Futures
Futures are derivative financial instruments that allow market participants to obtain assets at a predetermined price and date. The seller vends reference assets according to the price agreed in advance, which means a current market value is not relevant on the exercise date. At the same time, the buyer is also obliged to comply with the terms of such an agreement.
The basis of reference assets are tangible goods and other financial facilities. Thereby the futures contracts specify the quantity of reference assets. They have a standard look in order to simplify a trading process. Futures can be taken for hedging and speculating operations.
Findings:
- Futures are financial contracts with obligations for both sides: for buyer - to obtain the assets, and for seller - to negotiate them on the predetermined date in future but for the price derived from past.
- Security papers, goods and financial facilities can be called a basis for investor’s speculating operations.
- Hedging the price movement of reference assets in futures contracts allows avoiding adverse price fluctuations.
Essence of Futures
Actually, thanks to these contracts, the price of a reference asset or item is fixed. As a result, their validity period is also specified. The expiration month helps to separate this kind of contract from others. For instance, a Sonia futures contract expires in a month.
Investors and traders understand “futures” as a general asset class. Although there are many other types of futures contracts available for transaction operations:
- commodity futures (crude oil, wheat, natural gas and corn);
- stock index futures (Standard & Poor's 500 Index);
- currency futures (containing the British pound and the euro);
- futures on precious metals - gold, silver;
- U.S. Treasury futures for bonds and other products.
Nevertheless, it is necessary to draw a line between the terms “options” and “futures”. The right to sell or to buy reference assets even before their exercise date is only given with American options. European ones can be traded just right after their expiration.
On the contrary, the futures buyer is laid under the obligation to acquire the reference asset or its monetary value not before the predetermined exercise date. However, the purchaser is able to vend his asset regardless of the time, i.e. be released from liabilities. The summary is the following: buyers of futures and options contracts make profit by closing the leverage status before the exercise date.
Benefits and implications:
+ Futures exertion is possible for investors to capitalize on the price movement of reference assets.
+ Hedging opportunities on raw materials and products are presented for the companies to protect against price fluctuations.
+ Deposit equaling to a broker’s fraction of the whole price is needed for futures contract.
– Risk emergence for brokers is created taking into account the fact that margin trading is involved.
– Futures contracts go along with a peril of losing an advantageous price development.
– Margin has the reverse side of the coin: profits rise as well as trade losses.
Futures exertion
Futures exchange market tends to take into account high margin trading. So that obligatory paying 100% of the contract cost isn’t required during trading accedence. The broker would take a substitution in the amount of initial margin that is made of the agreement price part.
Notice: A price of futures contact, investor’s credibility and broker’s conditions are key components for pricing the margin account.
The proportioning, whether the agreement is for physical settlement or may be paid by cash, will take place on the stock exchange. Physical settlement can be carried out if the company needs to fix the required item price. On the other hand, lots of agreements are speculated by traders. That’s the reason for their shutting down or substituting, which means a variance between the initial transaction and its closing price. In that case, the payment should be provided in cash.
Futures for speculative trading. Owning a future assists traders in proceeding speculative operations on item pricing. In case a trader acquires futures and the price has gone up before exercise date, then they gain a profit. The contract, that is considered a long position, would be sold at the actual price.
Price margin would be refunded by cash in the brokerage account, so no physical item would circulate. Anyway, a trader is able to lose if an item price is lower than the purchasing cost.
Opening a short position happens in case of reference asset declining. During the lowering process, a trader establishes an offsetting transaction to terminate the agreement. A contract exercise date would regulate a net difference. In other words, the profit-making is possible when the reference asset price was lower than the agreement cost. The converse is also true.
Let’s picture the following. A trader has an account balance equaling $3,000 and an $80,000 crude oil position. Damages will be incurred in case of the oil price falling. There would be the greater losses, surpassing a $3,000 of initial margin. So a broker has to execute a margin call in order to cover additional expenses.
Futures for hedging. Hedging of reference asset prices can be accomplished with futures contracts. The aim is to avoid damages from unwanted price fluctuations and not to just speculate. Therefore, a majority of corporations prefer to use reference assets in the hedging process.
For instance, wheat farmers involve futures to fix the current price of their harvest. The risks are reduced to zero and profit-making is insured under any circumstances. Resulting from this approach, hedging can be the favorable instrument to establish an affordable price on the market.
Futures control. Commodity Futures Trading Commission (CFTC) administers futures exchange. The agency was created in 1974 to regulate transactions in the commodities purchase/sale and to protect participants from unfair trading and fraud.
Futures example
A trader’s goal is to profit from crude oil prices. Futures agreement is signed in May, anticipating the rise by year-end. In December the contract costs $50 which contributes to the trader's decision to acquire.
As oil is sold in increments of 1,000 barrels, the trader has a contract worth $50,000. But the whole amount is not required, the investor needs to pay the initial margin.
Meanwhile, the price goes up and down, as well as the cost of the contract. As a result, additional funds may be charged from the margin account. The name of this phenomenon is maintenance margin.
On the exercise date, December’s cost of crude oil reached $65. A trader vends a contract and the net difference is paid by cash. So that the profit amounts to $15,000, meaning $65 - $50 = $15 x 1000 = $15,000.
Price drop to $40 results in profits loss of $10,000, respectively.
Purpose of futures contracts
Futures contracts can be called an investment instrument that help traders to put a stake on the cost of an item or a security in the future. There are lots of different futures contracts open to the community. They include reference assets, for instance, oil, stock market index, currency and farm products.
Futures agreements market on established exchanges, and are runned by the CME Group Inc. (CME). Such contracts are into play by traders willing to profit from price fluctuations and mostly by commerce clients who are keen on hedging the risks.
Futures as a derivative tool
Futures are called derivatives as their pricing policy has grounds on reference cost assets. Being a financial instrument, futures imply borrowing costs which, as the time is extended, anticipate profits or damages. So, the underlined tool is regarded as a developed trading vehicle for sophisticated investors and enterprises.
Possessing futures until the exercise date
Having futures until the exercise date means paying a trader's position by cash. Putting the matter another way, regardless of growth or decline of the reference asset, a trader would make profit or discharge a cost difference.
Sometimes physical settlement is needed for the futures agreement. In that case, an investor, who possesses a contact until the exercise date, will obtain a reference asset. Their obligations will include item storage, cargo-handling operations and insurance.
