated by the Commodity Futures Trading Commission (CFTC), a federal agency established in 1974 to ensure fair futures market pricing. The oversight authority keeps a close eye on the market to prevent abusive trading practices and fraud. It also regulates exchanges facilitating futures trading to ensure the integrity of the trading activity.
Exchanges set up principles and standardization requirements that unify and systematize how their products are offered to the market. This helps ensure that each product offering is consistent with other equivalent items in the same class. Alternatively, it guarantees that the derivatives contract will always have the same characteristics, no matter whether you buy it today or in a month.
Thanks to this, investors can enjoy greater liquidity, trade execution efficiency, and clarity in transaction execution so that each counterparty knows what to expect from a trade.
This tight regulation from top to bottom ensures that futures markets are fair, transparent, and resilient.
In contrast, unregulated derivatives markets for exotic instruments have proven to be a hostile environment for their issuers, traders, and the global financial system. For example, the shady activities that have taken place across the market for credit default swaps (CDSs) and collateralized debt obligations (CDOs) triggered the Global Financial Crisis of 2008. The lack of tight regulation proved that even a single default could prove disastrous for the entire market.
Example of Futures Contracts
Let’s look at an example of a futures contract to examine what its specifics and characteristics mean.
Chicago SRW Wheat Futures – Contract Specifications
Contract Unit – specifies how many and what type of units a single futures contract covers. In this case, each wheat futures contract covers a quantity of 5,000 bushels;
Price Quotation – specifies how the price of the futures contract is formed. In this case, it is estimated per bushel;
Trading Hours – the exact days and time slots you can trade the particular contract on the different markets;
Minimum Price Fluctuation – indicates the smallest possible price movement when trading a given contract (a tick) – in this case, $12.50;
Product Code – the codes under which you can find the instrument on the different CME-operated venues;
Listed Contracts – specifies the duration and expiration details of the futures contracts offered on the exchange;
Settlement Method – clarifies whether or not there is a physical delivery of the underlying asset upon expiration;
Termination of Trading – indicates when trading activity for the current contract halts;
Grade and Quality– specifies the quality of physical commodity assets.
How Long Can You Hold a Futures Contract?
While most of the specifics of futures contracts are pretty self-explanatory, many individuals struggle to understand the expiration details. So, let’s focus a bit more on that.
Futures contracts have an expiry date. Alternatively, this is the date the agreement needs to be settled in one way or another.
However, the expiration date doesn’t mean you can’t hold the contract for longer. You can also take an offsetting position or roll the contract over to a future date. Alternatively, these options allow you to extend the contract’s expiration or maturity by closing the initial contract and opening a new longer-term one. It has to be for the same underlying asset at the current market price.
So, in a nutshell, you can hold a futures contract as long as you want if you know how to do it.
All futures contracts expire. As a futures trader, you should know what to do once the expiration date approaches since it influences the outcome of your trades and exit strategy.
Upon expiration, the futures contract has to be settled. There are two ways to do that: cash settlement or physical delivery. Contracts based on commodities like oil, wheat, corn, lumber, or else can be settled through delivery to a physical location. In contrast, contracts on indices or currencies have a cash-only settlement. However, in most cases, the delivery is settled in cash, no matter the underlying asset. In rare cases, physical delivery can happen.
The settlement is conducted and monitored by the exchange and its clearinghouse. In financial settlement cases, the exchange adjusts the trader’s account balance to reflect realized gains or losses. If the settlement is physical, the exchange mandates the production and delivery of the particular commodity from the responsible party as per the original contract’s terms.
How Can You Trade Futures Contracts?
The futures market is centralized. The trading activity happens in a physical location or an exchange, like the CME, for example.
There are two main ways to trade futures contracts as a retail trader. The first one is by trading on an exchange through a broker. That way, you will be able to set up an account and start trading relatively quickly. However, bear in mind that trading alone through a broker is the riskier and more complicated way. You are jumping directly into the “deep water” that the futures market is, and if you don’t have prior experience, you will be risking your capital. Furthermore, most brokers have a minimum capital requirement and might charge you hefty fees. Last but not least, you will require a margin account to be eligible to trade futures contracts.
The other way is through a funded trader program like the Gauntlet Mini™. For a small monthly fee, it offers you an in-depth guided training program with lots of perks. Furthermore, you can complete the program at your own pace and in as little as 15 days. Once you pass the certification exam at the end, you will receive a funded trader offer. The successful completion of the Gauntlet Mini™ will pave the way for a professional futures trading career at a proprietary trading firm. That way, you will be able to trade futures with someone else’s money while receiving 80% of the profits for yourself – zero risk, great rewards!
The futures market is one of the healthiest markets globally. It is highly transparent and offers deep liquidity. It allows retail and institutional investors to trade various assets, including commodities stocks, bonds, indices, currencies, real estate, and more.
Futures markets can serve you well for different purposes. You can trade futures to speculate, hedge, or ensure the physical delivery of commodities of interest.
Furthermore, futures trading is highly regulated, making it a stable market with minimal predatory activity. The standardization of futures contracts on exchanges helps bring transparency and clarity to the trading process.
Futures contracts are also much more straightforward and less risky than other derivatives like options, forwards, synthetic instruments, and more. Check out our comparison of futures and options contracts to find out the differences between both asset classes and why the former is a better choice for beginners.
Who Trades Futures Contracts?
Futures contracts are used mainly by hedgers and speculators. The former engage in futures trading to offset losses from market moves going against their positions. For example, many institutional investors who use futures trading for hedging purposes usually use or produce the underlying asset (e.g., airlines and jet fuel; corn farmers and corn, etc.).
The majority of market participants use futures contracts for speculation. They buy and sell futures contracts to capitalize on their short-term price movements. For example, if a trader buys a futures contract and the underlying asset’s price starts trading above the original contract price at expiration, they have a profit. On the other hand, if the price dives lower than the purchase price specified in the futures contract, upon expiration, the trader will be on the losing side of the trade. And vice-versa if you are a short-seller.
Speculators often trade on margin to magnify their purchasing power. However, margin trading is highly risky, especially if you are a beginner.
Fun Facts About Futures Contracts
Who says futures contracts aren’t fun? Here are some interesting facts that you have probably never heard of:
The CME was originally called the Chicago Butter and Egg Board – by that time, it was always known as an agricultural and livestock exchange that traded mainly eggs, cattle, pork belly and butter;
Lean Hogs were initially called “Live Hogs” – the name of the futures tracking the pork industry was changed to sound more appealing;
The CBOT building was Chicago’s first skyscraper – built in 1885; it also became the first commercial building to use electric lighting;
The statue of Ceres, the goddess of grain, at the top of the CBOT building lacks a face – the reason is that at the time, the builders didn’t think other buildings would ever get high enough to see her closely;
At one time, the CBOT was known for the most millionaires per square foot in the world– this is remarkable considering the immense physical space that used to house thousands of traders;
The first CBOT contract was for 3,000 bushels of corn – it was traded on March 13, 1851, and specified that 3,000 corn bushels had to be delivered to Chicago in June. The price was one cent below the March 13th cash market price;
At the time he came up with the idea of a financial futures contract, Leo Melamed was relatively young andconcerned that his idea would be rejected– he asked Milton Friedman, the Nobel Prize-winning economist, to help him present the idea and secure CME’s board of directors’ approval.
Origin of Futures Contracts
Around 1750 BC, ancient Mesopotamia (present-day Iraq) was under the rule of the sixth Babylonian king, Hammurabi. In history books, he is known for inventing the famous Code of Hammurabi – one of the world’s first written legal codes. The code is famous for its “eye for an eye” and “tooth for a tooth” axioms.
However, its 48th law also helped shape the modern version of derivative contracts (futures included). It mandated the future delivery of goods and assets for a pre-agreed price. The rules of each trade were written down in a contract.
At the time, this made the exchange of goods very transparent and straightforward, paving the way for a lively derivatives market. Ancient Mesopotamians would gather at temples to exchange forward and futures contracts.
Learn more about the Code of Hammurabi and how it shaped modern derivatives markets here.
History of Futures Markets
In one form or another, futures markets have been around for centuries.
Eastern commodity futures markets first arose in England during the 16th century. However, the first modern organized futures exchange started operating in 1730 at the Dojima Rice Exchange in Osaka, Japan. In the United States, the earliest official commodity trading exchange, the Chicago Board of Trade (CBOT), was formed in 1848. The first official commodity trading exchange in England, the London Metals and Market Exchange, was established in 1877.
The common thing between all those exchanges is that they were born out of the necessity of farmers and commodity producers to find buyers for their produce and vice-versa. Due to this, historically, futures exchanges have always appeared in geographically-critical locations like big cities and transportation hubs with well-developed trade and massive concentration of people.